Proposed US Tax Deal Offers Relief for Canadian Investors

You may not be a US citizen, you may not reside in the USA or you may not even set foot in the country but if you have US assets including stocks, bonds, ETFs or other securities, you may be liable for US estate tax. Many Canadian investors are not aware of this reality, though they should be, especially if the Obama-Republican tax deal with its provision for US estate tax falls through. The prospects for the deal are changing daily and news reports suggest it is not at all a sure thing. However, US estate tax law will apply no matter which way the tax deal goes since a law is already in place. The Obama deal modifies the law in a way that substantially benefits Canadian investors so it well worth examining the situation.

Why Canadians Should Worry About US Estate Tax
US estate tax rules apply to anyone (i.e. including non-citizen, non-residents) with US assets whose worldwide estate (i.e. US assets and non-US assets, which includes investments outside or inside registered plans like TFSAs, LRIFs, LIRAs, RRSPs etc) exceeds the exemption amount. The catch, and the reason for the current anxiety amongst many people, is that a 2001 law progressively raised the tax-exempt total from US$1 million to a point of complete repeal of estate taxes in 2010 but it reinstates the low 2001 exemption limits as of January 1, 2011. It may seem that $1 million is quite a high total affecting only a few rich people until we realize that the US estate tax law defines a very broad range of assets to tally up the worldwide estate, some of which are not subject to tax at all in Canada. Most notably, that includes a principal residence and proceeds of life insurance.

On top of that, the US estate tax is applied against the value of the US-situated (and not, thankfully, against a non-resident alien's worldwide estate) assets, in contrast to Canada's tax system, where deemed disposition rules result in only capital gains being levied on assets at death. The result is possible hefty tax amounts to pay to the US upon death even if there has been no gain on the US investments. People in retirement and those later in life probably have most cause to worry about this but anyone who has amassed substantial assets needs to pay attention.

The Obama proposal sets the tax exempt amount at US$5 million worldwide assets and the top marginal estate tax rate at 35% according to this news report. The proposed estate tax change is not specifically targeted to foreigners or Canadians since US citizens are affected too, but it is good news as it would exempt most Canadian investors. The maximum tax rate is much lower as well.

Failing the tax deal going through, the 2001 rates will apply. To see the effect that might have, we work through an example using the rates cited in the Wikipedia article Estate Tax in the United States (we caution that though we believe the rates to be correct, to be sure you should consult a qualified tax professional). Our investor is assumed to have a US$2 million estate, of which US assets are US$250,000. By the 2001 rules, he/she would be liable for $27,575 in US estate taxes as shown below. Under the Obama deal, the $2 million is well below the $5 million exemption so no tax would apply.

Example

Tax on $250,000 (per table): $70,800
minus
Tax Credit of: US assets / Worldwide assets x Unified Tax Credit (which is the amount needed to exempt $1 million in assets i.e. the $345,800 tax on $1 million in assets in the table)
250,000/2,000,000 x 345,800 = $43,225
US Estate Tax Owed = US$27,575 or 11% of US assets

Should the 2001 rules become operative again, the Small Estate Exemption in the Canada - US Tax Treaty sets an exemption limit of US$1.2 million, up to which only US real property and business interests (which excludes stocks, bonds and intangible securities) are subject to estate tax, so that would help the Canadian investor.

No Double Taxation, Just Maximum Taxation
Canadians must of course, pay income tax on their worldwide assets, including US assets, so that introduces the possibility of double taxation. Though the Canadian taxpayer can claim the US estate taxes paid as a credit against Canadian taxes owing, thus eliminating double taxation, he/she often ends paying in total the US amount because the US estate taxes typically exceed Canadian capital gains tax as PriceWaterhouseCoopers explain in Estate Tax Update.

What to do

• Die in 2010 (just kidding!) - No US estate taxes to pay at all but it is a bit too extreme a tax reduction measure!
• Reduce US assets or Don't buy them in the first place - The less are the US assets, the lower the rate and the less tax to pay due to the sliding scale e.g. the same total estate with only $100k in US-situ assets would mean $6,510 owing, a 6.5% cost to US assets. There is an obvious trade-off to such an approach from an investment viewpoint since US markets offer the Canadian investor many opportunities for diversification, more companies in more sectors and many funds at cheaper fees than are available in Canada.
  
• Buy Canadian mutual funds or ETFs that buy US holdings - This is a viable option since such funds are not considered as situated in the USA and thus not subject to the tax (see Richardson GMP's US Estate Taxes Overview).
  
• Give away US investments before death - This works for investments since intangible property is exempt from another US law pertaining to gifts that catches and taxes other types of US assets.
• Establish a Canadian corporation to hold investments, Consider joint vs tenants in common ownership between spouses - These might or might not help and you would need professional guidance to figure it out and do it properly.
  
• Avoid the US tax by not reporting - definitely not advisable! If you invest in the USA, it is only fair to obey its laws, besides which the Canada - US Tax Treaty says the governments will exchange information to enforce taxes (see Article XXVII).
• Seriously consider hiring tax and legal professionals - This whole subject is fraught with complexity and critical details that can be very costly. If you are above the threshold, whatever it becomes in 2011 and beyond after the political tussle in the US is over, seeking qualified professional advice could save you a lot of money. Though we have focused on investing issues, people with other types of property like vacation homes, or who are resident in the US, may have multiple factors to trade off and an integrated financial and tax plan devised with expert help becomes more and more advisable.
  

As this is written, the outcome of the tax legislation struggle in Washington is not known. However, we can confidently trot out the hoary expression enunciated thus by famous American Benjamin Franklin - "In this world nothing can be said to be certain, except death and taxes" (as found on The Phrase Finder), to which we will append for this blog post, the word "together".

Further Reading: For a more precise and complete description of the issue, read professional accountant firm BDO's US Estate Tax Issues for Canadians, and lawyer Joseph Grasmick's Canadian Snowbirds and US Tax.

Update December 22. The tax deal has become law.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.