The Biden administration’s “Made in America Tax Plan” and what it could mean for U.S. citizens residing in Canada

Citizens of the United States residing in Canada and owning Canadian companies have had a rough time since the Tax Cuts and Jobs Act (TCJA) was signed into law on December 22, 2017. Since then, most have become only too familiar with terms like “controlled foreign corporation” (CFC) and the dreaded “global intangible low-taxed income” (GILTI). The change in U.S. government and the Biden administration’s recent introduction of The American Jobs Plan¹ and The American Families Plan² have the potential to make matters even more challenging for this small but beleaguered segment of the Canadian population.

Background

In attempting to migrate the U.S. from a global system of international taxation to a quasi-territorial one, the TCJA introduced two sections of the Internal Revenue Code that have proven to be very disruptive for U.S. owners of Canadian companies: section 965 (Repatriation Tax) and section 951A (GILTI). To encourage large multinationals to repatriate business activity to America, these provisions tax profits of CFCs. CFCs generally are non-U.S. companies controlled by U.S. persons. While the changes were aimed at global multinationals, they have the potential to penalize severely U.S. citizens residing in Canada who control Canadian companies, exposing them to the prospect of true double taxation. 

Section 965 was a one-time tax on profits accumulated in CFCs up to December 31, 2017.³ GILTI, on the other hand, was intended to tax any profits earned thereafter. Like many countries, the U.S. has taxed passive income earned through foreign companies for decades. The GILTI regime extended the reach of U.S. taxation to active business profits earned through foreign companies.⁴ Positioned as a corporate minimum tax, the GILTI regime taxes the income of a CFC in the hands of the individual shareholder, requiring proactive planning to avoid double taxation.⁵

Current GILTI planning

Active business income earned through a Canadian-controlled private corporation (CCPC) that qualifies for the small business deduction can result in a very low rate of corporate tax. This small business rate provides a significant tax deferral opportunity⁶ that is fundamental to Canadian tax planning for private companies. Given that deferral of U.S. tax on foreign-earned profits is the target of the GILTI regime, taxpayers and their advisors must plan actively to mitigate the effects of GILTI.

Several strategies are used commonly to mitigate GILTI’s threat of double taxation. Obviously, these strategies must be considered in the context of the taxpayer’s overall Canadian tax and non-tax objectives.

1. Bonuses – Some business owners simply pay a bonus to the extent of GILTI. Unfortunately, this strategy forgoes any deferral of tax since bonuses are subject to current taxation. For many incorporated professionals, it might make more sense simply to practice through a sole-proprietorship and avoid the onerous CFC reporting.


2. Section 962 election –Section 962 allows an individual taxpayer to elect to be taxed as a U.S. corporation. The benefits of this election include:
   1. reducing U.S. tax on GILTI to 21% (the U.S. corporate tax rate) vs. 37% (the top U.S. individual tax rate);
   
   
   2. allowing the taxpayer to claim a foreign tax credit of 80% of the Canadian corporate taxes paid on the GILTI income; and
   
   
   3. allowing the taxpayer to claim a deduction of 50% of the GILTI, which is permitted under section 250.

The combination of these section 962 benefits creates an effective “hurdle rate” of 13.125%. In other words, if a CFC’s Canadian corporate tax rate is 13.125% or higher, no U.S. tax should be payable on the GILTI income. Since this threshold is very close to the small business rate of tax in most provinces, the section 962 election is as close to a “silver bullet” as exists currently for U.S. persons with smaller CFCs (incorporated professionals, small businesses, etc.).

3. High-tax exclusion⁷– To the extent that GILTI income is subject to Canadian corporate tax at a rate in excess of 90% of the U.S. corporate tax rate, a taxpayer may elect to exclude the income from GILTI. Given the current U.S. corporate tax rate of 21%, the Canadian corporate tax rate must be greater than 18.9% to qualify for this exclusion. This option is a good solution for owners of Canadian CFCs with income greater than approximately $800,000 (depending on the province of taxation, the availability of the small business rate of tax, etc.).


4. Opting out of the small business deduction – Since the small business deduction is optional, not claiming the deduction (i.e., voluntarily paying high-rate Canadian corporate tax) is a strategy that may be used in combination with either the section 962 election or the high-tax exclusion to eliminate double taxation. While this strategy might forgo some Canadian tax deferral, it increases the company’s general rate income pool (GRIP) balance, which unlocks eligible dividend treatment on the ultimate distribution to the shareholder.⁸


5. Unlimited liability companies (ULCs) – Some provinces (Nova Scotia, Alberta and British Columbia) have legislation geared toward unlimited liability companies. Such companies are disregarded for U.S. tax purposes, which means the income earned by the ULC is simply taxed as income of the owner of the ULC. As such, income of a ULC is not subject to GILTI. Unfortunately, since all income of the corporation is considered income of the individual owner for U.S. tax purposes, a certain level of Canadian tax deferral must typically be forgone to avoid double taxation. In addition, the ULC solution is not always feasible for existing companies, since converting a limited liability company to a ULC would be treated as a liquidation transaction for U.S. tax purposes. Finally, due to their unlimited liability to shareholders, ULCs are not suitable for all situations.


6. Avoid CFC status – Since only U.S. shareholders of CFCs are subject to the GILTI provisions, structuring corporate ownership to avoid CFC status can be an effective strategy to avoid GILTI.


7. Renunciation – U.S. tax reform was the last straw for many U.S. citizens resident in Canada. Many have chosen simply to renounce their citizenship. Of course, for many tax and non-tax reasons, the decision to renounce should not be made lightly. Taxpayers and their advisors should carefully review the U.S. expatriation rules (IRC 877A) and their potential impact.⁹

We expect that planning approaches generally will fall along one of two lines:

1. Owners of smaller CFCs wanting to keep it simple will opt for section 962 planning or, if possible, will migrate to a non-CFC structure.


2. Owners of large CFCs will avail themselves of the high-tax exception.

Of course, in real life there are many factors, nuances and complexities to consider in developing an effective plan. Layering on other U.S. tax rules (e.g., the U.S. subpart F rules (like GILTI but for investment income), the U.S. ordering of distribution of earnings and profits, etc.) and the Canadian passive income rules can quickly become a large and complex planning exercise. However, the 2020 taxation year was the first year since 2017 in which planning felt somewhat stable and settled. Enter the Biden administration…

Biden’s tax roadmap

Consistent with its election platform, the Biden administration recently introduced two significant proposals: The American Jobs Plan and The American Families Plan. These proposals contemplate a four-trillion-dollar investment in infrastructure, jobs, education and childcare, along with significant tax measures consistent with the administration’s election platform. The primary tax proposals impacting U.S. citizens in Canada are:

1. Increasing the top marginal tax rate from 37% to 39.6% – This increase, in theory, should not be problematic since Canadian tax rates generally are much higher than U.S. rates. However, the closer Canadian and U.S. tax rates become, the more likely U.S. tax will become an issue for U.S. citizens residing in Canada.


2. Increasing the top capital gains and qualified dividends tax rate from 20% to 39.6%¹⁰ – With current Canadian capital gains tax rates ranging from 22.25% to 27%, the increase could result in additional U.S. tax being payable on large capital gains realized by high-income taxpayers.  


3. Taxing unrealized capital gains at death – Unlike Canada, the U.S. does not currently tax capital gains on the death of a taxpayer (presumably since it has an estate tax). Assets passing through a taxpayer’s estate would typically receive a stepped-up cost (to fair market value), regardless of whether estate tax was actually paid. This proposed change could significantly impact cross-border estate plans. Notably absent from the proposals was a much-anticipated reduction in the estate tax exemption to $3.5 million, plus an increase in the top rate of estate tax to 45%.


4. Increasing the corporate tax rate from 21% to 28% – This proposal is widely accepted to be a starting point in the negotiations, so expect any change to be less than 7%. In general, any corporate tax rate increase will be detrimental for U.S. citizens in Canada owning CFCs.


5. Reducing the section 250 deduction – Again, this change, if applied broadly, would be quite problematic for U.S. citizens in Canada owning smaller CFCs.


6. Eliminate the qualified business asset investment (QBAI) exemption – Currently, a 10% return on tangible property used in a CFC’s business is allowed in calculating GILTI. The elimination of this exemption generally would result in higher GILTI income for owners of CFCs.

Impact on U.S. citizens in Canada with CFCs

The two most significant tax proposals for U.S. citizens with Canadian CFCs are the increase in corporate tax rates and the reduction of the section 250 deduction.¹¹

For owners of smaller CFCs, the combination of an increase in the corporate tax rate to 28% and the elimination of the section 250 deduction would eliminate the section 962 election as a viable planning option on its own. Under the existing regime, the current U.S. corporate rate and the 50% deduction provided by section 250 create an effective section 962 hurdle rate of 13.125%. With the proposed changes, this hurdle rate would increase to 26.25% (approaching the highest rate of corporate tax in Canada). Most smaller CFCs have much lower average tax rates due to the small business deduction. Even with a U.S. corporate tax rate increase to 25%, the effective hurdle rate would be 23.44%. This rate is unlikely to be achieved by a small CFC using the small business rate of tax. Of course, a taxpayer could opt not to take the small business deduction, however an immediate tax cost in the form of lost deferral would result.

Bottom line: Any combination of a corporate tax rate increase with a reduction of the section 250 deduction will be bad news for the owners of small CFCs. 

For larger CFCs, the proposed changes may be a lesser threat. At a 28% U.S. corporate tax rate, the Canadian corporate tax rate would need to exceed 25.2% to qualify for the high-tax exclusion (HTE). At a 25% U.S. corporate tax rate, the HTE hurdle rate would be 22.5%. Many larger CFCs would have a Canadian corporate tax rate in excess of these rates, which should make the high-tax exclusion a viable go-forward planning option. However, Canadian tax factors, such as investment tax credits and loss carryforwards, may reduce the effective tax rate and make the HTE unavailable without other planning.

Bottom line: The proposed tax rate increase and related reduction of the section 250 deduction will provide a smaller margin for error for large CFCs. However, existing planning options could still be available.

What’s next?

The Biden administration has a limited window to move these proposals through Congress before mid-term elections and has set as a target the fourth of July. At this point, hitting that target appears possible without Republican support by using the budget reconciliation process. To that end, it is possible that these proposed tax changes will significantly impact U.S. citizen owners of Canadian companies for the 2021 taxation year. 

Taxpayers and their advisors should monitor the progress of these bills closely.

Meet the Author

Todd King
Dartmouth, Nova Scotia
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Connor MacKenzie
Dartmouth, Nova Scotia
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