Post-mortem planning becomes more complex when there’s a U.S. beneficiary.John Wirta/iStockPhoto / Getty Images
Many high-net-worth Canadians have a significant portion of their net worth tied up in Canadian corporations because of the tax deferral and other benefits these structures provide. In addition, many of these families have beneficiaries who are U.S. taxpayers (either U.S. citizens resident in Canada or U.S. residents).
This situation – lots of value in a corporate structure and U.S. beneficiaries – gives rise to potential U.S. estate and income tax issues. The estate tax issues are the easy ones for cross-border estate planning, and Canadian tax and estate planners are typically well-informed of the planning options (e.g., sheltering the inheritance of U.S. resident beneficiaries from the U.S. estate tax at their deaths through the use of dynasty trusts).
However, the income tax issues are often poorly understood.
Standard post-mortem planning
When the second spouse dies, there’s a capital gain on the shares of Canadian corporate interests. That presents an inherent double (or triple) tax exposure, as the capital gains tax payable at death doesn’t reduce the taxes owed when the corporate surplus is withdrawn from the corporation, nor does it reduce the capital gains tax the corporation would owe when it disposes of its assets.
To rectify this situation, Canadian tax law permits various types of corporate reorganizations, such as the loss carry-back, the pipeline, bump planning or a combination of the three. Such techniques are fairly standard, if not always straightforward.
What happens with U.S. beneficiaries?
The complexity of these post-mortem plans is magnified when there’s a U.S. beneficiary. The U.S. federal tax system has a complex series of income tax rules that apply when a U.S. taxpayer has an interest in a foreign corporation, even if that interest is held indirectly through a foreign trust or estate. These rules are intended as “anti-deferral” rules and were designed to apply to U.S. multinationals such as Apple Inc. and ExxonMobil Corp. Their application in this context is strange from a policy perspective, but unambiguous from a technical perspective.
These rules fall into two broad categories.
The controlled foreign corporation (CFC) rules can apply when more than a majority (by vote or value) of the foreign corporation is owned by U.S. taxpayers.
The passive foreign investment company (PFIC) rules can apply when the foreign corporation is not a CFC and has passive income or assets that exceed certain thresholds.
The nuances of the PFIC and CFC rules fill pages of statutes, regulations and case law. Without engaging with all that detail, three key points stand out.
- Both rules look through any and all foreign intermediary entities, such as trusts or estates, and connect the U.S. taxpayers directly with the corporations immediately upon the Canadian parent’s death.
- Both rules can create U.S. tax even without an income distribution by taxing the U.S. beneficiary personally on corporate income.
- Both rules are punitive in nature, and their application is based on the substance of the arrangement, not the form of the estate planning documents.
How the CFC and PFIC rules interact with standard Canadian post-mortem planning will differ in each situation, but what starts as a fairly standard domestic Canadian reorganization becomes mired in cross-border complexity.
Consider the following example based on a real-life scenario. A high-net-worth Canadian died owning a holding company with real estate that had appreciated significantly in the Vancouver real estate boom of the past 50 years. Two-thirds of the beneficiaries were U.S. residents, and the standard U.S. estate tax protections were put in place.
When a standard Canadian post-mortem plan was executed, the U.S. beneficiaries owed millions in U.S. income tax on top of the Canadian taxes paid by the estate and the companies. Had some simple planning been done before death, there would not have been any U.S. taxes owed.
What could the business owner have done? Frequently, these issues can be solved or at least mitigated by converting the Canadian companies to unlimited liability companies (ULCs) before the death of the Canadian parents. A ULC is a type of Canadian corporation that isn’t a corporation in the U.S. income tax system. As such, the PFIC and CFC rules don’t apply.
The conversion to a ULC is a non-event in Canada, but it bumps the cost basis in both the ULC interests and the underlying assets for U.S. purposes. ULC planning must be integrated carefully with the U.S. estate tax planning, as a ULC no longer serves as a corporate blocker for any U.S.-situs assets it may hold.
The key issue for U.S. beneficiaries of high-net-worth Canadian estates is not protecting the kids from the U.S. estate tax. That’s easily identified and solved, and only really applies at the death of the beneficiaries, and so is not a top-of-mind concern. The income tax issues, on the other hand, apply immediately and are often a nasty surprise – but one that can be avoided with a simple pre-death ULC conversion.
Max Reed is a cross-border tax lawyer and founding partner of Polaris Tax Counsel in Vancouver.