The federal budget proposes tax changes to level the playing field between ordinary Canadians and non-residents who avoid tax by owning otherwise-taxable Canadian property through Canadian mutual funds.

In an effort to capture those who currently avoid conventional tax treatment, the government proposes to treat distributions that mutual funds pay out of their gains on taxable Canadian property as Canadian-source trust income, if the fund is organized as a trust, or as a taxable dividend, if the mutual fund is organized as a corporation. The taxable dividend is subject to the existing non-resident withholding tax of 25%, although it is typically reduced to 15% by tax treaty. The budget says the new treatment will apply to distributions of gains realized on dispositions after March 22.

Also, capital gains tax will be applied to certain otherwise tax-free distributions made after 2004 by Canadian mutual funds to their non-resident investors. The 15% tax will be withheld from distribution at the source. The distributions that will be subject to this new tax are those paid on units of Canadian mutual funds listed on a prescribed Canadian or foreign stock exchange, and the value of which is “principally attributable” to Canadian real estate or Canadian resource property.

Generally, if more than 10% of a mutual fund’s property consists of taxable Canadian property, and the mutual fund is established primarily for the benefit of non-residents, the fund may lose its status as a mutual fund. The use of mutual funds to reduce Canadian tax is particularly relevant to investments in Canadian resource property and timber resource properties, as non-residents generally do not benefit from any tax treaty relief for gains from this property.

The 2004 budget also proposes that, for the purpose of the special rules limiting non-resident participation in mutual funds, the properties a mutual fund must include in computing its 10% threshold will include Canadian resource properties and timber resource properties. An existing mutual fund that may no longer qualify as a mutual fund because of this proposal will have until Jan. 1, 2007, to comply with the modified rule.

The proposal is part of the government’s general effort to plug some of the revenue leakage it fears it has suffered through non-residents owning income trusts and other taxable resource property through Canadian mutual funds.

The government indicates that the new tax withheld on the distribution will be a final tax. The non-resident investor will not need to report the distribution on a Canadian income tax return, nor will the cost base of the share or unit have to be adjusted to reflect the distribution.

The imposition of the new tax will also allow non-resident investors to use realized losses on disposing of a Canadian mutual fund to offset a gain on some other taxable Canadian property. If a non-resident investor realizes a loss on the disposition of a fund where the investor has paid the new tax on distributions, the investor will be able to file a special Canadian income tax return for the year the fund was sold to offset those distributions, or to reduce other distributions that have been subject to the new tax. This special form of capital loss may be carried back three tax years, or carried forward indefinitely.