The U.S. tax system has never been kind to U.S. citizens in Canada. Now, with the 2017 Jobs and Tax Cuts Act (JTCA), the U.S. Congress has made life even more challenging for many U.S. citizens in Canada who operate businesses.
U.S. citizens who own Canadian corporations have long been subject to Subpart F of the Internal Revenue Code, which requires certain types of income earned within the corporation to be taxed as U.S. personal income. These rules are known as the Controlled Foreign Corporation (CFC) rules, and they are intended to prevent the U.S. tax deferral that comes with earning investment income through a non-U.S. corporation.
When a CFC earns Subpart F income (mainly comprised of interest, dividends, rents and royalties), that income is added to the personal income of the CFC’s U.S. shareholders in the year the income was earned by the CFC—unless taxable dividends have been paid. This is unlike the Canadian regime, where tax is only imposed when funds are distributed from the corporation.
Therefore, deferral of tax within a corporation carries a risk of double taxation: within the corporation as Subpart F income by the U.S. system, and then again by the Canadian system when the funds are distributed.
Up until the JTCA took effect, U.S. citizens in Canada had been able to avoid this accrual taxation in the U.S. for any active business income earned by their corporations. Thus, many owner-operators have been able to retain earnings in their corporate structure to build up a nest egg for their retirements.
Section 965 of the JTCA punishes this type of planning by enacting a deemed repatriation tax.
The stated policy of Section 965 is to provide for a transition to a territorial system of corporate taxation whereby the offshore earnings of foreign subsidiaries of U.S. corporations can be brought back to the U.S. without further taxation. However, in order to level the playing field, Section 965 imposes a one-time tax on the retained earnings of “specified foreign corporations,” which are defined as any CFC (whether owned by a U.S. corporation or person).
This one-time tax applies to all post-1986 earnings and profits of a CFC that have not yet been taxed in the U.S. under prior Subpart F rules. For most individual U.S. shareholders of a CFC, this tax applies for the 2017 tax year, and works out to approximately 15.5% of the cash (or cash equivalents) held by the CFC and 8% of the other assets.
Foreign tax credits (FTCs) can generally offset the Section 965 tax, and U.S. citizens that have substantial carry-forwards from prior years may not have much to worry about. As well, FTCs generated by dividends paid in 2018 can be carried back to offset the tax paid in 2017 under Section 965. However, this latter strategy merely avoids the double taxation that would otherwise arise on future dividends, and we expect the IRS will be sluggish in issuing refunds for 2017 based on a carryback of Canadian FTCs.
U.S. owners of Canadian businesses need to evaluate their exposure to the Section 965 tax and implement plans to avoid the double taxation that results from ignoring the problem. Each situation will be different, and some tax will likely need to be paid. However, with proper planning and implementation, that tax can likely be mitigated.
David A. Altro, B.A., LL.L., J.D., D.D.N., F.Pl., TEP, is the managing partner of ALTRO LLP, which specializes in cross-border tax and estate planning, U.S. real estate and immigration, and has offices in Canada and the United States.