When purchasing a property from a non-resident of Canada, one of the most important aspects is to address the liability the purchase could incur if section 116 Income Tax Act (“ITA”) is not dealt with appropriately. The purpose of s. 116 ITA is to collect tax on capital gains on real estate owed by a non-resident vendor. The section still applies if a non-resident holds property or co-owns with a resident of Canada. The reason s. 116 was put in place is that it creates a mechanism for capital gain taxes to be collected from the disposition of the property by a non-resident. The caveat is that it is the purchase who could bare the liability for non payment of taxes. If appropriate amount is not collected and remitted to Canada Revenue Agency (“CRA”), the buyers will become liable for outstanding taxes as a result of disposition and a lien may be registered against their home.
Ontario Real Estate Association (“Orea”) standard agreement form stipulates what should happen if the seller of the property is a non-resident. Residence section states that should the seller be a non resident, the seller shall credit the buyer with the amount necessary for the buyer to pay to the Canada Revenue Agency (“CRA”) to satisfy buyer’s liability in respect of tax payable by seller under the non-residency provisions of Income Tax Act by reason of the sale. However, the matter is much more complex than stated in the agreement. What is the amount of credit? Who holds the amount? What happens is proceeds of sale are insufficient? Who is liable at the end of the day? In this article we will give an overview of s. 116 ITA and how best to deal with the situation to ensure that the Buyer as well as the Seller are protected. For the purpose of this article, we will only be discussing taxable property and an individual vendor rather than excluded property or other property described in s. 116 (5.2) and a corporate owner.
How to Determine if the Seller Is a Non-Resident
The first obstacle is to determine whether the seller is a non-resident. A seller may be considered a non-resident if they do not have significant residential ties with Canada and they lived outside of Canada throughout the year or stayed in Canada for less than 183 days in the tax year. Significant residential ties refer to a home in Canada, a spouse or common law spouse or dependents in Canada. Once the seller meets these criteria, they would be considered a non-resident and would have to adhere to the laws that follow a disposition of the property by a non-resident.
Clearance Certificate and Holdback Rules Explained
Once it is confirmed that the seller is a non-resident, the seller should apply for a clearance certificate under s. 116 ITA. A clearance certificate is issued by CRA, the certificate states the amount of tax owing or remitted to cover capital gain taxes owed by non-resident vendor. If the taxes were paid as per the clearance certificate the remaining holdback balance can be released to the vendor. As with everything it takes time to apply and receive the clearance certificate, standard wait times are around 8-12 weeks, however it could take longer due to backlog. As such it is important to apply for the clearance certificate as soon as you have a firm agreement of purchase and sale, that way time between signing the agreement and closing is counted against the time line for receipt of clearance certificate. While the vendor is waiting for CRA to calculate the outstanding taxes and determine the amount payable, the lawyer for both the vendor and the purchaser have to determine the amount of holdback. Preparing the documents for a clearance certificate is not complicated however it is best to hire an accountant to assist to ensure that all the calculations are done correctly.
Determining the amount of the hold back is a crucial step when dealing with a disposition of a property by a non-resident. The Income Tax Act stipulates the holdback amount:
- If the property is a primary residence, meaning that it never generated income, it is not rental and it was occupied by the vendor or a family member for a personal use, the hold back shall be 25% of the sale price.
- If the property was rented or generated income, the hold back is 25% on the land value PLUS 50% related to the building value. However, industry practices dictate that once it is determined that the property was rented or generated income, the holdback amount is 50% of the sale price.
What Happens If There Is a Shortfall or Delay?
In some circumstances the purchaser may be required to withhold and remit up to 50% of the purchase price. This could pose a challenge in the event where the seller has a mortgage and there are insufficient funds to forward to CRA. In that instance, the seller would have to bring additional funds to close the transaction, alternatively, the funds are not available the vendor could put a clause in the agreement of purchase and sale that both parties agree to extend the deal until such time that the clearance certificate is received. This allows the vendor to pay the exact amount of Tax owing under s. 116 ITA and it allows the purchaser to avoid liability as the Tax is paid from the sale proceeds.
If the deal cannot be extended to allow for receipt of the Clearance Certificate, and both parties agreed to the amount of the hold back, the parties have to decide which lawyer shall hold the funds in their trust account. The agreement of purchase and sale, clearly states that it is the buyers’ lawyer who holds the funds for the payment of taxes under s. 116 ITA. This allows the purchaser control over the payment and ensures compliance with remittance. However, many vendors would feel uncomfortable and write in a clause in the agreement of purchase and sale to ensure that it is the vendors lawyer who holds the funds intended for remittance of taxes. The reason being that the vendor wants to ensure that once the taxes are paid that the remaining funds are returned to the vendor quickly.
Another important aspect of the holdback is that it is not held indefinitely in the lawyers trust account. There is strict time limits put on the holdback by CRA. The amount withheld by the vendor or purchasers’ lawyer must be remitted to CRA within 30 days after the end of the month in which the transaction closed. For example, if the sale took place on February 14, holdback remittance to CRA must be done by March 31. The amount of time allocated for remittance is not sufficient for the seller to apply and subsequently receive clearance certificate. If clearance certificate is not received by the end of the timeline stipulated by CRA, the full amount of hold back must be remitted to CRA to ensure compliance. This can create difficulties for the vendor as it takes a long time to receive remaining funds, after remittance of taxes, from CRA. As such best practice is to apply for a clearance certificate as soon as the vendor has a firm offer. Ideally, there is a clause in the agreement that states that the buyer agrees to extend the deal should clearance certificate not arrive in time for the original closing date. Lastly, vendors lawyer or purchasers’ lawyer can write a letter to CRA and request an exception from remitting the funds to CRA if the timeline for remittance will not be met. Once comfort letter is issued by CRA stating that they are aware that the funds are being held in trust and there is sufficient funds, CRA is comfortable and agreeable to for the lawyer to continue to hold the funds until clearance certificate is issued.
Dealing with a disposition of a property by a non-resident is complicated matter, but if you know the rules and follow the law, as a buyer you could avoid liability under s. 116 ITA. Unfortunately, the burden is on the buyers to ensure that there is a sufficient amount of holdback, and it is remitted within the allocated timeline. It is equally as important for the vendors to act quickly to ensure compliance. The vendor must apply for a clearance certificate quickly as time is of the essence. If there is a potential shortfall, meaning that there is not sufficient amount of funds available for the holdback, and the vendor does not have additional funds, the vendor must be ready to negotiate with the purchase for an extension or borrow funds to cover the shortfall. If vendor fails to secure additional funds and the purchase is unable to extend, the vendor could be noted in default and be liable for damages.
If you are planning to purchase a property from a non-resident seller and want to ensure your transaction is structured correctly to avoid tax liability, we recommend discussing your case with a qualified real estate lawyer. Contact MBLAW Professional Corporation to get professional legal support tailored to your specific situation.
