The possible use of the Canada U.S. tax treaty to defeat the “transition tax”

Beginning with the conclusion (for those who don’t want to read the post)

For the reasons given in this post, I believe that there are grounds to argue that the imposition of the Sec. 965 “transition tax” on Canadian resident/citizens DOES violate the Canada U.S. tax treaty. It is my hope that this post will generate some badly needed discussion on this issue.

If you are an individual who believes you may be impacted by the “transition tax”, you should consider raising this issue with the Competent Authority. I would be happy to explore this with you.

The possible use of the U.S. Canada Tax Treaty to as a defense to the U.S. “transition tax”

In Part 1 of this series, I wrote: “Responding to the Section 965 “transition tax”: “Resistance is futile and compliance is impossible“. I ended that post with a reminder that the imposition of Section 965 “transition tax” on Canadian residents has (at least) four characteristics:

1.The U.S. Transition Tax is a U.S. tax on the “undistributed earnings” of a Canadian corporation; and

2. Absent deliberate and expensive mitigation provisions, the U.S. transition tax contemplates the “double taxation” of Canadian residents who hold U.S. citizenship.

3. The “transition tax” is a preemptive “tax strike” against a corporation in Canada. Historically Canada would have the first right of taxation over Canadian companies.

4. The U.S. Transition Tax creates a “fictitious” taxable event. It is not triggered by any action on the part of the shareholder.
The purpose of this post is to argue that the Canada U.S. tax treaty may be a defense to the application of the Section 965 “Transition Tax”

Part A – Exploring  what a “Subpart F” inclusion really is

Part B – The Canada U.S. Tax Treaty: Relevant provisions

Part C – Impact of the “Savings Clause”

Part D – The Interpretation of the tax treaty: WHO interprets the treaty and HOW is the treaty to be interpreted

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Part A – Exploring what a “Subpart F” inclusion really is exploring what the “transition tax” really is

Under the Internal Revenue Code of the United States, the “transition tax” is a “Subpart F” income inclusion. The purpose and effect of the “Subpart F” rules are to attribute income earned by a foreign corporation to the U.S. shareholder(s) of that corporation. This is achieved by creating  a “legal fiction” that creates “fake income”. This “fake income” is then “attributed to the individual shareholder” (even though the U.S. shareholder did NOT actually receive the income). This attribution of the corporate income (which the United States cannot directly tax) to the individual (which the United States can tax), allows the United States to impose direction taxation on a “foreign corporation” by imposing direct taxation on the U.S. shareholder instead.

To put it another way:

The Subpart F rules exist for the sole purpose of finding a way to impose taxation on a “foreign corporation”. In this case the Subpart F rules are being used to impose taxation on the “undistributed earnings” of the Canadian corporation. This is achieved by simply attributing the corporate earnings to the individual “United States Shareholder”.

To summarize, the effect of the 965 “transition tax”, is: The application of the Section 965 “transition tax” would be that the United States would impose taxation on the “undistributed earnings” of a CANADIAN corporation. This is achieved by first creating a “pretend transfer” of the corporate earnings to the individual U.S. shareholder and then imposing taxation on the “individual shareholder”. The effect of this would be to create a situation that would eventually result in “double taxation”. Each of these factual realities must be independently considered in terms of the Canada U.S. “tax treaty”.

Part B – The Canada U.S. Tax Treaty: Relevant provisions

The U.S. Tax On The “Undistributed Earnings” of a Canadian Corporation and the tax treaty

S. 5 of Article X of the Canada U.S. Tax Treaty read as follows:

5. Where a company is a resident of a Contracting State, the other Contracting State may not impose any tax on the dividends paid by the company, except insofar as such dividends are paid to a resident of that other State or insofar as the holding in respect of which the dividends are paid is effectively connected with a permanent establishment or a fixed base situated in that other State, nor subject the company’s undistributed profits to a tax, even if the dividends paid or the undistributed profits consist wholly or partly of profits or income arising in such other State.

To the extent that we are talking about a company incorporated in Canada, it seems clear that S. 5 of Article X of the treaty means that the United States cannot impose a tax on the Canadian company’s “undistributed profits”.

It appears that the Section 965 “transition tax” exists for the sole purpose of imposing U.S. taxation on the “undistributed profits” of the Canadian company. The fact that the taxation is accomplished by creating a fiction that attributes the income to the shareholder does NOT change this reality. WHAT one does, is different from HOW one achieves the goal.

WHAT the transition tax is: The U.S. tax is being imposed on the “undistributed earnings” of a Canadian corporation.

HOW the tax is implemented: The mechanism for collecting the tax is, through the “legal fiction” of using Subpart F to characterize the “undistributed earnings” as “fake income”, and then to attribute the “undistributed earnings” to the income of the individual shareholder. This is what “Subpart F” inclusions have always been. Therefore, it is reasonable to argue that all “Subpart F” inclusions violate the Canada/U.S. tax treaty.

The argument that the “transition tax” violates S. 5 of Article X of the treaty is NOT dependent on the “citizenship” of the shareholder of the Canadian company. The treaty appears to prohibit the United States from imposing taxation on the “undistributed earnings” of any Canadian company period. Since a Canadian company is NOT a “U.S. citizen”, arguments based on the “savings clause” (discussed below) have no applicability.

The U.S. Tax On The “Undistributed Earnings” of a Canadian Corporation and “double taxation” of the individual shareholder

In Part 1 I explained how the “transition tax” would lead to “double taxation”. As a reminder the sequence of events leading to the “double taxation” is summarized as follows:

Re: The question of double taxation

As a reminder, we are discussing the “transition tax” applied to individual shareholders who are “tax residents” of other countries and subject to taxation in those countries.

Here is the order of events as contemplated by the Internal Rev. Code 965:

1. Inclusion of retained earnings in income of U.S. shareholder and U.S. tax paid on that deemed distribution.

2. The 965 deemed distribution is taxable in the U.S. but there is no taxable event in the country of residence and therefore no tax paid in the country of “tax residence”.

3. There is no credit allowed for the U.S. tax paid (in the year the transition inclusion is made) on the individual’s tax return where he actually lives.

4. When the amount that was the 965 distribution is later distributed in the country of tax residence the individual is taxed on that amount a second time.

The amount 965 inclusion is taxed twice (first by the United States and then by the country of residence).

One of the purposes of the Canada U.S. Tax Treaty is (sort of) to avoid double taxation. Article XXIV of the treaty includes:

Article XXIV – Elimination of Double Taxation

In the case of the United States, subject to the provisions of paragraphs 4, 5 and 6, double taxation shall be avoided as follows: In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof), the United States shall allow to a citizen or resident of the United States, …, as a credit against the United States tax on income the appropriate amount of income tax paid or accrued to Canada;

The sequence of events caused by the “transition tax” leads to “double taxation” because of “timing differences”  when income is received. The “double taxation” arises because there is NO ACTUAL INCOME REALIZATION event that triggers taxation. Rather the United States has created a “fictitious” taxable event in the United States when there is no corresponding taxable event in Canada. This leads to the absurd and perverse situation where:

• there is an income inclusion (“fake income”) in the United States and not in Canada (generating ONLY U.S. tax); and
• there is a later “real income” inclusion in Canada and not in the United States (generating ONLY Canadian tax)

Interestingly, the United States is creating a “fictitious” taxable event to take a preemptive tax strike against a pool of Canadian source capital. The effect is to “sneak up” and “tax it away” before there is a corresponding “taxable event” in Canada.

It is the “timing mismatch” (let’s go in and tax before Canada would impose a tax) that leads to “double taxation”.

How should the “tax treaty” be interpreted when the United States creates a “fake income” inclusion?

In the case of an “actual distribution” of “real income” …

It is clear that if the “undistributed earnings” were actually distributed, there would be no “timing mismatch”, which would mean that:

• taxes would be paid in Canada; and
• those taxes paid in Canada would be used as a credit to offset U.S. taxes.

In the case of a “deemed distribution” of “fake income” …

It is my respectful submission that the proper interpretation of the U.S. Canada Tax Treaty should be that:

If the United States creates a “deemed distribution” of “fake income” that the shareholder ought to be able to take as a credit against U.S. tax, the amount of Canadian tax that would have been paid in to Canada on that same income. My interpretation is supported by the language in the treaty that specifically allows a credit for taxes either “paid or accrued to Canada”. It would be a gross perversion of the stated purpose of Article XXIV to allow the United States, through the creation of a fictitious event, to create a situation that results in double taxation.

(Interestingly the situation of a fictitious event is considered in S. 7 of Article XIII which appears to deal with “fictitious capital gains” in the context of a “Departure Tax”. My point is that this does reflect an intention on the part of the treaty drafters to NOT allow “fictitious events” to create unreasonable tax burdens on individuals.)

Part C – Impact of the “Savings Clause”

Does the “savings clause” found in S. 2 of Article XXIX (the “Savings Clause”) mean that the United States can impose taxation on the “undistributed earnings” of the company? How would such an argument be made?

To review:

I am making two separate and independent arguments for why the Sec. 965 “transition tax” violates the Canada U.S. tax treaty. The “savings clause” does not apply (and is therefore irrelevant) to each argument.

What is the “savings clause”?

In general the “savings clause” is a provision in almost all U.S. tax treaties that allows the United States to impose U.S. taxation, according to U.S. rules on residents of the other country, that the U.S. considers to be U.S. citizens. In practical terms it is a mechanism that allows the United States, under the guise of “citizenship-based taxation” to impose indirect taxation on the economies of any country, by imposing direct taxation on the residents and citizens of other countries. The “savings clause” makes the definition of “U.S. citizen” important and relevant. Most treaties do include various “exceptions to the “savings clause”.

Bottom line: In most cases, U.S. citizens do NOT get the benefits of U.S. tax treaties!

What does the “savings clause” in the Canada U.S. tax treaty say?

Article XXIX: Miscellaneous Rules

2. Except as provided in paragraph 3, nothing in the Convention shall be construed as preventing a Contracting State from taxing its residents (as determined under Article IV (Residence)) and, in the case of the United States, its citizens (including a former citizen whose loss of citizenship had as one of its principal purposes the avoidance of tax, but only for a period of ten years following such loss) and companies electing to be treated as domestic corporations, as if there were no convention between the United States and Canada with respect to taxes on income and on capital.

3. The provisions of paragraph 2 shall not affect the obligations undertaken by a Contracting State:

(a) under paragraphs 3 and 4 of Article IX (Related Persons), paragraphs 6 and 7 of Article XIII (Gains), paragraphs 1, 3, 4, 5, 6(b) and 7 of Article XVIII (Pensions and Annuities), paragraph 5 of Article XXIX (Miscellaneous Rules), paragraphs 1, 5 and 6 of Article XXIX B (Taxes Imposed by Reason of Death), paragraphs 2, 3, 4 and 7 of Article XXIX B (Taxes Imposed by Reason of Death) as applied to the estates of persons other than former citizens referred to in paragraph 2 of this Article, paragraphs 3 and 5 of Article XXX (Entry into Force), and Articles XIX (Government Service), XXI (Exempt Organizations), XXIV (Elimination of Double Taxation), XXV (Non-Discrimination) and XXVI (Mutual Agreement Procedure);

Why the “savings clause” does NOT “save” the “transition tax”

Tax on “undistributed earnings” of a corporation: The “transition tax” is really an attempt to tax the “undistributed earnings” of a Canadian corporation. This is prohibited by S. 5 of Article X of the Canada U.S. tax treaty. The “savings clause” has no application to a U.S. tax imposed on a Canadian corporation.

Double Taxation as applied to individuals: The “savings clause” in Article XXIX in its plain terms exempts Article XXIV (the elimination of double taxation) from its scope.

Conclusion: The “savings clause” is irrelevant to any analysis of whether the U.S. “transition tax” violates the Canada U.S. tax treaty.

Part D – The Interpretation of the tax treaty: WHO interprets the treaty and HOW is the treaty to be interpreted

Most “tax professionals” who think about the Canada U.S. tax treaty are U.S. accountants and U.S. lawyers. It is understandable that they would analyze and interpret the U.S. Canada tax treaty in a “U.S. centric” manner. We all view the world through our own “legal” and “cultural” assumptions and perspective.

That said, tax treaties are agreements between two parties. In this case the treaty is an agreement between Canada and the United States. Therefore, in interpreting the “treaty” one is required to interpret it through the understanding, intention and expectations of both Canada and the United States. In other words, one does NOT interpret the treaty by simply asking ONLY:

“What is the U.S. understanding of how the treaty should be interpreted?”

One must also ask:

“What is Canada’s understanding of how the treaty should be interpreted?”

Shocking as this may be to various tax professionals, this principle was reinforced in August of 2016 by the United States Court of Appeal for the District of Columbia, per Millett, Circuit Judge, in the Esher case. My commentary on the case included:

The court ruled that international tax treaties must be interpreted in the context of what were the expectations of the country when the treaty was signed. This may open up the possibility of reconsidering how various U.S. tax laws may affect the residents and citizens of other nations.

For example: To what extent was or is it the expectation of a country that it can be interpreted to allow the U.S. to impose punitive taxation on those who are primarily citizens of and factually residents of other nations? (I have also argued that the principle in the Esher case would require the United States to allow a foreign tax credit to offset the 3.8% Obamacare surtax.)

I believe it’s fairly clear that, Canada would believe that the Canada U.S. tax treaty would prevent the United States from creating a fictitious taxable event, to attack the “undistributed earnings” of Canadian corporations, before Canada they were taxable under Canadian law.

Put it another way:

The treaty should be interpreted to allocate taxing rights in a reasonable way  and to eliminate double taxation. It should NOT be interpreted to allow the United States to create “fake events”, which generate “fake income”, which is them attributed to “Canadian residents” in a “fake way”, and take a preemptive tax strike against Canadian capital.

Conclusion

I have not seen a single post, article or discussion that suggested that the imposition of the Sec. 965 “transition tax” violates the Canada U.S. Tax Treaty. Why not? Most “tax professionals” appear to not even be willing to consider the question. Why not?

Karen Alpert (of “Fix The Tax Treaty” fame) in a comment to recent post about the Transition Tax, published at “TaxConnections” writes:

It is frustrating that much of the tax compliance industry seems to be just rolling over on both the transition tax and GILTI. They are writing articles that tell US expats that they must just comply, even when compliance will have a serious adverse effect on planned retirement savings and the financial viability of businesses owned by US expats.

Where are the tax professionals who are working on ways to get around a literal interpretation of the legislative language? Is Congressional intent irrelevant? Are there treaty positions that could be taken, or appeals that could be made to the Competent Authorities under the tax treaties that these TCJA provisions are contrary to the intent of the treaty? Are there other avenues to challenge this law in the courts? Is anyone pursuing change or clarification from Congress (or the IRS)?

For the reasons given in this post, I believe that there are grounds to argue that the imposition of the Sec. 965 “transition tax” on Canadian resident/citizens DOES violate the Canada U.S. tax treaty. It is my hope that this post will generate some badly needed discussion on this issue.

If you are an individual who believes  you may be impacted by the “transition tax”, you should consider raising this issue with the Competent Authority.

Contact me and I would be happy to explore this with you.

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IRC Section 965 Transition Tax- Part 1