Editor’s Note: The information below isn’t exhaustive of all possible US income tax considerations nor is it intended to provide legal or tax advice to any particular holder or potential holder of Canadian income or royalty trust units. Holders or potential holders of Canadian income or royalty trust units or common stock of Canada-based corporations should consult their own competent legal and tax advisers as to their particular tax consequences of holding Canadian income or royalty trust units or common stock issued by Canada-based corporations and the most beneficial way of reporting the distributions or dividends received and Canadian withholding tax paid to the appropriate taxation authorities located in the various jurisdictions.

In the January Canadian Currents we outlined the case that, because of recently enacted changes to the US-Canada Income Tax Convention (the Convention or the Treaty), Canada should no longer be withholding 15 percent from distributions paid in respect of income trust units held within an IRA.

As was intimated in last month’s article, the only way to get satisfaction on this issue is through your aggressive outreach to your brokerage. As anticipated, and although generally speaking brokerage and clearing houses continue to insist that the 15 percent withholding is proper, your efforts have unturned some interesting information.

To review, Article 5 of the Protocol, “Dividends,” deals with amendments to Article X of the Treaty. According to the Explanation of Proposed Protocol to the Income Tax Treaty Between the United States and Canada prepared by the Staff of the Joint Committee on Taxation for a hearing before the United States Senate Committee on Foreign Relations, “The General Note states that it is understood that distributions from Canadian income trusts and royalty trusts that are treated as dividends under the taxation laws of Canada are considered dividends.” The “General Note” referred to is the set of diplomatic notes collectively referred to here and elsewhere as “Annex B.”

Annex B, paragraph 3, subsection 3 states:

Definition of the term “Dividends”: It is understood that distributions from Canadian income trusts and royalty trusts that are treated as dividends under the taxation laws of Canada shall be considered dividends for the purposes of Article X (“Dividends”) of the Convention.

Charles Schwab, responding to one client’s question about the changes brought about by the Fifth Protocol (the Protocol), wrote “the tax treaty to which you referred does not go into effect until 2011.”

Here’s the relevant portion of a response to a similar question posed by a CE subscriber to Schwab (sic):

Dear XXXXXX,  

Thank you for your email of January 19, 2010, in regards to tax treatment for IRA and Pension accounts.   Client assets are held in custody with Depository Trust Clearing Corp (“DTCC”) and to date there are no mechanisms in which Charles Schwab as well as other brokers who custody with DTCC to affect exemption status for IRA or Pension accounts.  Schwab has confirmed with our custodian, DTCC that changes for IRA and Pensions on trust securities will not be in effect until 2011. Once it’s effected DTCC will let Schwab know of the change in tax treatment. 

Thank you, 

XXXXXX

Schwab’s position is not supported by the law.

Article 27 of the Fifth Protocol specifies the effective dates for the amendments contained therein. The Fifth Protocol was signed in Canada Sept. 21, 2007, and entered into force on Dec. 15, 2008, when it was ratified in the US Senate.

The relevant language (Article 27, section 2, subsection a), states: The provisions of this Protocol shall have effect…[i]n respect of taxes withheld at source, for amounts paid or credited on or after the first day of the second month that begins after the date on which this Protocol enters into force…” The first day of the second month after Dec.15, 2008, is Feb. 1, 2009.

The second contention, raised by InteractiveBrokers, is that the Treaty/Convention and the Protocol don’t contemplate IRAs. Here’s the relevant portion of another subscriber’s correspondence:

Yes, funds may be withheld from dividends paid to an IRA. The withholding applied does not distinguish between account type. The only differentiation made by the payer is with the payee’s country of legal residence.

Not all assets are suitable for investment within an IRA. IB is unable to report any tax withheld within an IRA as the IRS has not provided a tax form for such reporting.

The referenced, however, to the Fifth Protocol to the US-Canadian Treaty does not appear to be applicable to your scenario. In part, the change is regarding the elimination of withholding tax on certain interest payments and the mutual recognition of contributions to pension (and other employer sponsored) retirement plans. The rate of Canadian withholding tax on the dividend payment referenced in your scenario would be subject to a 15 percent withholding rate under the Protocol.

If you have information on the changes which states otherwise, please let me know. We will certainly investigate the information. Rulings often change and IB is committed to remaining in compliance.

Further inquiry on this count yields less satisfying answers. Annex B, paragraph 10, “Qualifying retirement plans,” states:

For purposes of paragraph 15 of Article XVIII (Pensions and Annuities) of the Convention, it is understood that…[i]n the case of the United States, the term “qualifying retirement plan” shall include the following and any identical or substantially similar plan that is established pursuant to legislation introduced after the date of signature of the Protocol: qualified plans under section 401(a) of the Internal Revenue Code (including section 401(k) arrangements), individual retirement plans that are part of a simplified employee pension plan that satisfies section 408(k), section 408(p) simple retirement accounts, section 403(a) qualified annuity plans, section 403(b) plans, section 457(g) trusts providing benefits under section 457(b) plans, the Thrift Savings Fund (section 7701(j)), and any individual retirement accounts under section 408(a) that is funded exclusively by rollover contributions from one or more of the preceding plans.

The bolded portions, read together, provide a substantive limitation on the types of IRAs–which are established under Internal Revenue Code Section 408(a)–that can hold income trusts without having distributions withheld at the source. If your IRA was funded via a rollover of an employee-sponsored plan, a simplified pension plan, a simple retirement account, or a qualified annuity, it seems you have grounds to claim amounts withheld from February 2009 forward.

As for the broader concern you cash-funded IRA holders must have, first I’m disappointed my original research left such questions unanswered. On the other hand, there is a clear violation of the public policy–elimination of double taxation–that makes ventures such as bilateral international tax treaties worthwhile.

Make the case to your broker and clearing house, and let them know you’re not happy that you’re being taxed now on your Canadian income trust dividends and you’ll be taxed again when you take distributions from your IRA.

David Dittman is associate editor of Canadian Edge.