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...
The United States is in the throes of the most comprehensive tax reform since 1986. On November 16, the House passed its version of the Tax Cuts and Jobs Act (“TCJA”). The Senate passed its version on December 2. While there are significant differences, both versions of the TCJA include what we will refer colloquially to as a “one-time tax” for US citizens that own foreign (including Canadian) corporations. If the TCJA is enacted, US citizens with foreign corporations will owe a 14% tax on the total cash and investments owned by the corporation to the United States. The tax also applies, albeit at a reduced rate of 7%, to illiquid business assets.
A simple example illustrates the severity of this tax. Mrs. X is a US citizen in Canada who practices medicine through a Canadian corporation that she wholly owns. Her medical corporation has $ 1 million in investments. The “one-time tax” would cost her $140,000 (14% of her corporately owned investments). There are some solutions for Mrs. X. They may include:
- Renouncing her US citizenship prior to the enactment of the TCJA.
- Transferring her shares of her corporation to her Canadian resident spouse who is not a US citizen prior to the enactment of the TCJA.
The “one-time tax” and these solutions are explained further below. Before taking any action, Mrs. X should speak to her accountant and determine her precise exposure and whether any stored up credits can be used to offset the “one-time tax”.
The reason for the “one-time tax”
A key part of the TCJA is the transition of the US corporate tax system from a worldwide model to a territorial model. Because of the current worldwide system, large companies like Apple have an incentive to keep profits offshore and not repatriate them to the US. Apple, for instance, currently has over USD $ 200 billion offshore that is deferred from US corporate taxation. To pay for the transition of the corporate tax system, the House and Senate versions of the TCJA impose a tax on all such profits deferred from US tax since 1986 (the “one-time tax”). From a US federal corporate tax perspective, this makes sense. Apple will benefit significantly from the new corporate tax system, so it is logical to impose a one-time tax on deferred profits to pay for the transition to the new system.
The “one-time tax” also applies to individual US citizens
Unfortunately, the “one-time tax” extends to US taxpayers beyond Apple and includes US citizens who own foreign (i.e. Canadian) corporations. While this result is mystifying from a policy perspective, since US citizens abroad will not benefit from the change in the corporate tax rules, this is how both the House and Senate versions of the TCJA are drafted. A brief technical explanation is in order.
Overly simplified, under both the House and the Senate bills the “one-time tax” is integrated into the existing controlled foreign corporation (CFC) regime. That regime applies equally to both US citizens like the doctor above and Apple. Because of this, the “one-time tax” intended for large corporations like Apple, applies to individual US citizens as well. In its summary of the legislation, the Joint Committee on Taxation, a non-partisan arm of Congress, writes “In contrast to the participation exemption deduction available only to domestic corporations that are U.S. shareholders under subpart F, the transition rule [the technical term for the “one-time tax”] applies to all U.S. shareholders of a specified foreign corporation.” The definition of “specified foreign corporation” includes all controlled foreign corporations including those owned by individual US taxpayers. There is no relief elsewhere in either the House or Senate version of the TCJA.
Although it has passed the House and the Senate, the TCJA is not yet law. For it to be enacted, the House and Senate must reconcile differences between their versions, pass the same reconciled version, and President Trump will have to sign it. It is unclear whether it will become law or in what form. What is clear, however, is that a) the TCJA has progressed very quickly and b) the tax implications of the “one-time tax” are staggering. For those worried about the potential implications of the “one-time tax” there may be a couple of solutions:
- Renounce US citizenship prior to the enactment of the TCJA. If a US citizen renounces prior to the enactment of the TCJA, then the “one-time tax” may not apply. The application of the “one-time tax” to someone who renounces prior to its enactment would be a retroactive change in the law. Long-standing decisions from the US Supreme Court hold that new laws do not apply retroactively unless Congress clearly indicates that they apply retroactively. Our view is that the current bills may not meet this standard. There are also constitutional prohibitions on retroactive taxation that may strengthen this position.
- Gift ownership of the Canadian corporation to a spouse prior to the enactment of the TCJA. This gift would use up a US citizen’s lifetime estate and gift tax of US $5.49 million, but not be taxable in Canada, because it is a transfer to a spouse. After the gift, for similar reasons as outlined above, the “one-time tax” may not apply to the US citizen.
A few words of caution are necessary. Before making any decisions, a US citizen should contact his/her accountant to determine the amount of foreign tax credits he/she has stored up. These might take the sting off a bit and eliminate the need for either option. Both options above have a bit of risk to them. They are based on very complex areas of US tax and constitutional law and so written legal advice is a must before they are implemented. If neither option is pursued, a US citizen who owns a Canadian corporation should wait until the TCJA is enacted and consult with an accountant to make sure that double tax exposure is avoided.
In short, the “one-time tax” will be a significant tax hit to US citizens in Canada who own corporations, but there may be some ways to mitigate it prior to the enactment of the TCJA.
This blog post is a summary of very complex legal issues many of which are not discussed here. It is not intended as legal advice and cannot be relied upon as such. US citizens who own foreign corporations must get legal advice prior to taking any actions.