The largest U.S. tax change in more than three decades is expected to drive the U.S. economy, thanks to both corporate and individual tax cuts.
Unfortunately, your cross-border clients won’t be going along for the ride. In fact, it may have some American clients thinking about renouncing their U.S. citizenship.
Here’s a closer look at the hits and misses for cross-border clients from the 1,097-page legislation President Donald Trump signed late last year. (All figures are in U.S. dollars.)
U.S. estate tax exemption increases
Let’s start with the good news.
Canadians with more than $60,000 in U.S. property (real estate, stocks, life insurance), as well as worldwide assets over an exemption threshold ($5.49 million in 2017), are subject to U.S. estate tax of 40% on U.S. assets at death. (For Canadians and U.S. non-domiciled citizens, the exemption is pro-rated based on the value of U.S. assets relative to worldwide assets).
Effective for 2018, U.S. tax reforms double the exemption to $11.2 million per person ($22.4 million per family), so only ultra-wealthy Canadians—and ultra-wealthy U.S. citizens living in Canada—who own U.S. property will be affected by U.S. estate tax.
But there’s still value in estate tax planning.
Noting that Hillary Clinton campaigned on lowering the exemption, Matt Altro, president and CEO of MCA Cross Border Advisors in Montreal, asks, “What happens in two years if the Democrats get back in?” He adds that the exemption has varied over the last couple of decades and has never been as high as $11 million. “It probably has one way to go, which is back down,” he says.
That means typical planning to avoid U.S. estate tax should stand, he says, such as using cross-border irrevocable trusts. “That structure, if it’s set up properly, basically excludes the U.S. asset from a Canadian’s estate,” says Altro. A client with the trust already set up should maintain it, and a client with newly purchased U.S. property should consider setting one up, depending on goals and property value.
Such advance planning is required because “there could be a tax to sell the property into the trust later on, if the property’s gone up in value,” he says.
Even if a client is well under the exemption, planning is important to avoid other negative consequences. Says Altro: “Maybe you don’t need a structure that protects from estate taxes if you’re under the threshold, but you need a structure that protects from probate and capacity issues in the U.S. Do not rely on your Canadian provincial will to avoid those issues.”
For wealthy, married clients—one Canadian, one a U.S. citizen—other planning may be required. For example, the U.S. spouse shouldn’t inherit directly from the Canadian spouse if doing so puts the U.S spouse over the threshold, says Altro. When the U.S. spouse dies, the entire value of the estate would be subject to U.S. estate tax.
That tax is avoided if the Canadian spouse sets up a cross-border spousal trust in their will, with the U.S. spouse as beneficiary. The will should state that everything above the exemption—whatever that amount is at death—goes into the cross-border spousal trust.
For Canadian clients moving to the U.S., estate tax can be avoided by establishing pre-entry trusts before the move, which shelters assets from the U.S. estate tax, says Altro.
Ultimately, “the exemption may come down,” he says. “If you can do good planning to get assets out of your estate, that’s still a smart thing to do.”
For Canadian clients with U.S. property, Max Reed, cross-border tax lawyer at SKL Tax in Vancouver, says he aims to avoid estate tax even though, under the Canada-U.S. tax treaty, credit can be applied against the tax. “Taking that credit requires filing a complicated form soon after a person’s death,” he says, referring to a U.S. estate tax return. “So, generally, we tell people to avoid the estate tax altogether.”
Anik Bougie, senior financial advisor at Kerr Financial in Montreal, adds that, unlike American citizens living in the U.S., American non-domiciled citizens must also file a U.S. estate tax return to claim the exemption.
She also says some clients have non-recourse mortgages on their U.S. properties to reduce U.S. estate tax exposure. Such mortgages contribute to a reduction in the value of U.S. assets subject to estate tax. Canadians can probably get non-recourse mortgages more easily if they use a Canadian bank with a U.S. subsidiary, she adds. But, because of the increased threshold, “If there’s no tax purpose anymore, we’re going to rethink our planning,” she says.
She also reminds that clients with U.S. property should consider state estate tax, which varies, when reviewing estate planning.
An unintended consequence of the increased exemption is that it makes it easier to renounce citizenship by allowing greater room for gifting. A U.S. citizen with a net worth greater than $2 million is subject to exit tax on renunciation.
Says Reed: “Now, we’ll be able to make more gifts to the spouse, so a higher-net-worth client can renounce their citizenship without exit tax.” For example, a U.S. spouse could make a gift within the threshold to the Canadian spouse to drop the U.S. spouse’s net worth below $2 million.
Bad news for cross-border business owners
U.S. citizens who own businesses in Canada are already subject to unfavourable U.S. tax rules.
When they own more than 50% of a Canadian company, it is considered a controlled foreign corporation (CFC) for U.S. tax purposes, and anti-deferral rules (subpart-F rules) apply to passive income. (Reed notes the tax situation is more complicated if the business’s owners aren’t all Americans.)
Though the rules aim to prevent offshore tax evasion by wealthy taxpayers and multinationals, they affect incorporated U.S. citizens in Canada, including doctors and other service providers.
As a result, “you’ve got an onerous tax consequence on the U.S. side,” says Altro, with the U.S. citizen taxed personally on investment income earned inside the corporation that year.
The tax reform introduces two changes that make this situation worse.
First, there’s a one-time repatriation tax of 15.5% on retained foreign earnings since 1986 for cash and investments, and 8% on non-cash assets.
For example, a doctor with retained earnings of $1 million would face a $155,000 tax bill for the 2017 tax year—essentially a tax on retirement savings, Reed says. “This is one of the big pay-fors in the tax bill.”
(In contrast, multinationals essentially receive a benefit from the measure because, previously, they would have been subject to a 35% tax rate to repatriate assets. The new repatriation tax helps pay for the transition to a territorial corporate tax model from a worldwide one. The measure is also a potential windfall for investors if U.S. multinationals subsequently increase dividend payments.)
Clients have eight years to pay the tax according to a schedule, says Altro.
To offset the repatriation tax bill, incorporated clients could generate tax in Canada by paying dividends or bonuses, says Reed. Some clients will have credit carry-forwards to do so. That’s because Canadian rates are higher, so U.S. citizens in Canada accumulate surplus credits, which can be carried forward for 10 years.
“That will provide some relief to some people,” says Reed. “It’s fact-specific and depends on how many credits you happen to have.” Again, he expects the measure will increase citizenship renunciations.
Tax professionals are working out how to minimize the tax’s impact. “There’s still more information that needs to be shared from the U.S. government” to clarify technical issues, says Altro.
An associated second measure is the introduction of a tax formula for global intangible low-tax income (GILTI). Aimed at taxing multinationals’ income from intangible property, such as intellectual property, the formula establishes a minimum tax for U.S. corporations offshore. If not paid, personal tax rates apply.
The kicker: “Our clients are also subject to this,” says Reed. That means, for U.S. citizens in Canada who are business owners, income at the small business rate in excess of GILTI will be taxed personally. Reed adds: “This new GILTI regime will hamper the ability of U.S. citizens in Canada to benefit from corporate tax deferral.”
For a doctor, for example, “there will be substantially less deferral from medical fees because a large percentage will be taxable personally in the United States,” says Reed.
Further, the calculation is complex—about 10 pages long, he says, so compliance will be costly.
For U.S. citizens, the two changes “make it very unattractive to be an incorporated business owner in Canada,” he says, adding that clients will have to restructure their businesses as tax efficiently as possible.
U.S. property prize for Canadian corps
The drop in the U.S. corporate tax rate makes U.S. property acquisition a more attractive investment vehicle for Canadian corporations. With the U.S. capital gains rate previously higher than Canada’s, Reed would suggest Canadians own investment property personally through limited partnerships to minimize capital gains tax exposure.
Now, his advice has changed.
“With the new U.S. federal capital gains rate being 21%, more people should consider using corporations to buy U.S. real estate,” he says.
2017 tax filing reminders for cross-border clients
Though U.S. tax reform is touted as simplifying the system for both individuals and corporations, reporting obligations remain the same for cross-border clients, which is “time consuming and costly,” says Anik Bougie, senior financial advisor at Kerr Financial in Montreal.
Those obligations are onerous, including the various forms for foreign reporting. “Some people who think they are compliant with U.S. filing requirements are not necessarily compliant with the other forms,” she says. For U.S. citizens in Canada, that includes forms for holding TFSAs, RESPs or Canadian mutual funds (considered passive foreign investment corporations). Other forms are needed to have signing authority for Canadian accounts at work or on behalf of elderly parents.
In addition to filing U.S. tax returns (Form 1040) and FBARs each year, U.S. citizens in Canada may also have the following foreign reporting obligations:
- FinCEN Form114 for corporations
- Form 3520 for U.S. owners of Canadian (foreign) trusts
- Form 5471 for owners and directors of foreign corporations
Clients with foreign reporting gaps can file for voluntary disclosure of the forms, she says.
U.S. citizens in Canada get a filing extension to June 15 for both 1040s and FBARs.
“You can get another six-month extension beyond that if you file for one,” says Matt Altro, president and CEO of MCA Cross Border Advisors in Montreal, though you should pay taxes by June 15 to avoid interest, he adds.
Bougie notes the substantial presence test for Canadian snowbirds who want to keep their provincial healthcare coverage. Generally, “If they stay in the U.S. for more than 183 days, they are considered a U.S. resident,” she says, and thus would be subject to U.S. tax rules. Though such clients can rely on the Canada-U.S. tax treaty to opt out of the U.S. residency test (cue more form filing), they’d still be on the hook for U.S. reporting (cue even more form filing).
Says Bougie: “The rules make it so that most foreign reporting forms that are usually applicable to U.S. residents are still required.”
U.S. tax changes for individuals
U.S. citizens in Canada receive foreign tax credits, which typically offset their U.S. tax in full, since Canadian rates are higher. With U.S. personal tax rates now even lower, that continues to be the case.
The lower U.S. rates could encourage some people to move to the U.S., says Matt Altro, president and CEO of MCA Cross Border Advisors in Montreal. The increased disparity between taxes in the two countries means these clients require an appropriate immigration and tax strategy, he says.
Also, the new tax bill cuts or minimizes some state and local itemized tax deductions, which could lead to higher taxes for some U.S. clients in those states. (Some states have no state tax, like Florida and Washington, while California has a top rate of up to 13%.)
Here are highlighted tax changes for individuals:
- tax cuts across the seven tax brackets
- the repeal of personal exemptions in favour of a higher standard deduction
- cuts or limits to deductions for those taxpayers using itemized deductions
For example, gone are deductions for foreign real property tax (for a Canadian property, say), tax preparation fees and moving expenses. Less generous itemized deductions include those for medical expenses, mortgage interest and charitable donations. State and local property tax deductions are now limited to $10,000 for joint filers and $5,000 for single filers.
Noteworthy is that net investment income tax stands—a penalty of 3.8% on investment income above adjusted gross income thresholds (e.g., $250,000 for a married joint filer). The tax can’t be claimed with foreign tax credits, making it a potential double taxation for U.S. citizens in Canada, says Anik Bougie, senior financial advisor at Kerr Financial in Montreal. She also notes that many tax changes for individuals sunset after 2025, unless legislated.