Written by Max Reed Owning real property on both sides of the border can create a confusing tax situation. Consider this example. Stefan and Jane are married and live in...
This article addresses complex topics in a summary fashion and does not exhaustively discuss all potential issues. It is not intended to be legal advice and cannot be relied upon as such.
On August 1, the IRS released 250 pages of explanations and proposed regulations (the “Proposed Regulations”) related to the transition tax that is found under Code section 965 of the Internal Revenue Code (the “Code”). The most important part of these regulations relate to how US citizens in Canada, that are subject to the transition tax under Code section 965, can use taxes paid to Canada to minimize their double tax exposure.
The take away points of this article are:
- The regulations do not affect the use of foreign tax credit carryforwards to use prior tax to offset US tax paid;
- There are a couple strategies that should be considered to maximize the foreign tax credits in light of the proposed regulations:
- Using the Canada-US Tax Treaty to claim a full foreign tax credit; and/or
- Generating Canadian tax by way of increasing the paid-up capital (“PUC”) of the US shareholder’s shares.
Both strategies have some risk to them. First, though, it makes sense to start with an outline of the risk posed by section 965.
Note that this article is written in an argumentative fashion meaning that it makes the case for both strategies. It does not necessarily explore all nuances of either strategy. It is not a substitute for formal advice and any US citizen in Canada subject to Code section 965 should consult a tax advisor.
Background on Section 965
Put simply, Code section 965 poses a significant double taxation risk for US citizens in Canada because of a potential timing mismatch. Many US shareholders of Canadian corporations owe US tax in 2017 thanks to Code section 965. However, these same shareholders will again be subject to Canadian tax when the profits of their Canadian corporation are distributed to them as dividends. Unfortunately, at that time, Canada would not be obligated to provide a foreign tax credit for Code section 965 tax already paid to the US, as it was US tax imposed on Canadian-sourced income. Left unaddressed, the double tax risk would be significant. This is not news.
Previously, we recommended that extra tax be generated in Canada to mitigate the double tax exposure, either through a distribution in 2017, or one in 2018 and the excess tax carried back against the 2017 US tax liability. For lack of a better term, we refer to this as an “Equalization Dividend”. Our view was (and remains) that the Canadian tax (whether generated in 2017 or 2018) provides a dollar for dollar credit against the Code section 965 tax. Or, to put it in more technical terms, this foreign tax credit was not subject to the “grind down” in Code section 965(g). Our view is rooted in the text of the statute and the legislative history. You can read it here.
The IRS’ View in the Proposed Regulations
Treasury has taken a different view in the Proposed Regulations. The Proposed Regulations indicate that foreign taxes generated on a distribution of earnings and profits subject to the 965 inclusion would be subject to the Code section 965(g) grind down. That would reduce the Canadian tax available for the foreign tax credit by 55.7% on the cash portion and 77.1% on the non-cash portion. Specifically, Prop. Reg. 1.965-5(b) which interprets code section 965(g) reads:
Rules for foreign income taxes paid or accrued. Neither a deduction (including under section 164) nor a credit under section 901 is allowed for the applicable percentage [the applicable percentage refers to the grind down] of any foreign income taxes paid or accrued with respect to any amount for which a section 965(c) deduction is allowed for a section 958(a) U.S. shareholder inclusion year. Neither a deduction (including under section 164) nor a credit under section 901 is allowed for the applicable percentage of any foreign income taxes attributable to a distribution of section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits. […] Similarly, no deduction or credit is allowed for the applicable percentage of net basis taxes imposed on a United States citizen by the citizen’s jurisdiction of residence upon receipt of a distribution of section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits.
From its plain meaning, it does not restrict the use of foreign tax credit carryforwards from prior years. Prop. Reg. 1.965-5(b) only applies the grind down to distributions of previously taxed income under Code section 965.
Still, to put it lightly, the proposed regulation is problematic for a US citizen in Canada who is trying to avoid double tax. There are, however, a few potential planning strategies to maximize the value of the credit and avoid the grind down.
The Canada-US Tax Treaty provides a full foreign tax credit
The first strategy is to take the position that the Canada-US Tax Treaty provides a full credit. While this position is more complex, here is an outline of it in brief. Since it is directly contrary to an IRS proposed regulation, this position obviously has some risk to it and may need to be disclosed. But as is noted below, the very purpose of the Canada-US Tax Treaty is to minimize double taxation.
To start out, income from the Code section 965 inclusion is generally foreign source income under the Code. The Equalization Dividend is also foreign source income. Although not a dividend under Code section 959 since it is Previously-taxed income (“PTI”) for US tax purposes, the Equalization Dividend would qualify as a dividend under Treaty Article X(3). That means that under Treaty Article XXIV it is Canadian-source income. Obviously, Canadian tax paid on the Equalization Dividend is foreign tax. The application of the grind down to the Equalization Dividend causes double taxation in two different ways. First, it limits the full utilization of the Canadian tax paid as a US credit, thereby causing a US citizen in Canada to ultimately pay tax to both the US and Canada on Canadian source income, in situations where the Canadian tax paid is equal to or may even exceed the US tax owing on the Canadian source income. First, it limits the full utilization of the Canadian tax paid as a US credit, thereby causing a US citizen in Canada to ultimately pay tax to both the US and Canada on Canadian source income, in situations where the Canadian tax paid is equal to or may even exceed the US tax owing on the Canadian source income. For instance, if the Canadian company had 100 of earnings subject to the transition tax under Code section 965, the US citizen in Canada would have a US tax liability of 17.54 (assuming the 15.5% rate applied to the entire 100). If the grind down did not apply to the tax paid on an actual distribution, the Canadian company would only have to distribute 43.85 (assuming a 40% tax rate in Canada). The rule under Prop. Reg. 1.965-5(b), however, requires the US citizen to pay tax to Canada which substantially exceeds the US tax liability in order to fully offset the US tax liability on the Canadian source income by way of a foreign tax credit. That is, the Canadian company would have to distribute 98.98 and pay 39.6 in Canadian tax to have a sufficient amount of foreign taxes to carryback and fully offset the US tax liability of 17.54.
Second, future distributions beyond 2018 that are subject to Canadian tax cannot be used to offset any US tax paid on the section 965 inclusion in 2017. That’s because the US foreign tax credit carryback is limited to one year. There are a number of arguments as to why the Canada-US Tax Treaty should provide a full credit despite Prop Reg. 1.965-5(b).
A. There is a credit available under Article XXIV(4)(b)
The first route to a credit is under Article XXIV(4)(b). The text of Article XXIV(4) reads in full:
Where a United States citizen is a resident of Canada, the following rules shall apply:
(a) Canada shall allow a deduction from the Canadian tax in respect of income tax paid or accrued to the United States in respect of profits, income or gains which arise (within the meaning of paragraph 3) in the United States, except that such deduction need not exceed the amount of the tax that would be paid to the United States if the resident were not a United States citizen; and
(b) for the purposes of computing the United States tax, the United States shall allow as a credit against United States tax the income tax paid or accrued to Canada after the deduction referred to in subparagraph (a). The credit so allowed shall not reduce that portion of the United States tax that is deductible from Canadian tax in accordance with subparagraph (a).
While paragraph 4(a) refers only to Canadian FTCs on US source income, paragraph 4(b) is broader. It generally mandates that a US citizen in Canada gets a foreign tax credit against US tax for tax paid to Canada after the application of paragraph 4(a). If the value of the credit in paragraph 4(a) is zero, then the credit in paragraph 4(b) is not limited. There is no limitation in paragraph 4(b) to US source income. It applies regardless. The Technical Explanation to the 1980 treaty confirms this:
The rules of paragraph 1 are modified in certain respects by rules in paragraphs 4 and 5 for income derived by United States citizens who are residents of Canada. Paragraph 4 provides two steps for the elimination of double taxation in such a case. First, paragraph 4(a) provides that Canada shall allow a deduction from (credit against) Canadian tax in respect of income tax paid or accrued to the United States in respect of profits, income, or gains which arise in the United States (within the meaning of paragraph 3(a)); […]
The second step, as provided in paragraph 4(b), is that the United States allows as a credit against United States tax, subject to the rules of paragraph 1, the income tax paid or accrued to Canada after the Canadian credit for U.S. tax provided by paragraph 4(a). The credit so allowed by the United States is not to reduce the portion of the United States tax that is creditable against Canadian tax in accordance with paragraph 4(a).
As an aside, the importation of the principles of Article XXIV(1) into XXIV(4) goes beyond the scope of the text of XXIV(4). This is odd, but one cannot read into the text of Article XXIV(4) a limitation which is not present in the text itself. Taken on its face, the technical commentary indicates that the credit under XXIV(4)(b) applies to more than just US source income.
Regardless, the examples in the technical explanation demonstrate that the US must provide a credit for Canadian tax on Canadian-source income, but after the Canadian credit on US-source income. If the Canadian credit on US-source income would be zero, then the US would be obligated to provide a full credit for tax paid to Canada by a US citizen resident in Canada. That is the case under Code section 965 and the Equalization Dividend. This is one reason why the Treaty grants the full credit. The other is found under paragraph XXIV(1).
B. There is a credit available under Article XXIV(1)
Another, not mutually exclusive route to the same result, is under Article XXIV(1). The express text of Article XXIV(1) provides a US citizen a credit against US tax for Canadian tax paid to prevent double taxation. If not for the Proposed Regulations (and perhaps the text of Code section 965(g)), a Canadian resident US citizen would get a full credit against the US tax owing under Code section 965 for the Canadian tax generated by the Equalization Dividend.
The primary limitation in Treaty Article XXIV(1) is “subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof)”.
On a reading of the text of Article XXIV(1) itself, the scope of this limitation is constrained significantly in two ways. First, US domestic law can certainly limit the Treaty credit, but it has to be done in a way that does not change the general principle that there is a credit available. It is clear, and the technical commentary to the 1980 version of the Treaty supports this, that the domestic law limitation language refers to the general foreign tax credit limitations (such as the baskets found under section 904) found under the Code.
Second, the US domestic law limitation is also restricted in its scope by the presence of paragraphs XXIV(4) and XXIV(5). The text of Article XXIV(1) indicates that the entire article (including the domestic law limitation portion) is “subject to the provisions of paragraphs 4, 5, and 6.” This reading is supported by two authoritative sources. First, the 1980 Treaty Technical commentary reads, “The rules of paragraph 1 are modified in certain respects by rules in paragraphs 4 and 5 for income derived by United States citizens who are residents of Canada.” Second, the DC Circuit stated indirectly in distinguishing the Canada-US Tax Treaty from the US-German Tax Treaty, “The U.S.-Canada Treaty provision we examined contained a clause subjecting its tax credit to limitations of U.S. law, but it also explicitly conditioned the tax credit and arguably the limitation itself on subsequent paragraphs of the treaty.” (Haver v. Commissioner , 444 F.3d 656, 659, 370 U.S. App. D.C. 311, 314 (D.C. Cir. 2006)). As noted above, the plain meaning of paragraph XXIV(4) is to provide a credit to Canadian resident US citizens for tax paid to Canada – full stop. These restrictions on the scope of the US domestic law limitation support the view that Article XXIV would provide a credit.
Even under a broader reading of the limitation, our view is that there is an argument that the Proposed Regulations do not properly limit the Treaty credit under Code section 965. To start out, consider some general rules on interpreting Treaties and their interaction with the Code. Where possible, a Treaty and the Code are meant to be read harmoniously to give effect to both (see Haver v. Commissioner, No. 05-1269 (D.C. Circuit 2006)). The later in time rule does not apply unless there is a clear conflict between the Treaty and Code (Whitney v. Robertson, 124 U.S. 190, 194 (1888); Jamieson v. Commissioner T.C. Memo. 2008-118). The US Supreme Court has held that a treaty override must be explicit (Cook v. United States, 288 U.S. 102, 120 (1933)) and legislative silence does not indicate an intent to override the Treaty (Trans World Airlines, Inc. v. Franklin Mint Corp., 466 U.S. at 252). Even if an override is implied, in instances of inconsistency, the Treaty prevails (Protocol 3 Amending the 1980 Canada-US Tax Treaty (April 24, 1995)). That means a few things:
- The preferred reading of Code section 965 and the Proposed Regulations is one that allows both to accomplish their objectives;
- Any limitation on the Treaty credit with respect to Code section 965 has to be explicit;
- If there is any ambiguity, the Treaty prevails.
Taking these principles and applying them to Code section 965 and the Proposed Regulations, it is clear that there is no Treaty override. Both Code section 965 and the Proposed Regulations are silent with respect to their interaction with US tax treaties generally. In fact, the word “treaty” appears nowhere in the text of Code section 965, the Proposed Regulations, or the Conference Report explaining that section. Compare this to Code section 7874 or Code section 884(e) where the override of treaty benefits is explicit. Thus, it cannot be said that Code section 965 expressly overrides the Treaty, since it does not refer to the Treaty at all. That means that the Treaty and Code are not in conflict. Absent an express Treaty override, the Treaty and Code have to be read harmoniously to give effect to both. To give effect to the Treaty’s goal in preventing double taxation, the only way to read the Treaty and Code harmoniously is to give a full credit for the Equalization Dividend.
The only reading that accomplishes this is to take the view that while Code section 965 generally grinds down FTCs generated by a distribution of its previously taxed income, a smaller subsection of taxpayers (those entitled to benefits under the Canada-US Tax Treaty) are not subject to the grind down. Put differently, the application of the grind down to US citizens in Canada paying an Equalization Dividend would defeat the objective of reading the Treaty and Code harmoniously. It would also be against the text of Article XXIV(1) because it would: a) “change the general principle” that there should be a US tax credit for Canadian tax paid on a Canadian dividend; and b) limit the principle under Article XXIV(4) that a US citizen in Canada gets a full credit for tax paid to the United States.
In short, then, there is an argument that:
- The Equalization Dividend and associated foreign tax are Canadian source;
- Limiting the foreign tax credit poses a double tax risk;
- A credit should be available under the plain meaning of Article XXIV(4);
- Under normal circumstances, they would be eligible for a full US foreign tax credit under Treaty Article XXIV(1);
- Treaty Article XXIV(1) is subject to the limitations of US domestic law;
- The text of Article XXIV(1) narrows the scope of how those limitations apply;
- In interpreting how those limitations apply, the Treaty and Code need to be read harmoniously;
- The Code can limit the Treaty, but such a limitation has to be explicit;
- Code section 965 and the Proposed Regulations are silent as to the application of the Treaty;
- Thus, there is no explicit override and the grind down does not apply to US citizens resident in Canada.
This position would likely require advising the client of the risk and disclosing the position to the IRS on Form 8833. Although we think this position is legally correct, it is obviously not without risk. Using a Treaty to override an IRS regulation, even where the law is somewhat clear, is not for the faint of heart.
Generate the Canadian Tax by way of Increasing the PUC
A second option is to adjust the way the Canadian tax is generated. As noted above, the Proposed Regulations apply the grind down to FTCs generated by the “receipt of a distribution of section 965(a) previously taxed earnings and profits.” But what if the FTC were generated by something that was not a “distribution” for US tax purposes? Under Canadian tax law, it is possible to generate tax by increasing a corporation’s paid-up capital (“PUC”). Under this approach, the corporation first increases its stated capital for corporate law purposes by the amount that it wishes to distribute. This increase to stated capital results in a corresponding increase to PUC for purposes of the Income Tax Act (Canada). As a result, subsection 84(1) deems the corporation to have paid a dividend in an amount equal to the PUC increase.
The US tax system has no equivalent concept of PUC. Thus, from a US tax perspective there has been no contribution or distribution. The lack of a “distribution” would arguably avoid the grind down. Under Treas. Reg. 1.904-6(a)(1)(iv), where foreign tax is imposed on an item of income that does not constitute income for US tax purposes, that foreign tax paid is allocated to the general basket – the same basket to which the majority of the 965 inclusion is likely to be allocated.
When a distribution is made in the future, it would constitute a return of capital for Canadian tax purposes with the appropriate corporate resolution. Pursuant to subsection 84(4) of the ITA, the distribution of property (including cash) on a return of capital by a corporation to a shareholder does not give rise to a dividend, so long as the amount of the capital return is less than or equal to the PUC of the shares on which the capital is being returned. To avoid problems, the return of capital stage should be delayed until the money is needed. Only the amount of cash needed to pay the tax should actually be withdrawn.
For US federal tax purposes, a later distribution would be PTI. The Canadian tax generated earlier would not be associated with the distribution of PTI. While the US step-transaction doctrine may be applicable, particularly if all the cash is taken out in the same year as the initial PUC bump or shortly thereafter, that risk is reduced if the distributions are delayed.
The exact corporate law mechanics of this approach will vary by province. Further, some attention would have to be paid to those taxpayers that have already declared a dividend in a prior year. But from a combined Canada/US tax perspective, it seemingly generates the necessary foreign tax to fully offset the 965 inclusions without being subject to the grind down. Any US citizen in Canada who is considering this suggestion should certainly consult a tax advisor.
The Proposed Regulations present a significant obstacle to US citizens in Canada who want relief from the double tax risk posed by Code section 965. While the Proposed Regulations make this task more complex, our view is that it is still achievable under either the Treaty based argument or by way of an adjusted approach to generate the Canadian tax. If a taxpayer wants to be extra cautious, both approaches might be used together.