“This legislation is being interpreted by a number of tax professionals to mean that individual U.S. citizens living outside the United States are required to simply “fork over” a percentage of the value of their small business corporations to the IRS. Although technically “CFCs” these companies are certainly NOT foreign to the people who use them to run businesses that are local to their country of residence. Furthermore, the “culture” of Canadian Controlled Private Corporations is that they are actually used as “private pension plans”. So, an unintended consequence of the Tax Cuts Jobs Act would be that individuals living in Canada are somehow required to collapse their pension plans and turn the proceeds over to the U.S. government”
I have previously suggested that the Section 965 “transition tax” should not be interpreted to apply to Americans abroad. This argument was based largely on a “lack of legislative intention” coupled with the fact that individuals (whether in the USA or living abroad) do NOT get the benefits of the transition to “territorial taxation”.
These are difficult times for many Canadians who are the owners of Canadian Controlled Private Corporations. Canadian residents use Canadian Controlled Private Corporations (“CCPCs”) to operate small businesses and to create pension plans for their retirement. Importantly a Canadian corporation meets the definition of a “CCPC” only if it is controlled by residents of Canada. By definition all “CCPCs” are local to their owners. The use of “CCPCs” reflects the reality of Canadian tax laws going back to 1972. Governments the world over are taking steps to ensure that corporations cannot be used for the deferral or avoidance of taxation.
The election of the Trudeau Liberals resulted in the Government of Canada taking an interest in “Tax Reform” (or at least “tax reform” in relation to Canadian Controlled Private Corporations). On February 27, 2018 Finance Minister Morneau delivered the Liberals third budget. Although not widely publicized, the budget including major changes in how the passive income of CCPCs is to be taxed in Canada.
Of course those “CCPC” owners who have U.S. citizenship must also deal with the U.S. tax system. Interestingly, both the Government of Canada and the Government of the United States have the owners of “CCPCs” on their radar.
Canada – On the “Home front” (meaning in Canada) the Liberal Government of Justin Trudeau and Finance Minister Bill Morneau are targeting the “retained earnings” in their corporations. Specifically they believe that “retained earnings” that were subject to the lower small business tax rate provide an unfair tax deferral, resulting in more capital to invest, which allows for the creation of additional passive income. The February 27, 2018 Canadian budget is a direct response to this perception.
The United States – The “Homeland” has just passed the TCJA (“Tax Cuts Jobs Act”). One provision of the TCJA amended Internal Revenue Code Section 965 to impose a one time tax on the “United States shareholders” of “Deferred Foreign Income Corporations” (a “DFIC”). This tax is based on the “undistributed earnings” of corporations. The application of this tax to U.S. citizens living outside the United States is newsworthy, is debatable (and is being debated). The application of the Section 965 “transition tax (assuming the applicability of the tax to Canadian resident owners of “CCPcs”), would be a direct, retroactive tax on the “retained earnings” of Canadian Controlled Private Corporations. Notably these “retained earnings” were NEVER subject to U.S. taxation before (it’s retroactive). The mechanism that the U.S. Government is using to impose direct taxation on the retained earnings of “CCPCs” is to (1) attribute the corporate undistributed earnings to the individual shareholder and (2) impose taxation directly on the individual shareholder. For “Tax Geeks” (and those who want boring cocktail conversation), from a U.S. perspective this process of income attribution is called “Subpart F” income. (You can learn all about it by reading Internal Revenue Code Sections 951 – 965). I emphasize that a Subpart F inclusion (by definition) attributes corporate income to a “shareholder” without any realization event whatsoever.
Leaving aside the theory, the reality is that for many Canadian residents, the application of this Section 965 “transition tax” would operate to effectively “confiscate” their pension plans. “Confiscation” is what is really happening. But, “tax professionals” refer to this process of “confiscation” as a “Subpart F” inclusion.
An simple example of a “Subpart F” inclusion (assuming that the U.S. Section 965 “transition tax” applies to Canadian residents) …
John Smith lives in Canada and is a Canadian citizen. He was born in Canada to a U.S. citizen father. He is therefore considered to be a U.S. citizen living in Canada. John Smith also has a small business and over a 30 year period has managed to accumulate 1 million dollars of undistributed income in his corporation. He dutifully files his U.S. tax returns every year. Understand that this 1 million dollars of retained earnings was never subject to U.S. tax. On December 22, 2017 President Trump signed the TCJA which (according to a majority of “tax professionals”) retroactively subjects that 1 million dollars to a one time U.S. tax. So, John would be required to include 1 million on his U.S. tax return for a one time confiscation tax. Note that there is no “taxable event” in Canada. So, in theory, John Smith would be required with respect to the 1 million dollars to FIRST pay tax on it in the United States and SECOND pay tax on it Canada. In other words, (assuming the applicability of the tax) it would amount to:
- A U.S. tax on the undistributed earnings of a Canadian Corporation (Say what??) (this is accomplished through the “back door” by imposing the tax on the shareholder and not the corporation); and
- Very likely “double taxation”. The sequence of events leading to the “double taxation” are:
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:
- Inclusion of retained earnings in income of U.S. shareholder and U.S. tax paid on that deemed distribution.
- 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”.
- 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.
- 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).
Bottom line: Both Canada and the United States have a very keen interest in the “retained earnings of Canadian Controlled Private Corporations”. It’s too bad that you have one.
The response of the “tax compliance industry”
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)?
Resistance is futile!
Think of it! The tax compliance industry is largely telling people that the Section 965 “transition tax” applies to them and they must surrender a good part of (what is for many) their pensions to the IRS. An interesting discussion of the “Resistance if futile” principle is found in the Facebook discussion in the following tweet:
Some “tax professionals” are behaving as though the United States is an “occupying power”, the “tax professionals” are the representatives of the United States and their role is to impose the “transition tax” on a conquered people (The “It’s U.S. law” principle.)
Compliance is impossible!
While the tax compliance industry continues the “Resistance is futile” drumbeat, Canadians with undistributed earnings in CCPCs are dealing with the reality that “compliance is impossible”. The reasons for the impossibility are both “contextual” and “logistical”. Both set of reasons are discussed in the 7 part video series about the Internal Revenue Code Sec. 965 “Transition Tax”created by John Richardson and Dr. Karen Alpert.
Contextual reasons that compliance is impossible
- “Tax professionals” are just as confused about how to impose the tax on Canadian individuals, as individuals are about what is expected of them
- Some modes of compliance (for example the Sec. 962 election) will require records that may no longer exist
- Few (if any) have financial statements that have been done according to U.S. accounting principles
- The rules are even less understood for those corporations that do not have a December 31, year end
- There is a lack of agreement on what percentage of certain Canadian taxes can be used as a tax credit, etc.
Logistical reasons that “compliance is impossible”
- Assuming the application of the “transition tax”, as Charles Bruce of “American Citizens Abroad” fame notes, people may not have the money to pay the tax. After all, this is a retroactive tax with no “realization event”
- In order to find the money to pay the “transition tax”, the corporation would have to sell assets. The effect of the sale would be to generate further taxes and so on and so on …
- In order to find the money to pay the transition tax one could: First, renounce U.S. citizenship (meaning that one would no longer be subject to U.S. tax jurisdiction) and then Second, sell his/her principal residence in Canada (which would then be a tax free capital gain) and use the proceeds of the sale to pay the tax!
Readers should understand that the operation of the “transition tax” is the confiscation of the assets (and for some is their pension).
The “tax compliance industry” teaches that, when it comes to the Section 965 “Transition Tax”:
“Resistance is futile” (the theory according to most tax professionals) and “Compliance is impossible” (the reality according to anyone actually confronted with the problem).
In closing please remember four basic points:
- The U.S. Transition Tax is a U.S. tax on the “undistributed earnings” of a Canadian corporation; and
- Absent deliberate and expensive mitigation provisions, the U.S. transition tax contemplates the “double taxation” of Canadian residents who hold U.S. citizenship.
- The “transition tax” is a “tax strike” against a corporation in Canada. Historically Canada would have the first right of taxation over Canadian companies.
- The U.S. Transition Tax creates a “fictitious” taxable event. It is not triggered by any action on the part of the shareholder.
This concludes Part 1. In Part 2, I will explore how the U.S. Canada tax treaty may provide some protection from the Section 965 transition tax.
Contact John Richardson, Tax Lawyer with questions.