Investors be aware, not all US investors in Canadian stocks are treated equally for tax purposes!
There has recently been a flurry of Canadian resident corporations deciding to do business in the United States, including well-known companies such as Aurora Cannabis, Canopy Growth, Cronos, Curaleaf and Ianthus. Why? Simply put, cannabis is already legal in Canada as it offers a friendly environment for companies to raise public capital and list their shares on its stock exchanges. With the hot performance of this sector, U.S. investors have jumped into the fray.
The question becomes whether these investors are aware of the potential tax consequences of investing in these companies with respect to dividends (the ultimate reason for investing in shares). For certain U.S. investors, Canadian corporations withhold taxes on dividends even though the income underpinning the dividend is U.S.-sourced income. There are three major issues that this paper will address:
1) Differences in withholding tax rates by investor type (“Discrimination”)
2) Value of the Foreign Tax Credit derived from the withholding (“FTC”)
3) Paid-Up-Capital Election by Directors (“PUC”)
The pros and cons of each of these issues will be addressed so that investors can approach investing in the Canadian Cannabis sector more intelligently.
For Canadian companies, the Canadian withholding tax to U.S. investors who are non-residents of Canada vary significantly – between 0% and 25%. Please see Table 1 below:
Despite the potential tax withholding risks of being a U.S. LLC investor in Canadian Cannabis companies, with respect to dividend withholding taxes on U.S. sourced income, there still remain several LLC investors of major publicly trading Canadian stocks who have operations in the U.S. Here is a sampling of them in table 2 below:
To a U.S. investor, the withholding tax on Canadian dividends appears as a foreign tax on a brokerage statement. Normally, U.S. investors can take a foreign tax credit against the U.S. tax levied on their foreign source income. But wait! “Houston, we have a problem.” If the source of the dividend income came from the U.S., then the income is not considered to be foreign source. Worse, if the U.S. investor has no other foreign source income, then the U.S. investor will be denied the ability to use the foreign tax credit in the current tax year (there is a limited period of 10 years to use the FTC, and then it expires worthless).
Next time you read the footnotes from an annual report of a Canadian corporation with U.S. operations, be on the lookout for the following information disclosed:
- Company is a Canadian corporation
- It is classified as a U.S. domestic corporation for U.S. federal income tax purposes
- It will be subject to U.S. federal income tax on its worldwide income
- For Canadian tax purposes, the Company is treated as a Canadian resident corporation
- Dividends received by shareholders resident in the U.S. will not be subject to U.S. withholding tax but will be subject to Canadian withholding tax
In the event that the Company pays any dividends, they will be characterized as U.S. source income for purposes of the foreign tax credit rules under the U.S. Tax Code.
Take for example a Canadian corporation with only U.S. source income, which consists of $100, after the payment of Canadian corporate and provincial income taxes. If the Canadian corporation distributes its entire net income to its U.S. investors, Canada will withhold 25% on the gross dividend. If the U.S. investor also pays the maximum of 20% on the qualified dividend plus the 3.8% investment tax, then the U.S. investor keeps $51.20. That’s a 49% tax, and we haven’t touched state or city taxes on top of that! Since the dividend was sourced from U.S. earnings and not Canadian earnings, the U.S. investor cannot apply the $25 foreign tax credit unless it has other foreign source income.
In the more typical case where 15% is the withholding tax because of the U.S.-Canada Treaty, the U.S. investor keeps $61.20, which equates to a 39% tax before including state and/or city taxes.
Compare this scenario to investing, instead, in a U.S. corporation with identical facts. Since there is no foreign tax, the U.S. investor gets to keep $76.20 instead of $51.20. In sum, under the “worst” case scenario, U.S. investors would be 33% worse off; under the “typical” case scenario, U.S. investors would be 20% worse off.
Table 3 below illustrates the differences:
In Canada, company board of directors can elect to treat distributions as a return of capital, provided that there is still paid-up-capital on the balance sheet. This action, also known as “Paid-up capital” or “PUC” reduction is referenced in Canada’s Income Tax Act. In so doing, this board election allows for the distributions connected with PUC to be remitted free of any withholding tax. For shareholders, PUC reduces the cost basis of the investment by the amount of the PUC distributed to them. In contrast to the U.S. tax rules, which require distributions to be treated as taxable dividends, if there is current and/or accumulated earnings and profits or, secondarily, retained earnings, PUC could be a real life saver to U.S. investors. That is, a PUC reduction can afford the U.S. investor the same result as the “Best Case” scenario in Table 3. To anticipate whether the dividend could be potentially withholding tax-free, investors should review the balance sheet.
When considering investments in Canadian Cannabis stocks that do business in the U.S., U.S. investors need to decide how to hold their shares for minimizing their tax exposure as well as review the balance sheet in order to assess the potential to receive withholding tax-free dividends. If these investors expect not to have any foreign source income, then the potential for these investors to lose foreign tax credits should factor into the risk/reward analysis.