Canada: 2013 - The Fiscal Cliff, Obamacare, And Maybe Even US Tax Reform

The fiscal cliff has mostly come and gone. Last minute legislation has prevented the worst-case scenario of sharply higher US taxes on wages, interest, dividends, capital gains, and on estates.

We're gratified that the predictions we made in an August blog post (and hence republished elsewhere) were largely correct. We said that "we are confident that the legislation avoiding the worst case scenario, 'Taxmaggedon,' will be enacted, whether in 2012 or 2013." We called as the most likely scenario that "the lame-duck Congress takes action in November or December, to delay the effect of the new rules for a year or two...or to pass a compromise between the current rules and the ones scheduled to take effect in 2013." Congress actually waited until January 1, 2013 to pass the "American Taxpayer Relief Act of 2012" which did a little of both. Most of the cliff bill is a permanent compromise between 2012 rules and what was to take place in 2013, although there are a number of credits and other items that were merely extended for a year or two.

We also said that there was reason for hope that the estate tax wouldn't kick in at a US $1,000,000, as scheduled for 2013, instead of the 2012 exemption of US $5,120,000. That in fact happened. The new rate is the same as the 2012 rate, but indexed for inflation. The only bad news is that the top tax rate on estates exceeding the exemption amount has been bumped from 35% to 40%.

Here's what the most prominent features of the new landscape look like:

The top tax bracket of 39.6% kicks in at US $450,000 for married US couples, for US $400,000 for single US persons, and at US $225,000 for a married US person filing separately (typically the case when a US person is married to a non-US person (a "mixed" marriage)). These numbers are indexed for inflation. To the extent that a person is in this new highest bracket, capital gains and dividends, to the extent overall income is above the bracket floor, are now taxed at 20%, rather than 15%. An additional 3.8% tax on net investment income is applied under Obamacare. This tax kicks in at much lower thresholds (US $250K for marrieds, US $200K for singles, and US $125K for marrieds filing separately). The threshold is also calculated differently. It is based on adjusted gross income plus the amount of any foreign earned income exclusion. (The "foreign earned income exclusion" allows US persons working abroad to exclude some of their foreign earnings. The figure for 2012 was US $95,100 and is adjusted for inflation annually.) Moreover, unique rules apply for determining what constitutes investment income. Income from a passive business counts for purposes of this tax. So do some annuity payments as well as gain from the sale of certain interests, such as some partnership interests.

So where does that leave the typical American living in Canada? Well, although tax rates are now higher than they were in the US, overall the burden is generally still higher in Canada—even in low-tax Alberta. Given that reciprocal foreign tax credits are available, the rule of thumb is that a person subject to both taxing systems generally ends up paying the higher of the two. So if Canadian federal and provincial taxes are more than what is owed in the US, a change in the US rate doesn't affect how much you owe—just who is getting handed the check.

Except that is it unfortunately not so simple. Foreign taxes most likely will not be creditable against the 3.8% Obamacare tax on net investment income. The US provision governing foreign tax credits, section 901 of the Internal Revenue Code, doesn't apply to this tax. At this time it is unclear whether the Income Tax Treaty between the US and Canada, which strives to eliminate the double taxation of income, will apply. If it doesn't, many Americans living in Canada will owe US tax for the first time. Moreover, because investment income tax isn't typically withheld at source, estimated quarterly tax payments will be required in many cases.

Some other changes of which to be aware:

  1. The exemption from tax for interest-related and short-term capital gains dividends received from regulated investment companies ("RICs") was extended to the 2012 and 2013 tax years. This extension applies mainly to non-US persons who invest in US mutual funds.
  2. The "look-through" rule for controlled foreign corporations (CFCs) is extended through the end of 2013.
  3. The 3.8% net investment tax has some funky applications in the context of CFCs and PFICs (passive foreign investment companies). The details are technical (a code word for "will put non-tax people to sleep"), so we'll spare you. But something to watch out for.

Continuity of leadership in the US Congress bodes well for the prospects of tax reform. John Boehner was re-elected as Speaker of the House last week, and the Republican caucus has already determined that Representative David Camp will continue to serve as chairman of the powerful House Ways & Means Committee. For the past two years Camp has championed a reform effort with respect to the US corporate tax rules, even producing his own discussion draft to spark debate on how to switch to a territorial tax system. He may very well spearhead a reform proposal this year. Support for a reform effort may also be forthcoming from his counterpart in the Senate, Max Baucus, Chair of the Senate Finance Committee, who is similarly interested in pursuing comprehensive corporate tax reform. With the caveat that reform is more often predicted than accomplished, we think the odds are at least fair that some sort of reform package will make its way onto the 2013 agenda.

If there is any overarching theme that seems to define what we expect in 2013, it is that the dramatic changes in the US tax landscape that have occurred since 2008 are finally crystalizing into final form. The crackdown on international tax evasion through the banking system has solidified into a permanent policy framework under the FATCA rules. What began as an inquiry into the practices of Swiss banks morphed into a hunt for sophisticated tax evaders and now is reaching a policy framework for ordinary Americans living abroad to get and stay compliant, with the FATCA rules making  foreign governments and banks assist the IRS.

The new tax on net investment income under Obamacare is now in effect. Doubts as to its implementation persisted while litigation challenged the law and were only partially resolved by the Supreme Court's ruling that most of the law (including the tax) would stand. Mitt Romney campaigned on repeal and replacement of Obamacare and even with his defeat, some on the right hoped that the fiscal cliff standoff would be resolved in part by an undoing of the new health care tax.

And last, the drama of the fiscal cliff was resolved with an end to years of patchwork extensions of the Bush-era tax cuts and temporary fixes to the problem of the AMT (alternative minimum tax) reaching new taxpayers each year because of its lack of inflation indexing. We now have a relatively permanent regime that should stand at least through the end of the Obama presidency, if not beyond. Although the tax world looks quite a bit different than it did in 2007, the earthquakes of the past few years have largely dissipated. Of course, one big one is still threatening—corporate tax reform. We'll see what happens.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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19 Dec 2017, Webinar, Calgary, Canada

By December 19, 2017, the world should know whether or not the US was successful in implementing landmark and historic tax reforms – the largest and most impactful such reforms since 1986. These reforms appear to touch virtually every American individual and business, and will ultimately affect many Canadian individuals and businesses directly or indirectly as well.

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