U.S Citizens Living in Canada Swept up by Tax Reform’s “Transition Tax”

By: Jeffrey A. Fortin, C.A. (AB, BC), C.P.A (IL, U.S.A), Partner – Taxation Advisory If you are a U.S. Citizen living in Canada and hold shares in a Canadian corporation […]

By: Jeffrey A. Fortin, C.A. (AB, BC), C.P.A (IL, U.S.A), Partner – Taxation Advisory

If you are a U.S. Citizen living in Canada and hold shares in a Canadian corporation that is controlled by you and/or other U.S. taxpayers read on.

This short article is designed to highlight what is perhaps an unintended and certainly not intuitive application of the “transition tax” to US individual taxpayers who are at least 10% shareholders in corporations that are “controlled foreign corporations” for U.S. tax purposes.

A Little Background
One of the cornerstones of the Tax Cuts and Jobs Act of 2017 (“US Tax Reform”) is to move the United States from a deferral and foreign tax credit system of taxation of foreign subsidiary earnings to a territorial system of taxation similar to the system that has long been in place in Canada.  Under the system formerly in place in the U.S., foreign earnings in a foreign subsidiary would be subject to tax in the foreign country.  When those earnings were brought back into the U.S. by way of dividend to a US corporate shareholder, the dividend would be grossed up for the underlying foreign tax paid on those earnings, US income tax would be computed on the grossed up amount and then a foreign tax credit would be granted for the underlying foreign tax paid.  As corporate income tax rates around the world (outside of the U.S.) gradually fell, it made little sense for US parent corporations of multinationals to “repatriate” their foreign earnings because the US corporate income tax rate was invariably higher and incremental tax would have to be paid.  Accordingly, earnings in foreign subsidiaries were left offshore and reinvested abroad.  Other transactions known as “inversions” were implemented to ensure that the U.S. high rate of tax was only paid on US earnings and not foreign subsidiary earnings.  Burger King and Valeant Pharmaceuticals are two highly publicized examples of corporate inversions.

US Tax Reform introduced two very important changes that should serve to eliminate the incentive to 1) earn income offshore in a foreign subsidiary and leave those earnings offshore and 2) invert a multinational structure into a foreign parent.  The first change reduced the U.S. corporate income tax rate from 35% to 21%.  The second change generally moved the U.S. from the deferral and foreign tax credit system to the territorial system of taxation of foreign subsidiary earnings.  In the latter system, similar to our system in Canada, dividends from foreign subsidiaries received by U.S. corporate shareholders will generally not be subject to U.S. tax.
What is the Transition Tax?
The Transition Tax is a one-time tax on unrepatriated earnings of a controlled foreign corporation existing on the effective date of US tax reform, generally December 31, 2017 for a calendar year corporation.  The tax is intended to subject those accumulated offshore earnings to tax, computed as 15.5% for earnings held in cash and other liquid assets and 8% for the remainder of the offshore earnings.  The Transition Tax is the “price” of moving to the territorial tax system.  As an aside, earnings deemed repatriated and taxed under the Transition Tax become “previously taxed earnings” and are not subject to tax again when those earnings are paid out as a dividend.  Canada, of course, ignores all of this and will tax the dividends when received.

The mechanics of the computation of the tax are generally as follows.  Assume the accumulated offshore earnings in the foreign corporation are $1,000, comprised of cash:

Income Inclusion             $1,000
Allowable deduction        (557.14)
Net Income Inclusion      $442.86
Tax at 35%                         $155.00 (15.5%)

The allowable deduction is computed as the amount required to reduce the rate of tax to a corporate shareholder on the inclusion to 15.5%. 

It’s relatively easy to understand the logic and fairness of the Transition Tax to a US corporate shareholder.  After all, the US corporate shareholder is receiving a large benefit going forward both in terms of a tax rate reduction and greatly simplified tax compliance on its foreign subsidiary dividends.

Unfortunately, the Transition Tax also applies to U.S. individual taxpayers, including US citizens living abroad.  From a policy perspective, this makes no sense.  Individual taxpayers did not participate in the indirect foreign tax credit system previously enjoyed by U.S. corporate shareholders and will not enjoy the benefits of the new territorial regime.  In both cases, U.S. individual shareholders simply include the amount of their foreign dividends in income and claim a foreign tax credit for withholding tax imposed by the payor foreign country, if any.  Moreover, U.S. individuals did not receive a material tax cut under US Tax Reform as their top rate of tax only fell from 39.6% to 37% and the Obama Net Investment Income Tax on high income earners was retained.  Finally to add insult to injury, in computing the Transition Tax, U.S. individual tax payers may only claim the allowable deduction with reference to the amount that would have been allowable to a US corporation.  Assume the U.S. citizen has $1,000 of earnings sitting in cash in his Canadian professional corporation and that his marginal U.S. tax rate is 39.6% in 2017.  The Transition Tax payable would be computed as follows:
Income Inclusion             $1,000
Allowable deduction        (557.14)
Net Income Inclusion      $442.86
Tax at 39.6%                      $175.37               (17.537%)

The law is poorly drafted and the authors appear to have not been giving a second thought to individual shareholders.

Potential Mitigating Factor
The potential mitigating factor for many Canadian resident U.S. citizen shareholders of controlled foreign corporations is the typical build-up of “general basket” foreign tax credit carryovers on their U.S. personal tax returns. Since Canadian annual personal tax liabilities are typically much higher than U.S. tax liabilities at the same income level, most U.S. citizens living in Canada have a large “general basket” foreign tax credit carryover that they will never use.  These unused foreign tax credits build up over a 10 year period and then expire year by year.  Consequently, unused foreign tax credit carryovers for the years 2007-2016 plus 2017 foreign tax credits may be used to shelter this tax on a dollar for dollar basis.  This may save many Canadian resident U.S. citizen taxpayers from this very punitive tax for which they receive no benefit.