U.S. tax reform to bring double taxation to some Canadians

Changes will hit those with American property, dual citizens with Canadian earnings and even needy startups hoping for VC funds from U.S.

February 6, 2018

While much of the commentary on U.S. tax reform has focused on the impact on business, some nasty surprises are in store for individual Canadians, particularly those with dual citizenship or who hold a U.S. green card.

“The Americans have fundamentally changed the way that foreign income is taxed for U.S. citizens and residents,” says Roy Berg, director, U.S. Tax Law at Moodys Gartner Tax Law LLP. “For example, a doctor who is a dual citizen and practising in Canada and has $2 million of accumulated earnings in a private Canadian corporation, would have a one-time U.S. tax liability of $300,000 this year.”

The tax is part of the “participation exemption system” that allows income earned abroad to be repatriated to the U.S. without penalty.

“What it means it that foreign income is not taxed again when it comes into the U.S.,” Berg says. “That’s why Google, Apple and a host of other tech companies are bringing cash back in container loads.”

A doctor who is a dual citizen practising in Canada, with $2M of accumulated earnings in a private Canadian corporation, would have a one-time U.S. tax liability of $300,000 this yearRoy Berg, director, U.S. tax law, Moodys Gartner

But there is a price, now known as the “transition tax.” It imposes a one-time levy on U.S. citizens and corporations who own at least 10 per cent of the vote or value of a foreign corporation, including direct, indirect or constructive ownership of such stock.

“The transition tax is particularly onerous because it applies not only to cash and cash equivalents held outside the U.S., but also to non-cash assets realized from the investment of business earnings,” Berg says.

And while U.S. corporations are offered relief in the form of the tax-free repatriation provisions in the Tax Cuts and Jobs Act, individuals are effectively subject to double taxation. Even foreign tax credits will not be available in Canada because the transition tax is not imposed on a foreign (from the Canadian perspective) source of income.

To make matters worse, the Internal Revenue Service has recently issued a notice that it will disregard any transactions undertaken for the principal purpose of reducing the transition tax.

“Tax lawyers are trying to mitigate the transition tax, but currently there is no viable solution,” Berg says.

Traps for the unwary, including non-dual citizenship hockey and maple syrup Canadians, also lie in the estate tax regime.

To be sure, the basic exemption has doubled from inflation-indexed US$5.49 million to US$11.18 million — meaning Canadians will be subject to estate tax on U.S. property only if their worldwide net worth at death exceeds US$11.18 million.

But there’s a fly in the ointment.

“A separate law enacted last year imposes a penalty if the estate does not file a tax return,” Berg explains. “Previously, there was no such penalty.”

And the penalty is harsh: where a tax return is not filed, the cost base for assets as of the date of death is zero rather than fair market value.

“There’s no disadvantage in filing,” Berg says. “But filing does force disclosure of the estate’s worldwide holdings, which creates an opportunity for an audit to see if things have been done right.”

There are also consequences for Canadian entrepreneurs seeking to finance startups.

“The one thing that hasn’t got enough attention is the behaviour of U.S. capital and what choices it will make about investing,” says Paul Seraganian, a tax partner in Osler, Hoskin & Harcourt LLP’s New York office.

That’s important when the non-resource portion of the Canadian economy, particularly emerging technology companies, are looking for capital. Traditionally, much of that capital comes from or is managed by U.S. pools or venture capital funds.

“Tax reform has dealt these sources a set of cards that will change conventional thinking, to the detriment of Canadians’ ability to attract capital,” Seraganian says.

Historically, these pools structured their portfolios by setting up foreign parent companies in jurisdictions that offered lower tax rates than those in the U.S.

“The ‘inversion’ wave we saw was driven by the fact that, from a tax perspective, it was better for the parent company to be a foreign company rather than a U.S. company,” Seraganian says. “But tax reform has made that thinking a lot more choppy by creating a host of reasons that favour having U.S. parents.”

The upshot in the medium and long term may be that more and more Canadian businesses will be housed in U.S. corporate solutions.

“There could well be a hollowing out of emerging companies,” Seraganian says. “The jury’s still out on this, but the conditions are set.”

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