Canada: US Tax Reform: Increased Gift And Estate Tax Exemption And Withholding Tax On The Sale Of A US Partnership Interest

This article provides commentary on two changes contained in the US Tax Cuts and Jobs Act (TCJA) that are of interest to Canadians. The Act was signed into law on December 22, 2017.

Increased Gift and Estate Tax Exemption

The TCJA increased the unified federal estate and gift tax exemption to approximately US$11.18 million (inflation indexed). This exemption applies in the case of deaths and gifts that occurred after December 31, 2017 but has an expiration date of December 31, 2025. In the absence of a further legislative amendment, the exemption will revert to the pre-TCJA amount after the expiration date. The effective doubling of the exemption applies only to US citizens and does not apply to non-resident aliens. Under the Internal Revenue Code, the unified federal estate and gift tax exemption for a non-resident alien is limited to US$60,000, and this exemption was not changed by the TCJA. However, because of article XXIXB of the Canada-US tax treaty, an estate of a resident of Canada who was not a US citizen is allowed a prorated portion of the unified credit available to US citizen. This applies to US estate tax only. In particular, the estate of a resident of Canada who was not a US citizen is allowed an exemption equal to the greater of: (a) the exemption available to a US citizen multiplied by a fraction where the numerator is the value of the deceased's gross estate in the US and the denominator is the value of the deceased's worldwide estate; and (b) the exemption available to a non-resident alien (being US$60,000 as noted above). As a result of the calculation, the estate of a Canadian resident who was not a US citizen is typically subject to estate tax on US situs property only if his or her worldwide estate exceeds the amount of the unified credit (which is US$11.18 million for a death occurring today).

Because the increased exemption expires on December 31, 2025, a claw-back issue arises. For example, today a person may make a gift to which the increased exemption applies, yet at the time of the person's death, the exemption may have reverted to a lower amount. The issue is whether the offset for gift taxes payable will be based on the exemption amount at the time of the gift or at the time of death. Under the TCJA, regulations that avoid a clawback are to be prescribed.

A US person could give property to a non-resident alien (for example, a Canadian), and make use of the increased unified estate and gift tax exemption. A US person could die and bequeath property to a non-resident alien (for example, a Canadian), and make use of the increased unified estate and gift tax exemption. However, the different basis implications are significant. In the case of a gift, there is no step-up in basis for the recipient to fair market value when the gift is given. Rather, in the event that the donor paid no gift tax because of the exemption, the recipient is entitled to a carryover basis only meaning that the recipient's basis is effectively the donor's cost. In contrast, in the case of a bequest or gift by will, there is a basis bump to fair market value for the recipient. The basis implications for a Canadian recipient are important if the nature of the property makes its subsequent dealing subject to US tax.

Withholding Tax on the Sale of a US Partnership Interest

The TCJA includes a provision that introduces a 10 percent withholding tax on the sale of certain partnership interests, overriding the 2017 US Tax Court decision in Grecian Magnesite Mining, Industrial & Shipping Co. SA v. Commissioner, 149 TC No. 3. This new provision has implications for foreign persons, such as Canadians, who sell US partnership interests that have US-source effectively connected income (not real estate). The sale of an interest in a partnership holding "US real property interests" (as defined) is already classified as effectively connected under the Foreign Investment in Real Property Tax Act (FIRPTA) and subject to FIRPTA withholding, just as a direct sale of the real property would be. Thus, the change in the TCJA is relevant to non-real-estate partnerships.

The TCJA revised section 864(c) of the Internal Revenue Code to provide that after November 27, 2017, the gain or loss from the sale by a foreign corporation or non-resident alien of an interest in a partnership that is engaged in trade or business in the United States is treated as effectively connected with a US trade or business (and therefore subject to US tax) to the extent that the seller would have had effectively connected income if the partnership itself had sold all of its assets at fair market value on the date of the partnership interest sale. This provision reverses Grecian Magnesite, the taxpayerfriendly decision in which the Tax Court held that a foreign corporation's gain on the redemption of its interest in a US limited liability company (which was classified as a partnership for US purposes) was not effectively connected income and thus was not taxable in the United States. The limited liability company (of which the foreign corporation was a member) was engaged in the business of mining and extracting magnesite in the United States. It was conceded that the portion of the gain attributable to the limited liability company's real estate assets in the United States was effectively connected. The result in Grecian Magnesite was contrary to the longstanding administrative position contained in Internal Revenue Service revenue ruling 91-32, but a short-lived taxpayer victory in light of the TCJA amendment.

The new provision is based on a hypothetical sale of assets by the partnership and a hypothetical allocation to partnership interests in the same manner as "nonseparately stated items." While the latter term is not defined, commentary suggests that it is analogous to net operating income. If so, for this purpose gains on the hypothetical sale of assets would be allocated using the income allocation ratios in the partnership agreement. Unless the seller certifies that it is not a foreign corporation or a non-resident alien, the transferee is required to withhold 10 percent of the "amount realized" by the seller, which means withholding is based on the gross amount received (mechanically similar to FIRPTA withholding). If the transferee does not withhold the correct amount, the partnership is required to deduct and withhold from distributions the amount that the transferee failed to withhold. Withholding aside, the foreign partner selling its partnership interest must pay US tax at ordinary US income rates rather than capital gains rates. On the basis of the rate changes in the TCJA, a Canadian corporation selling an interest in such a partnership would be subject to US tax at the ordinary 21 percent rate.

Because of the hypothetical sale and allocation mechanism, the amount subject to US tax may not be analogous to the amount recognized as a capital gain for Canadian income tax purposes in respect of the sale of the partnership interest (assuming that the gain is considered to be on capital account). If the seller is a Canadian-controlled private corporation, this situation may exacerbate the integration issues for foreign investment income in the calculation of refundable tax. It may introduce a preference for holding shares of a US corporation rather than a partnership or limited liability company.

Originally published by STEP Inside, May 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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