US Taxation of MLPs
Beware the tax tribulations of U.S. MLPs
By JOHN HEINZL
Globe and Mail Update
U.S. master limited partnerships look enticing, but there are drawbacks for Canadian investors
The yields on U.S. master limited partnerships look very enticing – 6 per cent to 8 per cent or higher in some cases. Is there a catch?
There are a few catches, actually. First, some background on MLPs.
Most U.S. MLPs own energy-infrastructure assets such as pipelines, storage terminals and processing facilities, although there are MLPs in other industries as well. They are similar to income trusts in that MLPs don't pay tax at the corporate level but distribute most of their cash to unitholders.
For U.S. investors, MLPs offer a tax-deferral advantage: Distributions are classified largely as return of capital (ROC), which means investors are not taxed immediately but instead deduct the ROC from their adjusted cost base. This results in a larger capital gain (or smaller capital loss) when the units are ultimately sold. Many MLPs may also pay out a small amount of taxable income.
But for Canadian investors, the tax treatment is quite different. Canadian investors in an MLP with U.S. assets are generally considered to be engaged in a business in the United States. The result is that the MLP will withhold 39.6 per cent tax on any distributions paid to non-resident, non-U.S. citizens.
"That alone should give a Canadian taxpayer pause before investing directly in an MLP," says Jamie Golombek, managing director, tax and estate planning, with CIBC Wealth Strategies Group.
"But it gets worse," says Mr. Golombek, who points out that, technically, the Canadian investor is supposed to file a U.S. tax return to report the income allocated to him or her by the MLP. While the Internal Revenue Service is unlikely to chase down a Canadian investor who doesn't file a U.S. return, "the U.S. withholding tax will likely exceed the investor's actual U.S. tax liability and the only way to get the excess tax back is by filing a U.S. tax return," he says.
From a Canadian tax-filing perspective, things get even more complicated, he says. A Canadian taxpayer must report his or her allocated share of the MLP's income, which will likely not be the same as the amount actually distributed. MLPs typically use U.S. tax rules to calculate this amount, but a Canadian investor is technically supposed to recalculate that income under Canadian tax rules, which in most cases is either impractical or impossible, he says.
"Assuming that the allocated income is properly reported on the Canadian return, Canada will permit a foreign tax credit to be claimed for the actual U.S. tax liability – but keep in mind that this amount can't be known without completing a U.S. tax return," he says.
Finally, investors should note that the 39.6-per-cent withholding tax on MLP distributions applies to all account types – both registered and non-registered. This is in contrast to U.S. dividend income, which – under the Canada-U.S. tax treaty – is exempt from U.S. withholding tax for registered retirement accounts and subject to a reduced rate of 15 per cent for non-registered accounts, tax-free savings accounts and registered education savings plans.
"You really have to think twice about investing in MLPs, particularly in a registered account, because in that case, you will face the 39.6-per-cent withholding tax but you won't be able to claim any foreign tax credit," Mr. Golombek says. You can only claim a foreign tax credit if the MLP is held in a non-registered account but, as discussed above, that may be quite challenging.
Bottom line: Those juicy MLP yields might not look so tempting after you factor in the tax you'll have to pay – and the extra work that may be required.