It’s a planning flaw so fundamental that if an audience member at STEP’s 2015 conference hadn’t presented a similar case, many advisors probably wouldn’t think it plausible.
The scenario: six years ago, a Canadian tax planner organized his client’s Calgary company, which only had passive rental income, into a holding company. The planner created two new common shareholders: the owner’s sons. The eldest son lives in Vancouver and is a Canadian citizen, like his father. The youngest son moved to Chicago 10 years ago and is a U.S. person. Every year, the holdco distributes $50,000 in dividends to each of the sons.
The problem: the IRS classifies the holdco as a passive foreign income corporation (PFIC), because more than 75% of its gross income comes from passive income. That subjects the son in Chicago to America’s costly PFIC tax rules.
First, he pays more tax than he would on other types of dividends, says Michael Pereira, partner, tax, private client solutions, Global Mobility Services, at KPMG in Toronto. In the U.S., dividends from non-PFICs are eligible for a qualified dividend rate (between zero and 20%, depending on the son’s tax bracket), while regular PFIC dividends are taxed at the son’s marginal tax rate (as high as 43.35% in Illinois).
Second, if the holdco ever makes distributions that exceed 125% of the average of the past three years, the IRS taxes the extra cash at the highest marginal rate, explains David Altro, managing partner at Altro Levy in Toronto. So, if the Chicago son receives $50,000 each year for the past five years, and in year six he gets $65,000, the additional $15,000 would be taxed at the highest marginal rate. Were he to sell, the entire gain would be taxed at his highest rate during the ownership period, without any beneficial capital gains treatment.
Worse, the taxpayer is charged interest on an excess dividend (in this case, $15,000) and on any gain from a sale, retroactive to the date he first got the shares. It’s as though the excess distribution or sale was made six years ago, and he’d never paid tax.
“Let’s say you’ve had the shares for six years, and you get a dividend” that’s 125% larger than the three-year average in year six, says Abraham Leitner, partner at Davies in New York City. “One-sixth of the excess dividend is allocated back to the first year of your holding period. You’re subject to an underpayment interest charge for six years, and then for the portion that’s allocated to the next year for five years, and so on.
“You end up with sometimes shockingly high effective tax rates,” he says. “I have actually seen cases where the total amount of tax and interest charge on an excess distribution exceeded 100% of the excess distribution.”
So, how can this be fixed? The father may try to make things fair by giving his Chicago son extra money from outside the holdco. “A foreign person can make gifts to a U.S. person without tax consequence, assuming it’s not property that would, for Canadian purposes, give rise to a deemed disposition,” Pereira explains.
But Leitner says this additional gift is no substitute for remedying the holdco’s tax issues.
There are three main ways to lessen the tax burden, say the experts. But each option has its limits, and some are more risky or effective than others. Here they are.
1 Making a QEF election
The son in Chicago could file a Qualified Electing Fund (QEF) election along with his American income tax return, using IRS Form 8621. These optional elections work by including the holdco’s PFIC income in the son’s U.S. income every year. That means the PFIC income is taxed along with the son’s other regular income.
And, on receiving excess dividends or on selling the shares, “you won’t be subject to the highest tax rate applicable, nor will you be subject to an interest charge” on the excess, says Pereira.
This works because, every year, the corporation’s income is allocated among the shareholders in proportion to their stakes, whether or not they actually get distributions, he explains. Each shareholder reports his share on his return.
Were the holdco ever to realize a long-term capital gain (for instance, by selling one of its rental properties), the portion that’s taxable to the Chicago son would retain its character as a long-term capital gain. It would therefore be taxed at 20%, instead of being taxed as regular income, says Leitner.
The son would have to pay tax on his share of the holdco’s income as it’s earned, but as long as he keeps receiving a distribution, he should be able to cover its cost, says Altro. The trouble comes for people who have a stake in a PFIC but who aren’t getting any income from it, he adds. They’re stuck with the tax and can’t always afford to pay.
There’s one kind of QEF election, called a pedigreed election, for which he’s ineligible, but there are three others he can use:
Which one he uses depends on how aware he was of the PFIC rules when he received the shares, and how much tax he wants to pay now.
With six years of ownership behind him, he missed his chance for the ideal QEF election. Had he made an election when he received the shares, it would be pedigreed. “The beauty of a pedigreed QEF is that the excess distribution rules do not apply at all. That means that when the shareholder sells his stock, or gets a redemption distribution, it’s eligible for regular long-term capital gain rules,” says Leitner.
Now, whatever election he makes would be unpedigreed. “It claims the structure on a go-forward basis, but it doesn’t cure the historical PFIC taint,” says Pereira. Any future years won’t be subject to PFIC taxes, but the prior years will. That means, upon sale or higher dividends, the excess distribution rules would still apply to the years before the election.
If the son wanted to rid himself of the spectre of tax on excess distributions once and for all, he could do a purging election. That treats the stock as if it were sold the day before the QEF election, and triggers PFIC tax on all gains accrued until then. Altro warns this could be prohibitively expensive. But, going forward, any distributions wouldn’t be subject to the excess distribution rules. He stresses that a QEF election works best when it’s done in the first year the business is a PFIC.
The son could also make a retroactive election if he gets the IRS’s approval, says Pereira. This would allow him to amend his past returns with a QEF election.
To do this, he would ask the IRS for a private-letter ruling. To be eligible, the son must prove that he wasn’t aware of the holdco’s PFIC status by showing he consulted a tax professional who advised him that the holdco didn’t qualify as a PFIC, explains American cross-border tax firm Hodgson Russ in a publication.
No matter which election he chooses, the son must also get the holdco’s financial details in case the IRS audits him, says Pereira. His Canadian family shouldn’t mind, as it wouldn’t expose them to tax.
2 Turning the family business into a ULC
Structuring the business as an unlimited liability corporation (ULC) rather than as a regular corporation could save significant tax, says Leitner.
The IRS doesn’t consider unlimited liability corporations to technically be corporations, says Pereira. Rather, they’re treated as disregarded entities for tax purposes, or a partnership if there’s more than one shareholder. As such, it would be a pass-through entity (when shareholders pay taxes, not the company), and the U.S. son wouldn’t have to pay PFIC tax on distributions.
Instead, “the U.S. son is considered to own a proportional share of ULC assets, and will pay U.S. tax on his share of ULC income each year,” Altro says. “The result is similar to a QEF election.”
The ULC has a further benefit. It entitles the son to claim a foreign tax credit for its Canadian corporate taxes (see “QEF vs. ULC”).
But there are disadvantages. One is that the 25% Canadian withholding tax on its dividends can’t be reduced to 5% or 15% under the U.S.-Canada tax treaty, says Leitner.
The family could use a common workaround that CRA has approved. It involves increasing the company’s stated capital and distributing it so that the reduced tax rates apply.
All told, the Canadian corporate tax and the withholding tax are both creditable in America. Leitner says total Canadian tax may be large enough that there’s no additional U.S. tax to pay.
To take advantage of the savings, the holdco would first have to become a ULC, which requires merging the holdco into a ULC. ULCs can be established in one of three provinces: British Columbia, Nova Scotia, or the family’s home province of Alberta.
The cost to incorporate a ULC in Alberta is $100. (In Nova Scotia it’s $6,000 and in B.C. it’s $1,030.) Including advice, Pereira estimates it would cost between $3,000 and $10,000 to convert the business from a holdco to a ULC. However, there are serious reasons the family in this scenario shouldn’t go this route.
“You shouldn’t allow tax to be the primary driver,” Pereira says.
As the name suggests, an unlimited liability company passes liability on to its shareholders, be it lawsuits or unpaid debts, writes law firm McMillan LLP in a brief on ULCs.
Holding an investment portfolio in a ULC might make sense, say the experts, but in the case of a real estate company, the family would need the protection of a limited liability company.
Leitner gives an example of why. “If you have tenants and somebody slips on ice, you probably want to have another tier to protect you,” he says. He suggests combining the ULC with a limited partnership. The LP could hold the real estate assets, and in turn be owned by the ULC.
There’s one more catch. Moving the family business from a holdco to a ULC would trigger a deemed disposition for the U.S. son. “It is an opportunity to clean up the structure on a go-forward basis, but you’re unable to avoid the PFIC consequences,” says Pereira.
“Typically, ULCs are implemented at the outset of structuring,” he adds—too late for this family.
3 A new class of shares
A partial fix that would give the family some flexibility would be issuing a new class of holdco shares, says Pereira. If new shares are issued only to the Vancouver-based son and he returns the original shares, the holdco could make distributions to each son independently, according to what’s best for each. Ultimately, it doesn’t eliminate the PFIC problem, Pereira acknowledges. He warns that, depending on how the shares are re-organized, it could trigger a deemed distribution subject to PFIC rules.
Considering the tax burden, the Chicago-based son may want simply to give his original shares to his Canadian family. This would put him in an IRS grey area. “There are proposed regulations that suggest that gifting PFIC shares is a deemed disposition,” says Pereira. “A taxpayer isn’t bound to follow proposed regulations, but it does tell you what the IRS’s view is on that matter.”
Like the ULC structure and the QEF election, a dual share structure is best implemented from the start, he adds.
Had the family considered tax from the beginning, it could also have used trusts, notes Leitner. “There’s a whole other universe of structures involving trusts where you’re not giving the U.S. children anything now.”
As extreme as this family’s situation may seem, Leitner sympathizes with people who’ve missed cross-border planning.
“It sometimes gets overlooked, because the shareholder maybe isn’t getting any distributions, so they don’t think they have anything to do,” he says.
At the root of this family’s problem is passive income, says Pereira. If the PFIC issue had been caught at the outset of planning, he says it all could have been avoided by managing the real estate company differently.
“If either officers or employees of the company ordinarily and substantially manage the rental activities, then that would be considered an active business,” he says. “In that case, you wouldn’t even be concerned with the PFIC rules.” It’s too late now, says Pereira, as IRS rules mean that once a company is a PFIC, it’s always a PFIC. “It’s very difficult to get out of it.”
Jessica Bruno is a Toronto-based financial writer.