Canadian Taxation: Electing to File a Section 216 Tax Return for Rental Income
by George Gonzalez
A separate article in these web pages discusses the Section 217 election, an election that can reduce a non-resident’s taxes on Canadian-source pension income. In this article I discuss a similar but different election for non-residents, one that is available for rental income from Canadian property. We also discuss the importance of tenants fulfilling their tax withholding obligations for rents paid to non-resident landlords.
Tax Return Under a Section 216 Election
The Section 216 election is similar to the Section 217 election: a non-resident may elect to pay tax on the basis of a special income tax return rather than on the basis of the withholding tax. The Section 216 election is most commonly used for rental income from Canadian real property, e.g., houses, apartments and condominiums.
The election is also available for royalty income from Canadian timber resource property. Notably the Section 216 election is not available for rental or royalty income that arises from carrying on a business in Canada, in which case a regular income tax return must be filed to report that business income. Income from carrying on a business is distinguished from property income, also referred to as passive income, which essentially is income from an activity that does not require the investor’s active involvement.
The discussion in this article focuses on passive rental income from real property.
While the Section 217 election for pension income discussed in last month’s column may or may not result in a tax lower than the tax payable via non-resident tax withholding, the Section 216 election is frequently beneficial. The reason is that tax withholding on rental income is based on gross rental income while the tax calculated under the Section 216 election is based on net rental income.
Net rental income is defined as gross rental income less rental expenses. Thus, a Section 216 tax return allows for the deduction of rental expenses in arriving at taxable income, while the general withholding tax rules are based on gross rental income and, therefore, do not allow for the deduction of rental expenses.
For example, assume a non-resident that received gross rental income on Canadian property of $60,000, and paid total rental expenses (insurance, real estate taxes, management fees, repairs and maintenance, etc.) of $25,000. In this case net rental income would be gross income of $60,000 less expenses of $25,000, for a net rental income of $35,000. Further assume that the individual resides in a country with which Canada does not have a tax treaty and, accordingly, the withholding tax rate under general Canadian tax law is the default rate of 25%. The withholding tax in this scenario would be gross rental income of $60,000 x a tax rate of 25% = withholding tax of $15,000.
On the other hand, tax payable under the Section 216 election, which is based on the federal progressive tax rates plus a surtax for non-residents, would be about $7,770. Thus, in this example the tax payable under the Section 216 election is only 52% of the withholding tax of $15,000, i.e., $7,770 ÷ $15,000 = 52%. This illustrates the tax-saving benefit of making a Section 216 election.
Section 216 Election Filing Mechanics
Filing a tax return under a Section 216 election is less complicated than filing a Section 217 return. The form that is used is Form T1159 (Income Tax Return for Electing under Section 216), a two-page form on which the tax is calculated. Any tax on the rental income that was withheld during the year is also entered on this form as a credit, and the excess of such tax over the tax calculated on the form would represent a refund from the CRA.
Assuming the same numbers from the prior example, the amount of tax on Form T1159 would be $7,770, the amount of tax withheld during the year included as a credit would be $15,000, and the refund receivable from the CRA as shown on the tax return would be $7,230, i.e., $15,000 – $7,770 = $7,230.
Reduced Tax Withholdings Based on Net Rental Income
As just discussed, the tax-saving advantage of electing to file a tax return under Section 216 is that the calculation of final tax payable is based on net rental income rather than gross rental income. Additionally, there is a way to have the withholding tax calculated on the basis of net rental income rather than gross rental income. This is done by filing Form NR6 (Undertaking to File an Income Tax Return by a Non-Resident Receiving Rent from Real or Immovable Property or Receiving a Timber Royalty).
Form NR6 is actually a joint effort between you and your rental property “agent”, which the CRA defines as a resident of Canada who is your property manager or any other person who acts on your behalf regarding your Canadian-source rental income. The form must be completed and signed by both of you and sent to the CRA for approval. If the CRA approves the application, it will direct the agent to withhold tax based on the net rental income shown on the Form NR6 (rather than based on gross rental income).
The adjusted withholding would take effect after the CRA has approved the Form NR6 application. The agent must continue to withhold non-resident tax based on gross rental income until the CRA notifies the agent (and the taxpayer) in writing that Form NR6 is approved. Once CRA notification is received, the agent may commence withholding of tax based on net rental income rather than gross rental income.
Potential Penalties for Tenants Not Fulfilling Tax Obligations
There is one more point regarding passive rental income on Canadian real estate received by a non-resident that is worth discussing. Let us consider two types of arrangements for non-residents who rent their Canadian real property to tenants. In one arrangement there is a Canadian rental property manager involved, i.e., an agent who collects rents from the tenants and remits rental payments to the non-resident landlord. The other arrangement is a direct relationship between the non-resident landlord and the tenant, one in which the tenant pays rent to the landlord directly.
With the first type of arrangement, the tenant pays rent to the rental property manager. In turn, the rental property manager withholds tax on the amount of the rent, remits the withheld tax to the CRA, and sends the balance of the rent collected (after subtracting the withheld tax) to the non-resident landlord. Rental property management companies are inevitably familiar with their tax withholding obligations to the CRA, and there is usually not much issue with this type of arrangement.
With the second type of arrangement, however, a problem can potentially arise. The problem will usually arise because of ignorance of the tax laws. That is to say, the tenant may not be aware of the requirement to withhold tax from rents paid to the landlord and remit the withheld tax to the CRA. The tenant could potentially face severe penalties that the CRA may later impose for the failure to comply with withholding obligations. This is exactly what happened in a recent court case.
In a case decided by the Tax Court of Canada earlier this year (3792391 Canada Inc. v. The King, 2023 TCC 37), the court concluded that a tenant is fully liable to the CRA for penalties on the failure to withhold and remit withholding tax on rents paid to a non-resident landlord. The court’s decision stated that it was not relevant that the tenant did not know that the payee was a non-resident. The court found the tenant to be liable for withholding tax plus penalties and interest on the tax due.
This is a harsh outcome for a tenant. It is not difficult to imagine a tenant being ignorant of the withholding tax rules, or not knowing that the landlord to whom they pay rent is a non-resident, or both.
If you are a non-resident landlord who rents Canadian property to a tenant, and that tenant pays you rent directly, be sure to let that tenant know that they have tax withholding obligations to the CRA. This will help ensure that the tenant avoids problems with the CRA. It may very well help you avoid potential problems, too.
Non-residents who receive passive rental income from Canadian real property (or royalties from Canadian timber) are subject to a withholding tax of 25% (or a lesser withholding tax rate if a bilateral tax treaty between Canada and the country of residence is applicable). The party that makes payment to the non-resident calculates the withholding tax based on the gross amount of the rental income. It is possible to reduce the amount of tax payable by filing a special tax return under Section 216. The tax calculated under Section 216 is based on net, rather than gross, rental income.
A non-resident who files a Section 216 return may also wish to file Form NR6 with the CRA. With an approved NR6, the CRA will direct the non-resident’s agent to calculate withholding based on net income rather than gross income.
Payers of rental income to non-residents are obligated to withhold tax and remit the withheld amounts to the CRA. When a rental property manager is involved, usually no issue arises. However, in situations in which the tenant pays the rent directly to the non-resident landlord, issues can arise due to the tenant’s lack of awareness of the tax laws. It is imperative that the tenant become aware of and fulfill their withholding obligations, so as to avoid having to pay back taxes, penalties and interest to the CRA later.