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. That’s because U.S. estate tax applies to...
eae recently passed US tax law makes it more complicated for American citizens outside the United States to run businesses, because their income may be “GILTI”. GILTI is an acronym for “Global Intangible Low-Taxed Income”. Under the new US corporate tax system, US corporations are now generally only taxed on the income of the US company itself; dividends received from a foreign subsidiary are tax-free. The GILTI rules were enacted to ensure that companies do not then try to shift all profits to foreign subsidiaries in low-tax countries to then be repatriated tax-free. But these rules also apply to US citizens in Canada who own Canadian corporations. They make it more difficult to defer income from personal tax. That means that the immediate personal tax bill will increase. There are five different ways to plead not GILTI to try and maximize the deferral and minimize the personal tax bill. Each has pros and cons.
1. Basics of the GILTI regime
What follows is a very simplified version of the GILTI rules. The GILTI rules apply to US taxpayers who own 10% of a controlled foreign corporation (a technical term meaning a corporation that is more than 50% by US taxpayers who each own 10% of the shares). Profits earned by that corporation (even from regular business income) have to be judged GILTI or not GILTI.
Profits are judged to be GILTI if they exceed a 10% return on depreciable tangible assets owned by the corporation. The problem is that many corporations don’t own a lot of tangible property – think equipment. For example, many corporations used to provide professional services own very little in the way of equipment. That means that a significant amount of the corporation’s profits are going to be GILTI.
GILTI income is undesirable because it is taxed to the US taxpayer personally, even if it is paid out to of the company. Worse, there is no ability to offset the GILTI inclusion with Canadian tax paid by the corporation or on other income. As a result:
- because the GILTI rules are so complicated, the annual accounting costs to prepare a US tax return will be higher than normal;
- the ability to defer income from personal tax will be reduced and so the total immediate tax bill will increase; and
- the limitation on the foreign tax credits creates a significant risk of paying tax twice on the same income.
To illustrate these rules, let’s take an example. Dr. Jones is a US citizen living in Canada. She owns 100% of the shares of a Canadian corporation through which she provides surgical services. Each year Dr. Jones earns profits of CA$500,000, but only takes a salary from the corporation of CA$100,000. Prior to the new US tax law, she could have deferred the remaining CA$400,000 from personal tax until she needed the money. However, because she is a doctor working in a hospital, her company’s only tangible asset is a laptop worth CA$3,000. Under the new GILTI rules, all profits earned by the company (CA$400,000) in excess of a 10% return on her laptop (CA$300) would be taxed to her personally in the US That would significantly limit her ability to defer her medical income from personal tax, dramatically increasing the amount of tax she pays annually as she will pay personal tax on almost the full CA$500,000 she earns. The cost of her annual US tax return will also increase.
Dr. Jones has a number of options to plead not GILTI to try and maximize her tax deferral.
2. Renouncing US Citizenship
Dr. Jones’ first option is to cease to be a US citizen to stop her exposure to US tax laws. A full discussion of the pros and cons, as well as tax and immigration implications of renouncing US citizenship can be found here. The rules on renunciation are largely unchanged under US tax reform, but the new law does allow more people to renounce without paying taxes. In order to renounce without tax exposure, a US citizen’s net worth has to be less than US$2 million. It is now possible to make gifts of up to US$11.2 million (up from US$5.49 million under the prior law) to reduce a citizen’s worth below the threshold prior to renouncing.
With proper advice, it should be possible for Dr. Jones to renounce her American citizenship without paying any taxes to renounce and without any border risk. Renouncing US citizenship will provide the maximum tax benefits to Dr. Jones as she would no longer be subject to the GILTI rules.
3. Convert Her Corporation to a ULC
If renouncing US citizenship is not appealing, Dr. Jones’ second option is to convert her corporation into an unlimited liability company (ULC). This type of corporation is available under the corporate law of BC, Alberta, and Nova Scotia. A ULC is considered a corporation under Canadian tax law, but not under US tax law. As long as Dr. Jones’ corporation does not have unrealized gain, the conversion from a regular corporation to a ULC should not trigger too much tax in the US or Canada. Under a ULC option, some deferral of personal income tax should be available, but not to the extent if Dr. Jones renounced US citizenship. The downsides of this option are: 1) a lack of liability protection; 2) a ULC is not available in all provinces.
4. Restructure the Ownership of the Corporation
A third option is to restructure the share ownership so that Dr. Jones only owns shares that cannot receive a dividend. Doing so would allow her to avoid the GILTI rules. Assuming Dr. Jones was married to a Canadian resident who was not a US taxpayer, this type of restructuring can be done without income tax consequences in either Canada or the US. Dr. Jones would then be paid a salary for her services. This option significantly preserves the deferral possibility. But restructuring corporations is complex and expensive. And the newly enacted Canadian anti-income splitting rules may make this plan more expensive in some cases.
5. Take Advantage of the GILTI Exception
A fourth option is to use a narrow, technical exception to the GILTI rules. Income is judged to be not GILTI if it is:
- classified as Subpart F income (a U.S. tax term for certain income earned by a foreign corporation), and
- subject to tax at the corporate level in Canada of at least 18.9%.
Not all types of income will meet this criteria, and it requires giving up the Canadian small business tax rate. This strategy will increase the overall tax cost in Canada and the US of earning the money through a corporation, but will preserve some deferral.
6. Use the 962 Election
A final option for Dr. Jones would be to rely on an election found in section 962 of the US tax code. The mechanics of this election are complex, but in short, Dr. Jones can choose to be subject to US tax as if she were a U.S. corporation. The GILTI rules provide a 50% deduction to US corporations that have GILTI income. It is unclear whether this deduction applies to individual taxpayers who use the 962 election, so using it has significant risk. If the 50% deduction is not available, or Dr. Jones doesn’t want to take the risk, then the 962 election is not advantageous as it will result in a lot more tax owing than the other options.
GILTI is a problem for US citizens that own Canadian corporations like Dr. Jones. Left unchecked, it can significantly prevent deferral of corporately earned income from personal tax. Dr. Jones has a few different strategies to plead not GILTI. If she doesn’t value being a US citizen, then renouncing is probably the most effective solution from a tax perspective. But there are other options that will preserve some tax deferral. Choosing the best one will depend on her specific situation and her long-term plans.