The Taxpayer Relief Act of 1997, generally effective on August 5, 1997, significantly changes the tax consequences for Canadians who have investments in the United States. The new law changes the U.S. tax rate on certain types of income, adds new reporting requirements for certain types of taxpayers, and limits the availability of treaty benefits for income from investments held in certain structures. Knowledge of the new law could help reduce the U.S. tax bill associated with Canadian investments.
The recent Taxpayer Relief Act of 19971 does not contain many provisions that relate to Canadian investors in the United States. However, in the course of their tax planning, Canadians should consider the provisions that are summarized below.
Under the Internal Revenue Code,2 Canadian individuals investing in the United States are ordinarily subject to tax on any capital gains realized on their U.S. real property and U.S. real property holding corporations.3 With respect to capital gains realized on the sale of such investments, the Act lowers the tax rates on long-term capital gains realized after May 6, 1997. With certain minor exceptions, long-term capital gain rates have been reduced from 28 percent to 20 percent and, for certain lower-income taxpayers, from 15 percent to 10 percent. These reductions in rates apply only to Canadian individuals, not to corporations. However, the Act has also extended the holding-period rules so that, to qualify for these lower rates, Canadian investors must hold the asset for more than 18 months. A special transition rule applies to assets sold after May 6, 1997 and before July 29, 1997. Capital assets sold during this period qualify for the new lower rates as long as the asset was held for more than one year.
With respect to sales after July 28, 1997, there are three different kinds of capital gains with different treatment for each. As under prior law, net short-term capital gains remain taxable at ordinary income tax rates (15 percent to 39.6 percent). "Short-term capital gain" continues to mean gain from the sale or exchange of a capital asset held for one year or less. Mid-term capital gains (from the sale of assets held more than a year but not more than 18 months) are taxed at a maximum rate of 28 percent. Finally, long-term gains (which now mean gains on the sale of assets held more than 18 months) are taxed at a maximum rate of 20 percent (10 percent to the extent that they would be subject to tax at a 15 percent rate if taxed as ordinary income).4 In the case of gains realized from the sale of U.S. real estate, a special 25 percent tax rate is applicable to gains attributable to unrecaptured depreciation.
Unfortunately, in its haste to pass the capital gain rate reduction, Congress did not adequately address the proper way to net capital gains and losses. Therefore, a technical correction amendment to the Act is necessary. Since such an amendment may not be passed by Congress and signed by the president before the end of 1997, the Internal Revenue Service has issued a notice that it will apply the new capital gain rules retroactively to 1997, as if the technical correction amendment and the Act were enacted on the same date.5
Canadian Investment Companies
Before the Act was enacted, Canadian companies that traded in stocks or securities for their own accounts were generally not treated as engaged in a U.S. trade or business so long as they were not dealers in stock or securities and their principal office was not in the United States.6 Effective for tax years beginning after December 31, 1997, the Act eliminates the prohibition on having a principal office in the United States.7 Foreign investment companies will now be able to move their personnel and offices to the United States without being treated as if they are engaged in a U.S. trade or business.
A significant change in the Act eliminates a common technique that Canadians have often used to exploit the difference between the U.S. and Canadian classification of a limited liability company (LLC). U.S. law generally classifies an LLC as a transparent passthrough entity (that is, a partnership), while Canadian law generally classifies an LLC as a separate taxable entity (that is, a corporation), causing the LLC to be a "hybrid" entity.8 Before the Act was enacted, a Canadian corporation could create a U.S. LLC, and an interest payment to the LLC from a U.S. corporation would be eligible for a reduced rate of withholding tax of 10 percent under article 11 of the Canada-U.S. tax treaty,9 instead of the normal withholding rate of 30 percent in the absence of the treaty. The interest income was eligible for the reduced treaty rate because, under U.S. law, the interest income passed through the LLC and was treated as received by the Canadian parent corporation. However, since Revenue Canada treated the LLC as a U.S. corporation, the interest income received by the LLC (but not distributed to the Canadian parent) was not subject to Canadian tax at all. Moreover, under Canadian law, a later distribution from the LLC to the Canadian parent also was not subject to Canadian tax.
However, effective for payments made after August 5, 1997, the Act provides that a foreign person shall not be entitled under any income tax treaty of the United States with a foreign country to any reduced rate of withholding tax on any item of income derived through an entity that is treated as a partnership for U.S. tax purposes, if: (1) the item is not treated as income of the foreign person under the foreign tax laws; (2) the treaty does not contain a provision addressing its applicability to items of income derived through a partnership; and (3) the foreign country does not impose tax on a distribution of the income from the partnership to the foreign person.10 This provision of the Act is intended to prevent Canadian companies from engaging in business in the United States at lower tax rates by using the above technique. The Act denies treaty benefits in these and similar circumstances on the grounds that treaties were designed to avoid double taxation, and because Canada never taxes the income there is no double taxation. The Treasury has recently adopted regulations that address similar issues arising under the Code.11
It appears that the Act and the new regulations inaccurately assume that a foreign treaty partner must actually impose tax on an item of income in order for a treaty benefit to be available with respect to that item. However, every concession of U.S. tax at source does not require actual taxation in the recipient's country of residence. If that were true, the United States would not reduce tax at source on payments that are exempt from tax in the recipient's country of residence, as is the case for certain payments to residents of Germany and the Netherlands. Reduced rates in tax treaties are based on the general notion that the country of residence should have primary jurisdiction to tax. In many cases, though, "jurisdiction to tax" does not entail actual taxation. The approach taken in the new regulations could endanger treaty benefits for payments to foreign tax-exempt organizations and payments of various types of income that, for one reason or another, are exempt from tax in the recipient's country of residence. It has never been the object of U.S. tax treaties to deny benefits in such circumstances.12
Since the days of the Truman administration, the Internal Revenue Code has exempted from tax a portion of the income (and also certain allowances) derived by U.S. citizens or residents while employed overseas.13 The amount of this exemption has changed from time to time. The Act increases the amount of the exemption from $70,000 to $80,000 in increments, beginning in 1998 and ending in 2002. Thereafter, the exemption is indexed for inflation.14 The change is available not only for U.S. citizens working abroad, but also for U.S. employers who frequently enter into tax-reimbursement or tax-equalization agreements for their employees in Canada.
Before the Act was enacted, the Code did not contain rules addressing when a foreign partnership was obligated to file a U.S. tax return,15 but provided that a partner of a partnership was not allowed losses or credits if the partnership failed to file a required return, and its tax-matters partner resided outside the United States or the partnership books and records were kept outside the United States.16 Treasury regulations required every partnership that was engaged in trade or business, or that had income from sources within the United States, to file a partnership return; a partnership that carried on no business in the United States and that derived no income from U.S. sources was not required to file a return.17 To address the concern that a large number of foreign partnerships doing business in the United States, including Canadian partnerships, were making biased determinations that they were not required to file U.S. tax returns, the Act has clarified the reporting requirements for foreign partnerships in the Code. Under the Act, unless regulations provide otherwise, Canadian partnerships are required to file a U.S. partnership tax return if they have U.S. source gross income, or gross income that is effectively connected with the conduct of a U.S. trade or business.18 Moreover, if a foreign partnership fails to comply with its reporting obligations, its partners will not be allowed deductions, losses, or credits. In contrast, partners of U.S. partnerships do not risk disallowance of their losses, deductions, and credits if the partnership does not file a tax return. This disparity has generated debate over whether such a disallowance for partners of Canadian partnerships is a violation of the non-discrimination provision of the Canada-U.S. tax treaty.19
1Taxpayer Relief Act of 1997, Pub. L. no. 105-34, enacted on August 5, 1997 (herein referred to as "the Act").
2Internal Revenue Code of 1986, as amended (herein referred to as "the Code").
3Code sections 865, 872(a), 882(b), and 897.
4Section 312 of the Act.
5Notice 97-59, 1997-45 IRB 7, November 10, 1997.
6Code section 864(b)(2)(A).
7Section 1162 of the Act.
8An entity that is treated as transparent in one tax jurisdiction and as a separate entity in another is often referred to as a "hybrid" entity.
9The Convention Between Canada and the United States of America with Respect to Taxes on Income and on Capital, signed at Washington, DC on September 26, 1980, as amended by the protocols signed on June 14, 1983, March 28, 1984, March 17, 1995, and July 29, 1997 (herein referred to as "the Canada-US tax treaty").
10Section 1054 of the Act.
11TD 8734, 1997-44 IRB 5, November 3, 1997. The new regulations address withholding from distributions of interest, dividends, royalties, and other fixed, determinable, annual, or periodic income to non-US persons, and will become effective on January 1, 1998. These new regulations will be the subject of a future article.
12See letter from H. David Rosenbloom, former international tax counsel to the Treasury Department, to the commissioner of internal revenue, July 17, 1997.
13Code section 911.
14Section 1172 of the Act.
15Code section 6031.
16Code section 6231(f).
17Code reg. sections 1.6031-1(c) and (d).
18Section 1141 of the Act.
19Article XXV of the Canada-US tax treaty. The non-discrimination provision generally provides that the United States cannot subject Canadian persons to any taxation or requirements that are more burdensome than the taxation and requirements imposed on US persons in the same circumstances.
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.