This small business thought it was saving to invest in business expansion – Wrong, they were saving to be robbed by America!

This is the eighth in my series of posts about the Sec. 965 Transition Tax and whether/how it applies to the small business corporations owned by taxpaying residents of other countries (who may also have U.S. citizenship). These small business corporations are in no way “foreign”. They are certainly “local” to the resident of another country who just happens to have the misfortune of being a U.S. citizen.

Considering the impact of the “transition tax” on the corporation itself

The  Sec. 965 “transition tax” is a provision that the United States is using to impose taxation on the UNDISTRIBUTED earnings of Canadian corporations. (Section 5 of Article X of the Canada U.S. Tax Treaty prohibits the United States from imposing taxation on the “undistributed earnings” of Canadian corporations.)

The mechanism to impose the “transition tax” is the Subpart F income inclusion (a way of attributing the earnings of the corporation to the shareholder). Because the corporate income is attributed to the individual shareholder, my first posts have focussed on the impact on the individual. These posts have focussed on the impact of the “transition tax” at the individual shareholder level.

The purpose of this post is to focus on how the “transition tax” will impact the business, expansion and growth of the corporation. It will focus on how the “transition tax” impacts the local Canadian economy on a macroeconomic level.

Here we go …

I recently received a call from a small business person who had learned very late about the “transition tax”. Because he learned about the “transition tax” so late, he had no time to take corrective action (with the few available options to generate “foreign tax credits”). This resulted in a “transition tax discussion“, with the owner of the shares of a small “Canadian Controlled Private Corporation“. What follows is the story, of what is happening to Canadian Controlled Private Corporations, that have “U.S. Person shareholders”. It explains, why some of those people organizing the structure of corporations in Canada, are restricting ownership opportunities to those who are NOT “U.S. persons”.

“Once upon a time in the real world”, there was a  …

– small family business in the hospitality industry

– where the owner had taken very few distributions (no dividends or salary payments), meaning he had allowed the corporation to retain the earnings

– his specific reason for NOT taking distributions and leaving the money in the company, was to accumulate capital inside the company for the purpose of expanding, renovating and generally upgrading the business

– because the owner had taken few distributions his personal assets were primarily the shares of the business

– after scrimping and saving he had accumulated about 2 million in cash which was earmarked specifically to renovate and expand the business

– his renovation and business expansion plans included hiring new employees for the business once expanded and of course hiring local contractors (good for the local economy)

Get it! This is money that to be used to invest in the business and in the local economy for years to come. Or so this, “poor” (soon to be) guy thought.

Let’s see how the “transition tax” would impact his plans. We assume the 2 million dollars of retained earnings. Here we go.

Watch how this confiscation and damage to the local Canadian economy will unfold:

1. The individual shareholder is required to pay 17.54% of the 2 million to the USA. That’s a total of $350,800.

2. Where would he get the money to pay this? Well he has no personal assets. So, he needs to get the $350,800 out of the company in the form of a distribution (dividends or salary).

3. But,  if he takes a distribution,  that distribution will be subject to taxation in Canada (remember??). Unless the timing of the U.S. “transition tax” is matched to the timing of the “distribution” in Canada, he will be subject to double taxation on the same income! (The only way for the timing of the “transition tax” to match the timing of the “distribution” would be if the “distribution is made in 2017  – or possibly 2018.) Again, with a timing mismatch the “transition tax” WILL result in double taxation! (A purpose of the Canada U.S. tax treaty is to prevent “double taxation“).

4. How much of a distribution would be needed (recognizing that the distribution is subject to Canadian tax), to be left with $350,800. Let’s assume a Canadian tax rate of 50%. (This is an estimate only and there are other factors. My point is only to demonstrate that more than $350,800 must be distributed from the company.)  If it were a 50% tax rate in Canada then he would have to distribute $350,800 times 2 = $701,600.

5. But wait just a minute!! What were you thinking? If the distribution is in the form of a dividend, the the poor guy also has to pay a 3.8% Obamacare (remember this guy?) surtax on the $701,600 dividend. This means an additional $701,600 times 3.8% = $26,660 to go to the USA (but hey, who’s really counting at this point?). Shouldn’t Canadian residents be required to contribute to health care for Homelanders? (Note that under the U.S. Internal Revenue Code the 3.8% Obamacare surtax cannot be offset by foreign tax credits. There are various arguments for why tax treaties might require the U.S. recognize foreign tax credits to offset the Obamacare tax.)

6. So how much is left in the Company (to use for the renovations and business expansion) after this $701,600 distribution? Well, the calculation works like this:

$2,000,000 less $701,600 = $1,298,400!! (And I haven’t added the 3.8% Obamacare surtax! Maybe he can get his Canadian wife to pay that $26,600.)

This is capital reduction of about 35%!!

To put it very simply: This is the United States simply stealing from Canada’s tax base. You may not care about the poor individual shareholder. You may think that this guy is rich and deserves to be taxed. You may not care if he has to pay this.

But, you might care about the fact that your son or daughter is no longer going to be able to apply for that job at his restaurant. You surely would care about the fact that this money is no longer available to expand this business and provide work for the local contractors. You surely would care about the fact that this means fewer jobs in the Canadian economy (both long term and short term)!

Mitigating the U.S. Transition Tax: The use of  “Canadian tax paid” as a credit against the U.S. transition tax owing

It is important to emphasize that the $350,800 is  (according to U.S. law) a tax that is due! The “transition tax”  can be offset (in some cases) by Canadian taxes paid. This does NOT change the fact that the $350,800 “transition tax” is payable. The tax credits generated in Canada are the WAY that the “transition tax” is to be paid. Tax credits are a method to pay taxes. They do NOT change the fact that a tax is payable.

The (non) response of the Government of Canada

What would the Government of Canada say about this outright confiscation of Canadian assets?

Well, so far they have said:

“It’s U.S. law. Take it up with the United States”.

What the Government of Canada doesn’t acknowledge is:

The fact that “It’s U.S. law is why the Government of Canada should be concerned. In fact it’s even more reason why the Government of Canada should be concerned!

But, back at the ranch (or rather the restaurant) …

Looks like that renovation is not going to be happening. Too bad. So sad. Maybe the U.S. Government can invest that $350,800 in the U.S. economy. Maybe it could be used to invest in a restaurant across the border in the United States. Canadians can then go and have lunch in the United States!

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IRC Section 965 Transition Tax- Part 1

IRC Section 965 Transition Tax- Part 2

IRC Section 965 Transition Tax- Part 3

IRC Section 965 Transition Tax- Part 4

IRC Section 965 Transition Tax- Part 5

IRC Section 965 Transition Tax- Part 6

IRC Section 965 Transition Tax- Part 7