Revenge of the Tax

You may have read headlines about a “Big Beautiful Bill” coming out of the U.S. Although this may simply sound like noise, it is anything but beautiful for Canadians. The bill has gained the attention of financial advisors and the tax planning community, and I wanted to discuss some of the details.

The proposed U.S. “Revenge Tax” (Section 899) targets foreign investors’ income (interest, dividends, other income) from U.S. assets. This bill is seen as retaliation for Canada’s Digital Services Tax (DST) targeting U.S. tech companies retroactively since 2022. The bill proposes to increase the U.S. foreign withholding tax on interest, dividends and other income.

Canadians who hold U.S. securities or invest in U.S. companies through Canadian investment funds could see the rate of U.S. foreign withholding tax on dividends they receive rise significantly. Additional taxes are something of a sticking point for Canadians.

How much is the increase?

Cross-border tax experts have different interpretations of how much the increase would be. Some interpret the bill as increasing the rate of U.S. foreign withholding tax by a maximum of 20 per cent, either to 35 per cent from the 15 per cent rate currently available under the Canada-U.S. tax treaty, or to 50 per cent from the 30 per cent statutory foreign withholding tax rate when a taxpayer is ineligible for the treaty rate.

Others interpret the ceiling as 50 per cent, or a maximum of 20 percentage points above the statutory rate of 30 per cent, starting from the treaty rate of 15 per cent, where applicable.

Is the Bill Law?

The bill has passed in the U.S. House but faces uncertainty in the Senate due to concerns about deterring foreign investment. This is seen as a strategy used by the U.S. to pressure Canada to withdraw the DST. The bill applies to both registered and non-registered accounts, including RRSPs, RRIFs, and pension plans, and may violate current treaty protections and United States-Mexico-Canada Agreement (USMCA) provisions. Section 899 could face legal challenges under the USMCA.

To understand more about what this all means, it is crucial to explain how U.S. withholding tax currently affects Canadian investors. This depends on the type of investments, and where those investments are held.

Current Canada – U.S. Tax Treaty

There is currently a Canada – U.S. tax treaty in place, where the U.S. charges a withholding tax of 15 per cent on dividends paid from U.S. companies to Canadian investors. This is half the default rate of 30 per cent under U.S. tax law. To access the reduced treaty rate, a Canadian investor holding U.S. investments in a non-registered account needs to complete a U.S. W-8BEN form. The withholding tax applies to dividends but, in general, not to interest from bonds or savings accounts, or to capital gains realized on the sale of U.S. investments.

The exception is U.S. real estate – Canadians pay U.S. taxes on interest earned from U.S. rental property and on capital gains from selling U.S. real estate.

Non-Registered investment accounts

Non-Registered accounts are considered fully taxable, and a Canadian investing directly in U.S. companies is subject to U.S. withholding tax on the dividends they receive.

When a Canadian invests in a Canadian ETF or Mutual Fund that invests in U.S. equities, the fund itself is the taxable entity in terms of U.S. withholding tax. The fund then distributes the foreign dividend income to the unitholder and reports the amount of foreign withholding tax.

Let’s take Darryl – he’s a Canadian investor who receives $1,000 in U.S. dividends. He would receive $850, and the financial institution remits $150 to the U.S. Internal Revenue Service.

The financial institution would then issue a tax slip to Darryl – either a T3 or a T5 – reporting $1,000 in foreign dividends and $150 of foreign tax paid. Darryl would then report the $1,000 dividend on his income tax return and claim a foreign tax credit for $150.

Under the proposed U.S. tax bill, the withholding rate would increase by five percentage points for every year the foreign country continues to charge an “unfair” tax. As previously explained above, cross-border experts have different interpretations on whether the increases would max out at 35 per cent or 50 per cent, where a treaty rate of 15 per cent is available.

Retirement Accounts: RRSPs, RRIFs, LIRAs and LIFs

The U.S. recognizes Registered Retirement Savings Plans (RRSPs,) Registered Retirement Income Funds (RRIFs), Life Income Retirement Accounts (LIRAs) and Life Income Funds (LIFs) as retirement accounts that are tax deferred. Canadians who invest in U.S. companies, or who hold ETFs listed on a U.S. exchange that invest in U.S. equities, are exempt from U.S. withholding tax on the dividends they receive. Canadian mutual funds and ETFs that invest in U.S. equities do not enjoy this exemption. It is unclear whether retirement accounts would continue to have access to their exempt status if section 899 were enacted.

Non-Retirement Accounts: TFSAs, FHSAs, RDSPs, and RESPs

The U.S. doesn’t recognize the tax-deferred status of Canadian registered plans that aren’t retirement accounts, such Tax-Free Savings Accounts (TFSAs), First Home Savings Accounts (FHSAs), Registered Disability Savings Plans (RDSPs), and Registered Education Savings Plans (RESPs). Canadians who invest in U.S. companies or hold Canadian mutual funds and ETFs that invest in U.S. equities held in TFSAs, FHSAs, RDSPs, and RESPs are subject to U.S. foreign withholding tax on dividends. This would be similar to investments held in taxable Non-Registered accounts.

Since these plans are tax-sheltered accounts in Canada, Canadian investors do not receive a tax slip reporting the foreign dividends and foreign withholding tax. They also cannot claim the foreign tax credit in Canada to offset the withholding tax.

With everything mentioned this all means potentially higher taxes for investors. It does not mean investors have to abandon their U.S. investments, as they are a key source of diversification, growth, and income. Since the bill has not been passed yet, outcomes are unclear. We continue to watch this closely and keep everyone updated on any new developments. If you’d like to discuss further, feel free to reach out.