Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Principal Issues: How must a Canadian investor report a distribution from a foreign mutual fund that arose from capital gains realized by the fund?
Position: It will depend upon the categorization of the fund for Canadian tax purposes. If it is a trust, it will be income of the beneficiary from a property that is an interest in the trust. If it is a corporation, it will be included in income as a dividend.
Reasons: The capital gain flow-through provisions in 104(21) and 131(1) of the Act will not apply.
QUESTION #12 - FOREIGN MUTUAL FUNDS
A taxpayer holds an interest in a foreign mutual fund, which is legally constituted as one of the following:
i) A foreign trust;
ii) A foreign corporation; or
iii) A US LLC.
No Canadian reporting is available, and no Canadian reporting slips are provided. Foreign reporting slips disclose that substantial capital gains were realized and distributed to the investors, including the Canadian investor.
Our question relates to how the Canadian investor is to report the income resulting in the mutual fund, and the distribution from the mutual fund.
For this purpose, it is assumed that section 94.1 is not applicable.
Our analysis indicates that there is no provision for capital gains of a foreign entity described above to be "flowed through" to a Canadian resident, and that the treatment of the distribution will depend on the nature of the entity itself. If the entity is a foreign trust, it would appear that the amount of the distribution would be considered income of a trust under subsection 104(13), and would be fully taxed, even though the source of the income is a capital gain. We reached this conclusion on the basis that the flow-through provisions dealing with the income of a trust apply only in the context of a trust which is Canadian resident and do not apply to a foreign trust. Alternatively, if the foreign mutual fund is constituted as a foreign corporation, including a US LLC, it seems that the amount should be reported as a dividend, which would be fully taxable, again because there is no provision which would allow a flow-through of the capital gain.
We ask that you confirm our understanding of this matter.
CRA Response
In order to determine how income from a foreign mutual fund is to be reported for Canadian tax purposes, one must determine what the fund qualifies as for Canadian tax purposes. It will be a question of fact whether, for example, a particular foreign fund constitutes a corporation or a trust for Canadian tax purposes.
As the CRA has previously stated, we generally employ a two-step approach in determining the status of a foreign entity for Canadian tax purposes:
1. the first step involves determining the characteristics of the foreign business association under the foreign commercial law; and then
2. the characteristics identified are then compared with those of recognized categories of business associations under the commercial law in order to classify the foreign business association under one of those categories.
The classification of the foreign entity will then determine the tax treatment of the distribution to the Canadian investor. There are limited provisions in the Income Tax Act that allow for the "flow through" of capital gains realized by an entity to the investors that hold an interest in the entity.
In general, subsection 104(21) allows a trust that is resident in Canada throughout its taxation year to designate its net taxable capital gains to its beneficiaries, where the conditions outlined therein are met. Where such designation is validly made, the amount designated is deemed for purposes of section 3 and 111 (with certain exceptions) to be a taxable capital gain of the beneficiary from the disposition of capital property.
No such provision exists in the Act for a trust that does not meet the residency requirement in 104(21). If a US mutual fund is a trust for Canadian tax purposes, paragraph 108(5)(a) will deem the distribution from the fund to be income of the beneficiary from a property that is an interest in the trust. Thus, there is no flow-through of the gains to the beneficiaries for Canadian tax purposes.
If a US mutual fund is a corporation for Canadian tax purposes, it will not qualify as a "mutual fund corporation", as defined in subsection 131(8) of the Act. Thus, it cannot elect pursuant to subsection 131(1) to flow through a capital gains dividend to a Canadian shareholder, as the election is available only to a corporation that is a Canadian mutual fund corporation throughout the taxation year.
The capital gains distribution from such a fund will be included in the Canadian shareholder's income as a dividend, in accordance with paragraph 12(1)(k) and section 90.
Phil Kohnen
June 2-3, 2011
2011-040526
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