A less inspiring sign of winter’s wane is that Canadian income and royalty trusts are beginning to issue guidance on the US treatment of their respective distributions to US-based unitholders–tax season is upon us, too.

As we did for the 2005, 2006 and 2007 tax years, we’re compiling links to the various statements issued by trusts on the status of their distributions to US unitholders. We’ll update the Links to US Tax Statements table in the Income Trust Tax Guide on a rolling basis as they become available.

Pay particular attention to statements issued by trusts you own that acquired, were acquired or converted during 2008. You may have to refer back to prior statements detailing plans of arrangement; this is where you find transaction details. Make sure the numbers in the respective plans of arrangement are mirrored in your brokerage statements.

Here’s a summary of how to deal the IRS with respect to your income and royalty trust distributions.

The 2003 US Jobs and Growth Tax Relief Reconciliation Act (2003 Act) lowered the US income tax rate on the receipt of qualifying dividends. The 2003 Act effectively reduces the tax rate on qualified dividend income by treating such dividends as net capital gains; it also reduced net capital gains on individuals from 20 percent to 15 percent. For 2008, the 5 percent rate on qualified dividends and capital gains, for whom that rate is applicable, has been reduced to zero.

As of Jan. 1, 2005, Canada is now withholding a flat 15 percent from distributions made to US-based Canadian income and royalty trust unitholders, regardless of whether the distributions are paid in respect to units held in a tax-advantaged account.

The IRS has provided guidance that they contemplate there will be situations where intermediaries may be required to report distributions as ordinary dividends on Form 1099-DIV although the US taxpayer may be entitled to (and, therefore, should) report the distributions as qualified dividends. Based on this IRS guidance, the Form 1099-DIV reporting does not control how the taxpayer is entitled to report distributions.

Review 1099s carefully and check the Web sites of the respective trusts for a statement on the US tax status of their distributions. (CE has provided links to statements issued by income trusts in its coverage universe in the Tax Guide.)

If there’s no statement, contact the investor relations (IR) representative of the particular income trust via e-mail or phone. If the Web statement or your contact with IR reveals the trust believes its distributions to be qualified–it’s best to get it in writing–give this information to your broker.

The best source of information–as indicated by the willingness of the IRS to rely on the tax-status interpretation of the trusts–is the particular trust. And we’ve heard many stories of CE subscribers successfully dealing with their brokerage firms on this issue.

And it makes a lot of sense to use the Qualified Dividends and Capital Gain Tax Worksheet of Form 1040 to determine the amount of tax that may be applicable.

The bottom line is this: The IRS will waive penalties with respect to reporting of payments if persons required to file Form 1099-DIV make a good faith effort to report payments consistent with the rules summarized above and described in detail in Notice 2003-79. Report a distribution in Box 1b as a qualified dividend even if the distribution doesn’t satisfy these simplified information reporting procedures. A recipient of Form 1099-DIV may treat amounts reported in Box 1b as qualified dividends, unless and to the extent the recipient knows or has reason to know that such amounts aren’t qualified dividends.

Fundamentals

The portion of the distributions treated as “qualified dividends” should be reported on Line 9b of Form 1040, unless your fact situation dictates otherwise. Commentary on p. 219 of the Form 1040 Instruction Booklet for 2008 with respect to “qualified dividends” describes hypothetical individual situations where the dividends would not be “qualified dividends.”

For example, dividends you received in respect of trust units you held for less than 61 days during the 121-day period that began 60 days before the ex-dividend date are not qualified. (The ex-dividend date is the first date following the declaration of a dividend on which the purchaser of a stock isn’t entitled to receive the next dividend payment. When counting the number of days you held your trust units, include the day you sold, but not the day you bought.)

Where, due to individual situations, the dividends are not “qualified dividends,” the amount should be reported on Schedule B, Part II, Ordinary Dividends and Line 9a of Form 1040.

For US federal income tax purposes, in reporting a return of capital with respect to distributions received, US unitholders are required to reduce the cost base of their trust units by the total amount of distributions received that represent a return of capital. This amount is non-taxable if it is a return of cost base in the trust units. If the full amount of the cost base has been recovered, any further return of capital distributions should be reported as capital gains.

The full amount of the distribution paid to a non-resident of Canada is subject to a minimum 15 percent Canadian withholding tax that is withheld prior to any payments being distributed to unitholders. Where trust units are held outside a qualified retirement account, the full amount of all withholding tax should be creditable, subject to limitations, for US tax purposes in the year in which the withholding taxes are withheld.

Where trust units are held in qualified retirement account, the same withholding taxes apply but the amount is not creditable for US tax purposes.

The amount of Canadian tax withheld should be reported on Form 1116, Foreign Tax Credit (Individual, Estate, or Trust). Information regarding the amount of Canadian tax withheld in 2008 should be determined from your own records. Amounts over withheld, if any, from Canada should be claimed as a refund from the Canada Revenue Agency no later than two years after the calendar year in which the payment was paid.

Investors should report their dividend income and capital gain (if any), and make adjustments to their tax basis in accordance with this information and subject to advice from their tax advisors. US individual unitholders who hold trust units through a stockbroker or other intermediary should receive tax reporting information from their stockbroker or other intermediary. Your stockbroker or other intermediary will issue a Form 1099–DIV, “Dividends and Distributions,” or a substitute form developed by the stockbroker or other intermediary.

For trust units held within a qualified retirement plan, such as an IRA, no amounts are required to be reported on a Form 1040.

Conversion Issues

On July 14, 2008, Canada’s Department of Finance released draft legislation that will facilitate the conversion of what it termed Specified Investment Flow-Through entities (SIFT) in the Tax Fairness Plan into corporations on a basis that will be tax free for Canadian purposes.

The Jan. 27 federal budget confirmed the government’s commitment to, among other initiatives, the Nov. 28, 2008 Notice of Ways and Means Motion. This motion included a number of tax measures including rules relating to the conversion of SIFTs to corporations and clarification of existing SIFT taxation rules

The draft legislation contemplates two alternative mechanisms for converting. Under the first method, SIFT unitholders would transfer their SIFT units to a taxable Canadian corporation in exchange for shares of the corporation. Under the second alternative, the SIFT would restructure so that its only asset is a taxable corporate subsidiary (to which the SIFT has transferred any assets previously owned directly by the SIFT), and the SIFT would then liquidate and distribute to the SIFT’s shareholders the shares of the taxable corporation.

Most conversions so far announced have opted for the first alternative.

The US income tax consequences of a conversion for US-based unitholders depend in the first instance on the entity classification of the SIFT. Although it’s possible for a SIFT to elect to be treated as a partnership for US tax purposes, most income trusts are treated as corporations, and that will be the assumption here.

If a SIFT is treated as a corporation for US tax purposes, it may be a passive foreign investment company (PFIC) which would be highly undesirable for US unitholders. Most energy-related income trusts, for example, are able to avoid PFIC classification, and again we assume here that the SIFT isn’t a PFIC.

In general, a SIFT conversion, structured as an exchange of trust units for shares of a new corporation should qualify as a tax-free transaction for US tax purposes. However, a conversion by means of a distribution of shares may run a risk of being considered a taxable liquidation.

Of course, if a unitholder has a tax loss (i.e., the value of the units is below his or her adjusted tax basis), then it might be the IRS arguing that the conversion qualifies as a tax-free exchange, in order to deny the unitholder a tax deduction. Alternatively, the IRS may be able to argue, even if the transaction doesn’t qualify as a tax-free reorganization, that a tax loss shouldn’t be allowed under US “wash sale” rules.

Procedural Background

The 2003 Act was enacted on May 28, 2003. Subject to certain limitations, the 2003 Act generally provides that a dividend paid to an individual shareholder from either a domestic corporation or a “qualified foreign corporation” is subject to tax at the reduced rates applicable to certain capital gains.

A qualified foreign corporation includes certain foreign corporations that are eligible for benefits of a comprehensive income tax treaty with the US, which the secretary determines is satisfactory for purposes of this provision and that includes an exchange of information program. In addition, a foreign corporation not otherwise treated as a qualified foreign corporation is so treated with respect to any dividend it pays if the stock with respect to which it pays such dividend is readily tradable on an established securities market in the US.

The 2003 Act excluded from the definition of qualified foreign corporation any foreign corporation which for the taxable year of the corporation in which the dividend was paid, or the preceding taxable year, was a foreign personal holding company, a foreign investment company, or a passive foreign investment company. Effective for taxable years of foreign corporations beginning after Dec. 31, 2004, the American Jobs Creation Act (the AJCA) repealed the rules applicable to foreign personal holding companies and foreign investment companies from the Internal Revenue Code (IRC).

IRS Notice 2003-79

In November 2003, the Treasury Dept and the IRS issued Notice 2003-79, which provided guidance for persons required to make returns and provide statements under section 6042 of the IRC–Form 1099-DIV–regarding distributions made in 2003 with respect to securities issued by a foreign corporation, and for individuals receiving such statements. Notice 2003-79 identified a series of separate determinations that must be made in order to determine whether a distribution with respect to a security issued by a foreign corporation is eligible for the reduced rates of tax under the 2003 Act.

Notice 2003-79 provided simplified procedures to be used for 2003 information reporting of a distribution with respect to such a security. It also provided guidance regarding the determination as to whether a security (or an American depositary receipt in respect of such security) issued by a foreign corporation other than ordinary or common stock (such as preferred stock) is considered readily tradable on an established securities market in the US for purposes of the 2003 Act.

IRS Notice 2004-71

In November 2004, the Treasury Dept and IRS issued Notice 2004-71, which provided guidance for persons required to make returns and provide statements under section 6042 of the IRC regarding distributions made in 2004 with respect to securities issued by a foreign corporation, and for individuals receiving such statements. Notice 2004-71 generally provided that the simplified procedures and other rules contained in Notice 2003-79 were extended to apply for 2004 information reporting of distributions with respect to securities issued by foreign corporations.

IRS Notice 2006-3

The Treasury Dept and IRS have extended the simplified procedures provided in Notice 2003-79 and Notice 2004-71, with respect to tax years 2003 and 2004, to 2005 and future years with appropriate modifications to take into account the changes enacted by the AJCA.

The rules for 2003 information reporting of a distribution with respect to a security issued by a foreign corporation will continue to apply for 2005. However, in order to account for the amendments enacted by the AJCA, for 2006 and future years the foreign investment company exclusion test shall be applied without regard to whether the foreign corporation is or was a foreign personal holding company or a foreign investment company.

A person required to make a return under section 6042 shall report a distribution with respect to such a security in Box 1b of Form 1099-DIV as a qualified dividend if: either the security with respect to which the distribution is made is a common or an ordinary share, or a public SEC filing contains a statement that the security will be, should be or more likely than not will be treated as equity rather than debt for US federal income tax purposes; and either the security is considered “readily tradable on an established securities market in the US;” the foreign corporation is organized in a possession of the US; or the foreign corporation is organized in a country whose income tax treaty with the US is comprehensive, is satisfactory to the Secretary for purposes of section 1(h)(11), and includes an exchange of information program, and if the relevant treaty contains a limitation on benefits provision, the corporation’s common or ordinary stock is listed on an exchange covered by that limitation on benefits provision’s public trading test, unless the person required to file an information return knows or has reason to know that the corporation isn’t eligible for benefits under that treaty; and the person required to file Form 1099-DIV doesn’t know or have reason to know that the foreign corporation is or expects to be, in the taxable year of the corporation in which the dividend was paid, or was, in the preceding taxable year, a foreign personal holding company, a foreign investment company, or a passive foreign investment company; and the person required to make a return under section 6042 determines that the owner of the distribution has satisfied the holding period requirement of section 1(h)(11) or it is impractical for such person to make such determination.

Generally, only those Canadian income trusts listed on a US exchange or traded over-the-counter in the US must file 1099s, and only for their directly registered US unitholders. Because income trust units are not considered common or ordinary shares, Canadian trust unit issuers must have a public filing containing a statement that the security is properly characterized as equity rather than debt for US tax purposes. Some of these trusts will be considered readily tradable in the US, others won’t, but those that aren’t will qualify based on the US-Canada convention on taxation.

The IRS will exercise its authority under section 6724(a) of the IRC to waive penalties under sections 6721 and 6722 with respect to reporting of payments if persons required to file Form 1099-DIV make a good faith effort to report payments consistent with the rules summarized above and described in detail in Notice 2003-79. A person required to make a return under section 6042 may report a distribution in Box 1b as a qualified dividend even if the distribution doesn’t satisfy these simplified information reporting procedures, subject to the applicable penalty provisions, as described in Notice 2003-79.

A recipient of Form 1099-DIV may treat amounts reported in Box 1b as qualified dividends, unless and to the extent the recipient knows or has reason to know that such amounts are not qualified dividends, as described in detail in Notice 2003-79.