The timeline, facts and legal interpretation presented below are derived from a letter to US Representative Phil Gingrey (R-GA) signed by Elizabeth U. Karzon, Branch Chief, Branch 1, Office of Associate Chief Counsel (International), US Dept of the Treasury, Internal Revenue Service, dated June 17, 2010.

This is your first tool to use against an intransigent broker who won’t properly adjust your account to reflect the fact that Canada cannot legally withhold 15 percent at the source from distributions paid by Canadian income trusts or royalty trust that are paying tax at the entity level as “specified investment flow-throughs” (SIFT) or from dividends paid by former trusts that have converted to corporations in respect of units or shares held in a US IRA account

I am happy to provide a pdf copy of the letter to any ready who’d like one. Please e-mail me at ddittman@kci-com.com if you’d like a copy; this will be your backup tool.

It’s a general rule of US federal taxation that an individual isn’t liable for US taxes on amounts earned through an IRA until those amounts are distributed. But US tax law can only defer US tax. US tax authorities have no power to influence a foreign country’s imposition of tax on income that the IRA derives from that country.

Distributions from Canadian income and royalty trusts therefore may be subject to tax in Canada depending on Canadian tax law and the terms of the US-Canada Income Tax Treaty (the Treaty).

Certain US entities that are generally exempt from taxation in a taxable year in the US–such as IRAs–are exempt from taxation on dividend income arising in Canada in that same taxable year, according to Article XXI of the Treaty, “Exempt Organizations.”

Based on a 2005 change in Canadian tax law, Canada began imposing a 15 percent withholding tax on distributions from income and royalty trusts to US residents. Canadian tax law didn’t initially treat these distributions as dividends, however, and so they weren’t exempt from Canadian tax under Article XXI of the Treaty.

In 2007, Canada amended its domestic law again and began taxing certain of these trusts as corporations and treating distributions from these trusts as dividends for purposes of both their domestic law and their tax treaties.

Canada and the US signed an exchange of diplomatic notes in 2007, on the same day the two parties signed the Fifth Protocol to the Treaty, that include what we’ve often referred to as “Annex B.” These notes confirmed, among other things, “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 [the Treaty].”

However, Canadian law–the Tax Fairness Act–provides that Canada won’t tax income and royalty trusts already in existence as of Oct. 31, 2006, as corporations until Jan. 1, 2011. Until then, Canadian tax law won’t treat distributions from such trusts as dividends. Distributions from these pre-existing trusts won’t be exempt from Canadian tax under Article XXI of the treaty until 2011–when these income and royalty trusts will become “Specified Investment Flow-Throughs,” or SIFTs, taxed at the entity level.

The IRS acknowledges that investors who hold Canadian trust units in IRAs may not claim a foreign tax credit for the Canadian taxes withheld on the income paid in respect of those units. This is consistent with a general rule that foreign tax credits may not be credited against an individual’s tax liability unless the individual is liable for the tax. Nor can the IRA make use of a foreign tax credit because it’s exempt from tax in the US.

This may ultimately result in double taxation when the IRA distributes this income to the unitholder. The 2007 Tax Fairness Act, when it and the Fifth Protocol have full effect, will generally eliminate the 15 percent Canadian withholding tax on dividends paid by income and royalty trusts in respect of units held in US IRAs.

The IRS position has been brought to the attention of at least one major brokerage, which places blame for continued incompetence on this issue at the foot of the Depository Trust & Clearing Corporation (DTCC), an old friend from the days of the qualified versus not qualified debate. Then as now DTCC was a stumbling block.

Citing the points made above, including references to the IRS chief counsel and Rep. Gingrey, contact the investor relations team at the trusts of which you hold units in your IRA. Let them know that DTCC is getting in the way of you and your proper payment. Your next step is to contact the Canada Revenue Agency at 800.267.5177.

Editor’s Note: For additional information on this topic, check out Roger Conrad’s latest report on Top Canadian Income Trusts.