Canada: U.S. Tax Reform Punishes U.S. Citizens Abroad

Part I – The Transition Tax

From a taxation perspective, the period from July 2017 to February 2018 has been one of the most tumultuous in recent history for Canadian private company owners. For those who also have the privilege of being U.S. citizens or resident aliens, things have gotten downright ludicrous. In a rush to pass into law the most sweeping tax reform in a generation, U.S. lawmakers have stuck U.S. citizens resident in Canada with retroactive, double taxation, the elimination of much of the tax deferral previously available in their companies, a looming April 17th payment deadline and virtually no rules or regulations to guide them through the chaos. 

Part 1 of this article will review the first of two contentious changes contained in U.S. tax reform – the Transition Tax – and provide some ideas on how to mitigate its impact. 

IRC 965 – a.k.a. the Transition Tax or Repatriation Tax

We have all heard President Trump's promise to "Make America Great Again" by inducing large multinational companies to bring trillions of investment dollars back to the U.S. Well, IRC 965 does exactly that. The idea is to transition the U.S. international tax system from its antiquated "deferral" regime (where U.S. companies pay U.S. tax when they repatriate earnings from foreign subsidiaries to the U.S. parent company) to an "exemption" regime (where foreign subsidiaries pay tax in their home country and can then send their profits back to a U.S. parent company free of U.S. tax). The idea makes sense and brings the U.S. into line with the majority of other countries

To migrate existing corporate profits to the new system, the law provides for a one-time "transition tax" on foreign corporate retained earnings existing at the time of implementation. This tax is at a discounted rate and can be paid over an eight-year period to ease the burden. While the changes may make sense for U.S. multinational corporations, the logic breaks down when applied to individual taxpayers residing in foreign countries. Yes, U.S. citizens and resident aliens living abroad are also required to pay the transition tax – even though they do not benefit from the new exemption regime. For American taxpayers who own companies in Canada, this results in not only double taxation, but retroactive double taxation!

How it works

The transition tax applies to U.S. shareholders of Deferred Foreign Income Corporations – generally Controlled Foreign Corporations (CFC's) – which have post-1986 Earnings and Profits (E&P). A U.S. shareholder is defined as a U.S. person who owns 10 per cent or more of the votes of a foreign corporation. 

Except in limited circumstances, the post-1986 accumulated E&P (basically retained earnings) is included, pro-rata, in the U.S. shareholder's 2017 income in the same way investment income would generally be attributed to the shareholder (i.e. through the existing Subpart F regime). To prevent taxpayers from manipulating E&P balances, E&P is measured as the greater of the balance at two measurement dates - Nov. 2nd, 2017 (the date the law was introduced) and Dec. 31st, 2017. Furthermore, dividends paid in 2017 are added back to E&P to prevent taxpayers from stripping their E&P to avoid the tax. A few limited exceptions apply, including pre-1987 E&P and E&P accumulated when the entity was not a CFC, etc.

The income inclusion is subject to a maximum tax rate of 17.5 per cent (a discount of 56 per cent from the top individual tax rate of 39.6 per cent) for E&P attributable to cash or near-cash assets or 9.05 per cent (a discount of 77 per cent from the top individual tax rate) for E&P attributable to non-cash assets. The definition of cash or near-cash is quite broad and includes things like accounts receivable and short-term obligations. Taxpayers can elect to defer the payment of the tax over an eight-year period (8 per cent of the amount owing in years one through five and then 15, 20 and 25 per cent for years six, seven and eight, respectively). No interest is charged should a taxpayer opt for this deferral. The initial installment must be paid on April 17, 2018 (with no extension available) which leaves very little time for taxpayers and their advisors to prepare. At the time of writing, very little guidance has been provided by the IRS and relevant forms have yet to be released.

What can I do?

If you think the transition tax applies to you, you should consult your cross-border tax advisor immediately. This tax is real, punitive and is due in a little over a month. Here are some ways you might reduce the impact of the tax depending on your situation:

  1. Foreign tax credits (FTCs) - Unfortunately, one of our greatest weapons in fighting double taxation is our extremely high tax rates here in Canada. To that end, many U.S. taxpayers residing in Canada have significant foreign tax credits carried forward in the general limitation (GL) basket (that's typically where income taxes paid on active income go). Since the income inclusion under IRC 965 will usually be considered GL income, any GL FTC carryovers can be used to reduce the transition tax impact on a dollar-for-dollar basis. Taxpayers can also use excess GL FTCs from 2017 to reduce the tax. Finally, 2018 excess FTCs can be carried back one year to offset 2017 tax.
  2. Bonuses – Bonuses have a double impact in minimizing the impact of the transition tax. First, they reduce the base upon which the tax is calculated (i.e. E&P). Second, since Canadian tax rates are generally higher than U.S. rates, bonuses generally create excess GL FTCs which can be utilized to further offset the transition tax. Assuming a CFC can use the bonus to reduce corporate tax, and assuming the shareholder will need the funds personally within a reasonable time period, paying a bonus may be a very effective strategy. 
  3. Paying Dividends – Paying dividends in 2017 will trigger Canadian tax which can be used to offset the transition tax. The key here is whether a full FTC will be available for the Canadian tax paid or whether the FTC will be ground down to put it on a level playing field with the discounted income inclusion mentioned above. Much has been written on this issue, but the matter will not be resolved without further guidance from the IRS.
  4. Section 962 election – The seldom used IRC 962 election is getting a lot of attention in the context of the transitions tax. IRC 962 permits an individual to elect to be taxed as a corporation, thereby allowing the U.S. taxpayer to take advantage of the generally lower corporate tax rates on the transition tax inclusion.  However, the most significant benefit of this election is the ability to obtain FTC treatment for the corporate tax paid by the CFC since 1986. While the FTCs are ground down (as mentioned above), the election may still have the effect of reducing the transition tax impact by as much as 30 – 50 per cent depending upon the client situation. The higher the historical corporate tax paid, the higher the available FTC.
  5. Optimizing Canadian Deductions/Credits – By opting not to deduct or take credit for certain tax preferences in Canada in 2017 (e.g. RRSP, charitable donations, etc.) and instead carrying them forward to use in future years, Canadian tax will be increased, thus increasing FTCs available to offset the transition tax. 
  6. Amending prior U.S. filings – Those who have claimed the s.911 (foreign earned income) exclusion may consider amending their prior years' U.S. filings to revoke the election. This may increase GL FTC carryovers which are often reduced when the s. 911 claim is taken.
  7. Revisiting entity classifications – Since the corporation must generally be a CFC in order for the transition tax to apply, taxpayers should double check their company is, in fact, a CFC, and that they meet the definition of a U.S. shareholder. Be careful what you wish for though – foreign companies which are not CFCs may be Passive Foreign Investment Companies (PFICs) which, while exempt from transition tax, are generally not desirable.

While paying double tax is never ideal, business owners are practical people. Sometimes cash flow drives taxpayer decision making. Tax on salary/bonus is very high in Canada (48-54 per cent) while the year-1 payment of transition tax is quite low (8 per cent of the 17.5 per cent tax, or 1.4 per cent). Many business owners will choose to plug their noses and write the cheque as opposed to accelerating significant Canadian tax.

There is a saying, "you never let the tax tail wag the dog", however, it is situations such as this that drive dual citizens to renounce their U.S. citizenship. Many will be exploring that option after being subjected to the transitional tax. In a cruel and ironic twist, the transition tax payable may prevent some individuals from renouncing due to the "tax test" which is part of the U.S. expatriation rules (IRC 877A) outlined here.

Cross-border tax planning has always been complex, and that complexity has increased significantly with U.S. Tax Reform. While the transition tax is a one-time phenomenon, in Part 2 of this article, we will examine the new tax on Global Intangible Low-Taxed Income (GILTI) – a punitive new tax law that will profoundly change tax planning for most U.S. owners of CFCs -  starting on Jan. 1st, 2018.

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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Todd King
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