Canada: Trump's Proposed U.S. Tax Reform And What It Means For Canadians

The announcement of the Trump administration's plan for tax reform has left Canadians concerned regarding the impact of such drastic changes by our neighbour and largest trading partner. Tax reform is one of President Trump's top priorities, however even with a Republican majority in both the House and the Senate, it is unlikely the proposal will be passed in its current form. At this point, the proposal or tax plan remains just that and the Republicans will likely have some compromising to do in order to obtain the super-majority generally required to formulate agreeable legislation and get it passed. Regardless of the extent of tax reform, there is no question that Canadians will be affected and we should be prepared if and when this occurs. Expanding on our recently published Tax Flash, consider these potential tax impacts.

Business Tax Reform Proposals

Canada has maintained a competitive tax advantage for some time, boasting low corporate tax rates compared to most countries, including the United States ("U.S."). Canada's current combined federal and provincial tax rates are approximately 15% for companies eligible for the small business deduction and 25% for most other active businesses. The Trump administration has proposed a reduction of federal corporate tax rates from 35% to 15%. This differs from the House of Representatives Republican Tax Reform Blueprint released in June 2016 where a corporate rate of 20% was presented. Regardless, a shift to lower tax rates in the U.S. compared to Canada will bring into question the effectiveness of certain cross-border corporate structures and annual planning. This change will provide an incentive to shift income from Canada to the U.S. Canadian businesses should take the opportunity to review their current cross-border structure to determine if it remains optimal. For example, Canadian businesses should consider their combined cross-border tax rate and compare it to other potential structures such as a corporate (blocker) or branch (flow-through) scenario. In certain instances, setting up a U.S. subsidiary corporation would take advantage of the low U.S. income tax and earnings could flow back to Canada as exempt surplus. The overall tax rate of this structure could be less than Canadian corporations are currently paying.

This change may also result in additional scrutiny on the reporting of non-arm's length transactions with non-residents and transfer pricing documentation in an effort to avoid a shift of the Canadian tax base.

Estate and Gift Tax

Most notably among the personal tax reform plan, President Trump has proposed to eliminate the U.S. estate tax. It is unclear if this also means eliminating gift tax and/or tax on generation-skipping transfers. This is significant for U.S. citizens who reside in Canada or Canadian residents who own U.S. situs assets.

Currently, individuals may transfer up to $5.49M USD of wealth to the next generation on a tax-free basis, either by way of a gift during their lifetime or through their estate. Any additional assets transferred above this are taxable at the time of transfer at a top rate of 40%. The repeal of these "transfer taxes" will allow U.S. persons living in Canada to take advantage of certain tax planning strategies previously unfeasible due to the adverse U.S. tax consequences. For example, individuals can undertake a traditional Canadian estate freeze, which freezes the value of an existing corporation and allows the future growth of the corporation to accrue to the next generation with no immediate tax consequences. Spouses may also have greater flexibility to transfer or gift assets between each other where one spouse is a U.S. citizen and the other is not. These are only two of the many planning opportunities available depending on an individual's unique fact pattern.

It is possible that the U.S. will replace the estate tax with a deemed disposition regime similar to Canada. At the top marginal rates, income tax on Canadian capital gains is higher than the equivalent U.S. income tax on capital gains. In that case, U.S. citizens living in Canada would pay the Canadian tax rate of 27%, being the higher of the two countries, rather than the estate/gift tax rate of 40% under the current U.S. rules.

The U.S. estate tax was previously repealed in 2010 as part of the "2001 Economic Growth and Tax Relief Reconciliation Act," but this tax cut "sunset" in 2011 and estate tax was reinstated. Existing legislation prohibits tax cuts from increasing deficits in the long term (typically 10 years) and therefore it is not uncommon for tax cuts to have an expiration date or "sunset" clause. Trump's tax reform may or may not have a sunset clause, but this opens up a significant number of tax planning opportunities, even if only for a short period.

Other Personal Tax Reform Proposals

The Republicans have also proposed to simplify personal income taxes, reducing the federal rate applicable to the top bracket from 39% to 35%, removing the alternative minimum tax ("AMT") and net investment tax, eliminating most itemized deductions and doubling the standard deductions. Commuters and U.S. citizens living in Canada effectively pay U.S. tax on U.S. source income and Canadian tax on Canadian source income after the application of respective foreign tax credits under the Canada-U.S. Tax Convention. A decrease in U.S. tax rates will likely not affect the overall tax paid by these individuals as they will generally pay the higher tax rates of Canada. However, a decrease in U.S. tax rates will provide fewer foreign tax credits and therefore more of the total tax payment will be paid to Canada. This may result in higher amounts due at tax time and therefore individuals should plan for this additional cash outlay. The repeal of AMT will result in a true tax savings for those U.S. citizens living abroad who pay this minimum tax.

Border Adjustment Tax

There has been significant discussion surrounding the implementation of a border adjustment tax ("BAT") in the U.S. The goal of a BAT is to discourage corporations from moving production overseas by taxing companies based on where the goods are sold rather than where they are produced, reversing the current tax environment.

In summary, corporations, both U.S. domestic and foreign, would be taxed as follows:

  • Sales to U.S. customers are taxable;
  • Sales to foreign customers are not taxable; and
  • The cost of imported goods will not be deductible.

Comparison of the current tax system to a BAT system:

Taxpayer's Financials

Current Tax System

BAT System

Domestic Sales Revenue

$800,000

$800,000

Foreign Sales Revenue

$200,000

Gross Revenue

$1,000,000

$1,000,000

$800,000

Cost of Sales – Domestic

$200,000

$200,000

Cost of Sales – Imported

$400,000

Other Expenses

$200,000

$200,000

Total Expenses

$800,000

$800,000

$400,000

Net Income Before Taxes

$200,000

$200,000

$400,000

Tax Rate

35%

15%

Tax Paid

$70,000

$60,000

After Tax Earnings

$130,000

$340,000

75% of Canada's exports are to the U.S. A BAT would provide a clear incentive for U.S. businesses to decrease the import of goods from Canada. However, this type of tax system would require a complete overhaul of the U.S. tax code from the current worldwide system to a territorial system. Other economic consequences such as the effect on currency value and trade also pose a concern. The World Trade Organization rules do not permit this type of consumption-based income tax so this proposal would likely be challenged from that perspective. Because of this, it seems unlikely this change will be implemented in the near future.

Conclusion

Trump's tax reform proposal is still in the very early stages. Given the uncertainties of the current U.S. tax environment and the magnitude of the proposed changes, it is important to be prepared for when these changes occur and to consider flexibility and ease of change, if currently implementing tax planning strategies.

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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