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.

What was then Colabor Income Fund acquired Summit Food Service Distributors on Jan. 8, 2007. The acquisition helped Colabor double its overall sales. It also rendered Colabor subject to entity-level taxation.

The tax regime for specified investment flow-through (SIFT) entities passed into law in June 2007 made listed income trusts, funds, and partnerships subject to similar tax treatment as corporations. This new tax treatment was applicable in fiscal year 2007. However, SIFTs in existence on Oct. 31, 2006, the night Finance Minister Jim Flaherty made his initial trust tax announcement, were protected by transitional rules and wouldn’t be taxed at the entity level until Jan. 1, 2011, provided they steered clear of “undue expansion.” At the end of 2007 the Canadian Department of Finance ruled that Colabor’s Summit acquisition violated these “undue expansion” rules, thus exposing Colabor to the new SIFT tax. In other words, 2011 started for Colabor in 2007.

Canadian tax law at the time did not recognize “income trusts” as corporations, and their distributions were not considered “dividends.” This meant the Canadian government withheld 25 percent from trust distributions as opposed to the 15 percent withheld from dividends and interest payments.

For US unitholders, by operation of the US-Canada Income Tax Treaty (the Treaty), the withholding rate was 15 percent. Canada withheld 15 percent rather than the 25 percent domestic law dictated because the Treaty mandated that US investors be treated as US law dictates, and vice versa, on matters of income tax. This 15 percent rate is derived from the 2003 tax cuts signed into law by President George W. Bush.

This trip through the recent past illustrates an absurdity created by the recently ratified Fifth Protocol to the US-Canada Income Tax Convention and accompanying “diplomatic notes,” which are meant to reconcile potentially conflicting domestic law and clarify definitions, among other things.

Under the Canada-US income tax treaty, interest and dividends received from investments in companies held inside an IRA or 401(k) are exempt from Canadian withholding taxes. The nub of this problem is that, until passage of the Tax Fairness Act, Canadian law hadn’t recognized “income trusts” as “corporations,” and thus trust distributions were not considered “dividends.”

Annex B to the Fifth Protocol–the Canadian explanatory notes–provides that distributions from “income trusts and royalty trusts” that are treated as dividends under Canadian tax law will be treated as dividends under the Treaty. This treatment is intended to provide relief for US investors in Canadian trusts subject to the SIFT rules. Annex B is being read to mean that only distributions paid by trusts paying entity-level tax according to the SIFT rules will be considered “dividends” in Canada and will therefore no longer be subject to withholding on the Canadian side of the border. Canada will not enforce an interpretation of the Treaty, the Fifth Protocol, and Annex B that results in it receiving essentially no tax at all from a SIFT.

Now, the lawyer in me–in all of us at this point, I would imagine–wants to argue the meaning of “subject to the SIFT tax.” Once it came into law the provisions of the Tax Fairness Act undoubtedly dictated substantive behavior by these businesses, regardless of whether they paid tax at the entity level.

Bottom line: Under the SIFT rules, a distribution (called a “non-deductible distribution”) made by a SIFT trust to its investors is generally deemed to be a dividend for Canadian tax purposes to the extent that it’s paid out of the trust’s earnings that have been subject to the new tax on SIFT trusts. The effect of Annex B to the Treaty is to confirm that such deemed dividend treatment also applies for Treaty purposes. If you held Colabor Income Fund in a US-based IRA anytime in 2007 up to the time it converted on Aug. 10, 2009, you have a great case to claw back any amounts withheld from your distributions.

With regard to virtually everything else in the CE coverage universe, the silver lining for those of you who hold trusts in your IRAs is that once Jan. 1, 2011, rolls around you’re going to realize a virtual dividend increase because withholding will go away; all SIFTs that haven’t converted will be paying an entity-level tax to Canada before they distribute to unitholders, and corporate dividends are already considered exempt from withholding.

This obviously means that folks who are collecting distributions from Canadian trusts (inclusive of “income trusts,” “income funds” and “royalty trusts”) and paying withholding to Canada at 15 percent are subject to double taxation: Once they start taking distributions they’ll have to kick a little more to Uncle Sam. The relevant language of the applicable law on both sides of the border suggests income trust distributions, as of February 2009, should no longer be subject to withholding when held in a US IRA. But Canada has to get its piece of income trust cash flow; the only way to do so is by taking it out of your distribution. We’ve had many fruitful conversations with CE subscribers on this matter, by telephone and via e-mail. Your experiences with your brokers and industry clearing houses reveal you to be persistent and effective advocates; the responses you’ve elicited from these institutions have shed a great deal of light on this matter. Now it’s time to turn your attention to your US congressmen.

David Dittman is associate editor of Canadian Edge.