Written by Max Reed Canadian residents who aren’t U.S. citizens may be surprised to know that U.S. estate tax can apply to them. Newly enacted U.S. tax rules have increased...
This blog post addresses a very technical question about the new US repatriation tax. It will only be of interest to US tax advisors. It is not meant as legal advice and cannot be relied upon as such. It involves complex US tax concepts so advice specific to the situation is required. Note that this post assumes that all Canadian corporate and tax law formalities have been followed to declare a dividend effective as at December 31, 2017. It does not comment on those requirements and US tax advisors should verify with Canadian corporate and tax advisors to make sure this is possible.
To be clear, if the 965 inclusion is fully covered off by the FTC carry forwards or carry backs no extra Canadian tax is required to be generated. Generating extra Canadian tax is only advisable if there are insufficient carry forwards. This post addresses the scenario where there is insufficient FTCs already available and more need to be generated.
The mandatory repatriation tax imposed by new Code section 965 is vexing and punitive. The exact mechanics of the tax are addressed elsewhere. Here, we address a very narrow, but important point– namely, whether there is a grind down on the foreign tax credit generated by dividends or salary income paid out by the Canadian company to offset the US tax. Our view is that there is no grind down and that a full US foreign tax credit is available for all Canadian tax paid by the US shareholder on a dividend or bonus paid on or prior to 12/31/2017. This is important because it significantly mitigates the double tax risk to the individual US taxpayer. Because the NIIT would apply to a dividend paid out to equalize the FTC even though that dividend itself is not taxable under Code section 959 a bonus may be preferred (see Reg. 1.1411-10(c)(1)(i) for why the NIIT would apply.). Alternatively, advisors may wish to rely on the position that the NIIT does not apply to US citizens resident in Canada.
There is a double tax risk
To start out, let’s illustrate the double tax risk created by Code section 965. Code section 965 imposes a US tax inclusion in tax year 2017 (for an individual who owns a CFC) on the post-1986 earnings and profits of the CFC. Canadian tax would be owing when the money is later paid out by the corporation. This creates double tax – US tax in 2017 and Canadian tax when the money is later paid out to the individual. To correct for this, it is necessary to fully offset the US tax in 2017 by generating additional Canadian tax. There is some confusion as to whether the US foreign tax credit (FTC) generated by this Canadian tax paid out would be ground down under Code section 965. Next, we look at the grind down under Code section 965 in general.
The grind down of FTCs under Code section 965
Code section 965(g) reduces certain foreign tax credits that can be taken against the 965 inclusion. The operative part reads, “No credit shall be allowed under section 901 for the applicable percentage of any taxes paid or accrued (or treated as paid or accrued) with respect to any amount for which a deduction is allowed under this section.”
There is a formula that follows which sets out how the foreign tax credit is reduced. Since we believe that this does not apply, we do not set it out in detail. At first glance, Code section 965(g) would suggest that the US foreign tax credit generated by a 2017 dividend to generate Canadian tax would be reduced. For the reasons that follow, we do not think this is the case.
Notice 2018-7 sets out the timing of the inclusion under Code section 965
The IRS recently released Notice 2017-8. You can find it here – https://www.irs.gov/pub/irs-drop/n-18-07.pdf.
At page 17 of the Notice, the IRS illustrates the timing of distributions for a CFC with respect to the Code section 965 inclusion. While it is not necessary to summarize the entire notice here, put simply the timing of the various tax inclusions are as follows:
- The 2017 Subpart F of the CFC is determined without regard to 965
- Distributions from one CFC to another are determined under section 959
- The 965 inclusion is calculated
- Subsequent distributions are exempt from US tax under Code section 959
- The 956 inclusion is determined
For the purposes of this discussion, ignore steps 2 and 5. What the Notice makes clear is that first the 965 inclusion is calculated and then subsequent distributions are tax free under Code section 959. While the ordering of these steps is clear, their respective dates are not. However, it is safe to assume that a dividend paid out for Canadian tax purposes effective as at 12/31/2017 would be taken into account for purpose of the tax calculation after the 965 inclusion. As the Notice is official IRS guidance, it can be relied upon.
The 2017 dividend would be considered previously taxed income for US tax purposes
Above, the order of the 2017 tax inclusions is set out. Notice 2017-8 makes clear that a dividend or bonus paid by a Canadian company effective as at 12/31/2017 would not be US taxable, because it would be considered previously tax income under Code section 959. This is because the Code section 965 inclusion is taken into account prior to the dividend. Recall that the foreign tax credit grind down under Code section 965(g) applies “with respect to any amount for which a deduction is allowed under this section.” The plain meaning of this phrase suggests that a dividend paid out by the Canadian company effective 12/31/2017 would not be caught. An individual Canadian shareholder who owns a CFC does not generate any Canadian tax with respect to the 965 inclusion itself so there is no US FTC generated because of that. Instead, the individual CFC owner gets a deduction as computed under the general principles of Code section 965. According to Notice Notice 2017-8, a dividend or bonus paid on 12/31/2017 would occur after the 965 inclusion has already been taking into income. Thus, any US FTC generated by the Canadian tax owed as a result of the dividend or bonus payment on 12/31/2017 is not “in respect of an amount for which a deduction is allowed” because the Canadian tax owing is not generated by the same item which is subject to the 965 inclusion, i.e. the CFC’s post-1986 accumulated E&P, but rather, the FTC is generated by the later-in-time dividend. Put differently, the US FTC generated by the Canadian tax on the dividend or bonus payment comes from a different tax event of income than the 965 inclusion. The deduction only applies to income generated by the 965 inclusion. Because the dividend is a different tax event, it cannot be said to be “in respect of an amount for which a deduction is allowed” under section 965. Thus, on the plain meaning of Code section 965(g) the grind down does not apply to the FTC generated by the dividend.
The context of section 965(g) supports this reading
While statutory context is not as authoritative as the plain meaning, it does help to understand that the purpose of the grind down mechanism is to apply to the 960 credit for domestic corporations, rather than subsequent dividends paid out by individual shareholders to avoid double tax. Code section 965(g)(4) states that the application of Code section 78 is limited as a result of the grind down. Without getting into the details, it suffices to say that Code section 78 only applies to domestic corporations and not individual CFC owners.
The legislative history supports the view that the grind down does not apply
The Conference Report to the Tax Cuts and Jobs Act suggests that the grind down was intended only to limit the Code 960 credit. The Conference Report indicates that the logic behind the House bill FTC grind down was the following:
The provision coordinates the disallowance of foreign tax credits described above with the requirement that a domestic corporate shareholder is deemed to receive a dividend in an amount equal to foreign taxes it is deemed to have paid and for which it claimed a credit. Under the coordination rule, the foreign taxes treated as paid or accrued by a domestic corporation as a result of the inclusion are limited to those taxes in proportion to the taxable portion of the section 965 inclusion. The gross-up amount equals the total foreign income taxes multiplied by the fraction, numerator of which is taxable portion of the increased subpart F income under this provision and the denominator of which is the total increase in subpart F income under this provision. (Page 610 of the Conference Report)
Then in the Conference version (at page 620):
To reflect the change in the applicable rates of deduction, the amounts by which foreign tax credits are reduced are also changed. In addition, the rules for coordination of this provision with the limitations on foreign tax credits follows the House provision. Under the coordination rule, the foreign taxes treated as paid or accrued by a domestic corporation as a result of the inclusion are limited to the those taxes in proportion to the taxable portion of the section 965 inclusion. The gross-up amount equals the total foreign income taxes multiplied by the fraction, numerator of which is taxable portion of the increased subpart F income under this provision and the denominator of which is the total increase in subpart F income under this provision.
These two passages support the view that the grind down was intended to apply to the 960 credit, which is irrelevant to individual US citizens who own CFCs, and would not apply to an FTC generated by Canadian tax dated effective as at 12/31.
The Canada-US Tax Treaty offers a backstop to this position
The Canada-US Tax Treaty offers a backstop (an alternate route to arrive at the same conclusion) that there should be no grind down in the FTC related to a dividend subsequently paid. That argument runs as follows. Under Treaty Article XXIV, the dividend income is Canadian source income when received by a Canadian resident US citizen. Under Treaty Article XXIV(1), the US has to give a credit for Canadian tax paid on that dividend unless there is a limit under US domestic law. Our general view is that the Treaty credit generally exceeds that available under US domestic law (consider the credit available under Treaty Article XXIV(5)). Regardless, any limitation under US domestic law would have to expressly limit the Treaty benefit. Code section 965(g) is silent as to the application of the Treaty. Thus, it cannot be said that there is a limitation as to the Treaty credit. Although the US generally has a later-in-time rule under which the Code can be used to override the Treaty, such Treaty overrides are generally explicit. Compare this to Code section 7874 or Code section 884(e) or where the override of treaty benefits is explicit. Where possible, a Treaty and the Code are meant to be read harmoniously (see Haver v. Commissioner, No. 05-1269 (D.C. Circuit 2006)). 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).)
In short, there is a reasonable position under the Treaty that the Code section 965(g) grind down would not apply to FTCs generated by Canadian tax paid on a subsequent dividend.
The Canadian tax generated by the dividend is a US general basket FTC
The Canadian tax paid is general basket. If, under the law of a foreign country or possession of the United States, a tax is imposed on an item of income that does not constitute income under United States tax principles, that tax shall be treated as imposed with respect to general limitation income (see Reg s.1.904-6(a)(1)(iv)).
To recap – a full US FTC should be available for all Canadian tax paid on a dividend paid on 12/31/2017 because:
- Notice 2017-8 indicates that the section 965 inclusion is calculated prior to the dividend or bonus being paid out;
- The express text of Code section 965(g) suggest that the grind down provisions would not apply to the 12/31/2017 bonus or dividend;
- The statutory context suggests that the grind down only applies to the 960 credit;
- The legislative history supports this view quite firmly;
- Even if the above is incorrect, there is a reasonable position that the Treaty would override the grind down to provide a treaty based FTC to prevent double tax — the entire purpose of the Treaty;
- The Canadian tax generated by the 12/31/2017 dividend or bonus generates a general basket FTC.
In short, a full US FTC should be available to offset the 965 inclusion based on Canadian tax paid from a dividend or bonus dated effective 12/31/2017.