GAIN ON SALE OF REAL PROPERTY LOCATED IN U.S. BY CANADIAN ON CALENDAR YEAR ACCOUNTING PERIOD IS EXEMPT FROM U.S. TAX IF SALE OCCURS BEFORE 1986

Rev. Rul. 85-76

ISSUE

If, under the circumstances described below, a Canadian resident derives gain in 1985 from the sale of undeveloped land situated in the United States, do the terms of the treaty agreements between the United States and Canada exempt that gain from United States income tax?

FACTS

On January 2, 1985, A, a resident of Canada, purchased undeveloped land in the United States as an investment for 2x dollars. A sold the undeveloped land for 3x dollars on June 15, 1985. A has no permanent establishment in the United States, and A's books and records are maintained on a calendar year basis.

LAW AND ANALYSIS

Section 897 of the Code was enacted by section 1122 of the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA), which is subtitle C of title XI of the Omnibus Reconciliation Act of 1980, 1980-2 C.B. 509. Section 897(a)(1) provides, in part, that gain or loss of a nonresident alien individual or a foreign corporation from the disposition of a United States real property interest is taken into account for purposes of sections 871(b)(1) and 882(a)(1) as if the taxpayer were engaged in a trade or business within the United States during the taxable year and as if such gain or loss were effectively connected with such trade or business.

In situations where a prior treaty obligation of the United States exempted from taxation the gains that are described in section 897, section 1125(c) of FIRPTA supersedes the obligation and provides effective dates for the taxation of those gains.

Article VIII of the former United States-Canada Income Tax Convention, 1943 C.B. 526, as amended (the 1942 Convention), contains a provision exempting from United States income tax all gains derived in the United States from the sale or exchange of capital assets by a resident of Canada, provided that the Canadian resident has no permanent establishment in the United States.

The new United States-Canada Income Tax Convention (the New Convention) was ratified and entered into force subsequent to the enactment of FIRPTA, Article XIII of the New Convention allows the United States to tax gains derived by a resident of Canada from the alienation of real property situated in the United States.

Paragraph 2(b) of Article XXX of the New Convention provides that, for taxes other than taxes withheld at the source on dividends, interest, royalties, and pensions and annuities, the provisions of the New Convention shall have effect for tax years beginning on or after the first day of January next following the date on which the New Convention enters into force. The New Convention entered into force on August 16, 1984. Thus, for a taxpayer that files income tax returns on a calendar year basis, the effective date for taxes covered by paragraph 2(b) of Article XXX is January 1, 1985. Among the taxes covered by paragraph 2(b) of Article XXX is the tax permitted by Article XIII of the New Convention, described above, which concerns United States taxation of gains by Canadian residents from sales of United States realty. Thus, taxation of gains such as A's is permitted by Article XIII for tax years beginning on or after January 1, 1985.

Paragraph 5 of Article XXX of the New Convention, however, states that where any greater relief from tax would have been afforded by any provision of the 1942 Convention than under the New Convention, any such provision shall continue to have effect for the first taxable year with respect to which the provisions of the New Convention have effect under paragraph 2(b). Under A's circumstances, Article VIII of the 1942 Convention affords greater relief than does Article XIII of the New Convention.

Since the New Convention was ratified and entered into force subsequent to the enactment of FIRPTA, the effective date provisions of the New Convention apply to the present situation, and section 1125 of FIRPTA does not apply. See Cook v. United States, 288 U.S. 102, 118-119 (1933); United States v. Lee Yen Tai, 185 U.S. 213, 220-221 (1902). The Senate Foreign Relations Committee, in its report on the New Convention, expressly adopted the view that paragraph 5 of Article XXX extended by one year the date on which Canadian residents would first be subject to United States taxation of gains derived from alienation of real property situated in the United States. See S. Exec. Rep. No. 22, 98th Cong., 2d Sess. 10 (1984).

Accordingly, Article VIII of the 1942 Convention continues to be effective for tax years beginning before January 1, 1986, where, as in the present situation, the taxpayer concerned would receive greater United States tax relief under that provision than under Article XIII of the New Convention. In such situations, the tax permitted by Article XIII of the New Convention applies only to real property gains derived in tax years beginning on or after January 1, 1986.

HOLDING

Pursuant to paragraph 5 of Article XXX of the New Convention, Article VIII of the 1942 Convention continues to be effective for A's tax years beginning before January 1, 1986. Thus, A's gain in 1985 is exempt from United States tax.