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U.S. tax reform hits Canada

Legal Report/ Tax Law
|Written By Elizabeth Raymer
U.S. tax reform hits Canada
Illustration: Mat Daley

Trump’s tax overhaul will have many ripple effects on tax planning in Canada.

Back when U.S. President Donald Trump was stumping on the campaign trail, he made some bold promises — among them to build a wall along the length of the U.S.-Mexican border and to reduce taxes. While the wall has shown no early signs of construction (or planning), in December, the American president signed into law the Tax Cuts and Jobs Act.

Among some of its bigger provisions, the act reduced the corporate tax payable by corporations to 21 per cent from 35 per cent as of Jan. 1. This means significant savings for Canadian companies that earn a high share of their revenues in the United States; but it also makes Canada a less attractive tax jurisdiction than the U.S. for foreign companies looking to set up shop.

Another major provision, for individuals, is the imposition of a one-time “transition tax” on U.S. citizens and residents living outside of the United States. And new estate tax-filing rules have doubled the threshold at which the state tax kicks in, to US$10 million from US$5 million. However, an estate tax return must be filed in the U.S. in order to avoid a hefty chunk of the sale of assets going to Uncle Sam.

The transition tax

The “transition tax” is a one-time tax payable by U.S. persons, including individuals, who own at least 10 per cent voting stock in a privately held, non-U.S. corporation, at 15.5 per cent on cash assets and eight per cent on non-cash assets.

Roy Berg, director of the U.S. tax law group for Moodys Gartner Tax Law office in Calgary, gives the example of a doctor with his own incorporated practice in Canada who holds dual U.S.-Canadian citizenship or is a Canadian citizen holding a U.S. green card. This good doctor has $2 million of accumulated wealth in his corporation, and he stands to have $300,000 of his hard-earned Canadian dollars confiscated by the U.S. government this year.

“If you have a corporation or an active business, you’re hit with this one-time tax at eight or 15.5 per cent on retained earnings” — post-tax earnings in the corporation that have not been distributed, he says. And there’s “no elegant solution,” adds Berg, who is himself a dual citizen, as are most of the counsel in his office.

Berg outlines a three-pronged strategy for such individuals. First, he says, “we go back and do a retained earnings analysis: What has been reported in the past, and is it correct?” There’s a good chance it may not be correct because, in the past, he says, the retained earnings figure was “essentially just a number on the page” without tax associated with it. “Now, it’s important.”

Second, was the correct exchange rate taken into account in the past? Tax filers in the past may have taken Canadian dollars and assumed an exchange rate of one to one against the U.S. dollar. “Then, it didn’t matter, but now it does,” says Berg. “That kind of stuff happened all the time.”

And third, says Berg, “Can we amend prior returns for prior years to accumulate more Canadian tax credit to wipe out [at least some of] what might be owed to the U.S.?” If Canadian tax filers can find even $5 in excess Canadian taxes that they paid, “that reduces by $5 what you will owe in U.S. taxes.”

Estate taxes

Trump had vowed to kill the federal estate tax, but in the end, he had to settle for doubling the base exemption. If you’re a Canadian who owns U.S. situs property (real estate, stocks and bonds), this is great news, says Berg, as the exemption amount for estate, gift and generation-skipping taxes doubled under the new act to US$10 million from US$5 million for tax years 2018 through 2025. The catch is that if you die holding U.S. situs property, your estate must file a U.S. estate tax return or be subject to pay a large portion of the sale of proceeds to the U.S. government. (Berg gives the example of an elderly woman who owns a condo in Phoenix valued at US$200,000; when her son sells the condo following her death, Berg says, he would need to fork over US$40,000 of the proceeds from the US$200,000 sale to Uncle Sam if he failed to file an estate tax return in the U.S.).

And not only are U.S. green card holders taxed in the same way as citizens, Berg says, but many who have held green cards in the past — such as children, for example — may not be aware that their immigration status in the U.S. has changed indefinitely. “It’s only the card that expires,” he says. “The underlying status doesn’t expire.”

The new legislation also affects the estates of Canadian parents who die in Canada but leave assets to children in the U.S., says Michael Kandev of Davies Ward Phillips & Vineberg LLP’s Montreal office. In the past, the so-called 30-day rule in the United States said that a U.S. person could own shares in a foreign corporation for a maximum of 30 days before it became a controlled foreign corporation. So, an individual settling an estate had a window of 30 days to unwind a structure relating to a corporation without being hit by taxes.

“The 30-day rule has now been repealed,” Kandev says. Unless pre-mortem steps are taken, the U.S. heirs may be faced with a “double tax,” payable in Canada and in the U.S. as well.

The new act also includes certain anti-hybrid rules that adversely affect certain financing arrangements that Canadian multinationals put in place in respect of U.S. operations, says Kandev.

Corporate tax changes

Paul Seraganian, New York managing partner for Osler Hoskin & Harcourt LLP, says that the act “resets the playing field for domestic competition in [the] U.S. and removed the structural disadvantages that foreign companies had. That’s far reaching, across industries, asset classes and life stages of companies.”

He predicts “a more level playing field,” yet Seraganian also notes that the most important international market for Canadian companies is the U.S., and their ability to compete against U.S. businesses is now “significantly downgraded” owing to the higher corporate income tax that Canada imposes. “A lot of the long-standing tax-planning advantages Canada has enjoyed over the past 20 years were significantly scaled back in this tax reform.”

For clients that have U.S. operations or are thinking of expanding into the U.S., the lower tax rates are a benefit, says Jeffrey Shafer, a partner at Blake Cassels & Graydon LLP in Toronto. “Many of the changes are helpful [in] reducing corporate income tax; it allows a lot more flexibility. Historically, we would have avoided certain structures that included corporate entities in [the] U.S. because of high taxes.”

“It’s too soon to tell” whether Canada will be less competitive owing to the new American tax rules, Shafer adds. “We have a very different business case and economy. I don’t think that will change just by virtue of these new rules.”

Along with the lower corporate tax payable under the new act comes diminished value of accrued losses, says Kandev. If a company operating in the U.S. has loss “carry-forwards,” those will now be valued at the 21-per-cent and not the 35-per-cent rate, he says. “So, the value of your losses has gone down.” This makes “any accrued losses . . . much less valuable. Companies will take significant writeoffs on their financials to reflect the fact that their losses have lost value.”

Also, Kandev says, the new act introduced the Base Erosion Alternative Tax, otherwise known as BEAT — a minimum tax that ensures that the U.S. gets a minimum cut of base-eroding payments to related parties.

Base erosion payments are any amounts paid or accrued by a taxpayer to a related foreign person and for which a deduction is allowable, including interest but generally excluding cost of goods sold. BEAT applies to most U.S. and non-U.S. corporations with average annual gross receipts of at least US$500 million for the prior three-year period that have a “base erosion percentage” of three per cent or higher for the taxable year. BEAT effectively disallows a portion of deductions for payments made from U.S. businesses to entities with foreign ownership and the disallowance of corporate interest deductions that exceed 30 per cent of earnings before interest and taxes.

Changes from the new U.S. tax legislation will unfold over time, says Seraganian. “But it’s clear that a lot of the norms of tax planning are back on the table and subject to discussion again,” he says. For example, when considering M&A transactions, should the combined company be U.S. or Canadian? “Under the old tax-planning norms, you would almost always choose a non-U.S.-based company. Now, it’s not clearly reversed, but you’re having longer, more protracted discussions.”

When you factor in U.S. taxes at the state and local levels, “Canada is still pretty competitive,” Shafer says, adding that “it’s too soon to tell” what, if any, the effects of the Tax Cuts and Jobs Act will be. “We have a very different business case and economy [in Canada].”