The new US “one-time tax” on US citizens who own foreign corporations

    Written by Max Reed

    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 f $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.

    Solutions

    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:

    1. 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.
    2. 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. 

    US Tax Reform Presents Opportunities for Canadian Businesses

      On November 2, 2017, the US House of Representatives unveiled the Tax Cuts and Jobs Act which contains the most sweeping changes to US tax law in 30 years. While it remains unclear whether, when, or in what form the new bill will become law, but if it passes in its current form Canadian businesses with US operations will want to revisit their cross-border tax and business plans.

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      The Application of the US PFIC Regime to Canadian Start-Ups

      The Application of the US PFIC Regime to Canadian Start-Ups

        Written by Max Reed

        Many Canadian start-ups, whether junior mining, biotech, or tech, receive funding from investors in the United States (or from US taxpayers who reside in Canada). If the proper steps are not taken, a punitive US tax regime (the passive foreign investment company or “PFIC” rules) may increase the tax cost on an exit of these investors.  Amongst other things, the PFIC regime can easily double the tax cost on exit from the investment. These adverse tax consequences can be mitigated if addressed in the first year the investment is owned. Consequently, to ensure tax efficiency for investors and avoid potential civil liability, early stage companies should make US investors aware of the potential application of the PFIC regime and take the steps necessary to address it.

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        US Government sues Canadian resident US citizen for 860K in penalties

        US Government sues Canadian resident US citizen for 860K in penalties

          By Max Reed and Charmaine Ko, US Tax Lawyers

          Last May, the U.S. Department of Justice sued Jeffrey P. Pomerantz — a Canadian resident, US citizen — for over USD $860,300 in penalties and interest for failing to file his FBAR bank disclosure forms. This case is one of the first known instances of the enforcement of FBAR penalties against a US citizen living in Canada. US citizens who have bank accounts abroad are supposed to file an FBAR each year if they have over USD $10,000 in the aggregate in bank accounts outside the United States. The penalties for failing to file an FBAR are very harsh – ranging from USD $10,000 per account to the greater of $100,000 or 50% of the balance of the account if the violation was willful.

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          Can Clients Ditch U.S. Citizenship Retroactively?

          Can Clients Ditch U.S. Citizenship Retroactively?

            Written by Max Reed

            Whether for ideological reasons or tax complications, many people want to shed their U.S. citizenship. There are two ways to do so: renunciation and relinquishment.  Renunciation requires swearing an oath at a U.S. consulate. A person who renounces is no longer a U.S. citizen from the date of that oath onward. Meanwhile, relinquishment refers to losing U.S. citizenship due to a prior external event called an “expatriating act.”

            This article will focus on relinquishment. It is possible – although not without tax risk – to have lost U.S. citizenship for both tax and immigration reasons due to an “expatriating act” that occurred prior to 2004. The tax and immigration consequences of relinquishment are complex, so professional advice is a must.

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            The Tax Consequences of Inheriting Money from the U.S.

            The Tax Consequences of Inheriting Money from the U.S.

              Written by Max Reed

              Many Canadians inherit money from relatives in the United States. There are generally no issues on either side of the border if a Canadian inherits property or money through a will. That being said, many U.S. residents plan their estates by using a trust rather than a will for the purpose of avoiding probate. U.S. tax law pretends this trust does not exist. As such, there is a bump in cost basis when the person who set up the trust dies so there is no capital gains tax when the assets are later liquidated.  

              Canada takes a different view, however, and this can cause tax problems for Canadian residents who inherit from U.S. trusts.

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              Protecting Canadians from the U.S. Estate Tax

                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 any assets that are considered to be located in the United States. This includes U.S. real estate, stocks in U.S. corporations (such as Apple, Exxon or Walmart), and personal property located in the country.

                The 2016 top U.S. estate tax rate is 40% of the value of the property. This could create a sizable tax bill when any Canadian resident who owns U.S. real estate or a large U.S. stock portfolio dies. Under domestic U.S. law, only US$60,000 of U.S. property is protected from estate tax. Note that RRSPs offer no protection from the U.S. estate tax. Canadians get an increased estate tax credit thanks to the Canada-U.S. Tax Treaty, which is more complicated than meets the eye.

                 

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                The QEF Election is a Suboptimal Remedy to PFIC Pain

                  QEF Elections and PFICs

                  Written by Max Reed

                  The standard solution to the PFIC problem offered by certain banks and investment funds is that a US investor in a PFIC should rely on the QEF election.

                  This is an election on behalf of the taxpayer that the products in which they have invested and to which the election applies are not to be treated as Passive Foreign Investment Companies (PFICs). Effectively, this will eliminate the PFIC tax moving forward for the investor, provided the correct paperwork is filed for each fund every year. Though often touted as a simple way out of the PFIC problem, QEF election is anything but.

                  The QEF election on behalf of investors is suboptimal for a number of reasons, not least of which being that, from a nuts and bolts point of view, it’s expensive to prepare. It can cost anywhere from $100 to $500 dollars to prepare Form 8621 properly: and this is per mutual fund, per year. This is a drop in the bucket when compared to the actual tax consequences of the QEF election, however. Though a far superior outcome to PFIC-status, QEF election is not as painless as many think.

                  The first major issue with QEF election is that a taxpayer must “clear the slate,” so to speak. This means that one must realize all unrealized capital gains for the years between when the individual bought the investment and when the individual first uses the QEF election. The taxpayer is then assessed the PFIC tax on all of this with the tradeoff of never again having to deal with it as a PFIC — provided the appropriate yearly filing obligations are observed, per mutual fund.

                  This of course assumes that the QEF election is done properly in the first place. In addition to the compliance costs already noted, Form 8621 is rather complicated, and there is much room for error. The problem with this is twofold: first, if done improperly an individual is still exposed to the PFIC problem and second, it now alerts the IRS to an individual’s holdings in possible PFICs and encourages the assessment of the PFIC tax as well as applicable penalties for incorrect filing.

                  Finally, the QEF election on behalf of an investor can change the character of an individual’s earnings. This can actually wind up including income otherwise taxed at preferential rates (notably, dividends) as ordinary income, taxable at an individual’s existing marginal rate.

                  All of this assumes that the funds in question make available all of the relevant material to make the QEF election in the first place. This is not always the case. Though many larger Canadian Mutual Funds do furnish the required information for QEF election, it is most certainly not the case for all funds. Where it is not the case, individuals still face exposure to the onerous PFIC regime and are unable to make a QEF election.

                  Ultimately, though the QEF election is preferable to PFIC status, it is not without its own problems. The problems noted here assume that Canadian mutual funds are PFICs. Our view is that this is not always the case.