The republicans and democrats couldn’t diverge more on tax policy. While President Donald Trump continues to focus on tax cuts, Democratic nominee Joe Biden proposes tax increases aimed at the wealthy and corporations — increases that could affect your cross-border clients if the Dems win in November.
However, the Democrats could find that passing major tax legislation will be difficult absent a strong blue sweep in the election. Tax policy originates in Congress, and the Dems currently control only the House.
With that caveat in mind, as well as acknowledging that neither party had released a detailed tax policy as of press time, here’s a high-level look at potential tax changes that may affect clients north of the border.
The focus is on Biden, because Trump’s tax policy wouldn’t have significant implications. The president wants to make permanent the provisions in the 2017 Tax Cuts and Jobs Act (TCJA) that are set to expire after 2025, and potentially build on tax cuts for middle-income Americans.
On Biden’s Chopping Block
Biden has called for returning the U.S. estate tax to 2009 levels, which implies a base exemption of $3.5 million per taxpayer (indexed annually to inflation) and a top tax rate of 45%. (All figures are in U.S. dollars.)
U.S. citizens, regardless of where they reside, are subject to estate taxes at death on any worldwide assets above the current base exemption of $10 million (indexed to inflation; $11.58 million for 2020) — a figure the TCJA doubled from a base of $5 million (indexed annually to inflation) beginning in the 2018 tax year. The U.S. estate tax rate currently is 40%.
Canadians are subject to the U.S. estate tax at death if they own more than $60,000 in assets located in the U.S. (including real estate and stocks) and their worldwide assets are worth more than the exemption. For Canadians, the exemption is pro-rated based on the value of U.S. assets relative to worldwide assets.
The exemption has varied over the years, and a decrease by the Dems wouldn’t be surprising, but may require planning by you and your clients. For example, wealthy Canadians who recently bought substantial U.S. property without thinking about the U.S. estate tax may need to consider it.
“Often, owning properties in a cross-border irrevocable trust is a good strategy to protect against U.S. estate tax,” says Matt Altro, president and CEO of MCA Cross Border Advisors Inc. in Montreal.
Altro says U.S. citizens living in Canada could take advantage of the high exemption while it’s still available by giving to family members or to an irrevocable trust.
Biden also proposes eliminating the stepped-up cost basis at death on transfers of property that has appreciated in value.
“‘Stepped-up basis’ is a U.S. tax benefit that essentially means unrealized capital gains are wiped out when assets are inherited,” says Max Reed, a cross-border tax lawyer at Polaris Tax Counsel in Vancouver. “Biden is proposing that, in addition to the estate tax, the U.S. would adopt a Canadian-style capital gains tax at death.”
The proposal would apply to U.S. citizens in Canada, who are subject to U.S. income tax on their worldwide assets and U.S. estate taxes. The proposal also may affect Canadians who own U.S. real estate, Reed says, but those details were unavailable at press time.
Altro describes the stepped-up basis proposal as “a major change” that would require some of your cross-border clients to reconsider the assets in their estates.
Reed says that if Biden imposes those changes, “Canadians who have [exposure to] U.S. tax at death, either because they’re U.S. citizens in Canada or Canadians with U.S. assets, will probably need to revisit their estate tax planning.”
Taxing Capital Gains as Income
Biden’s platform contains more bad news for the wealthy: he proposes to tax long-term (longer than a year) capital gains as ordinary income instead of at a flat 20% for people with taxable income of more than $1 million annually. (The top marginal capital gains rate in Canada is 27%.)
Biden also would restore the top personal tax rate for people earning more than $400,000 per year to 39.6% from 37%. Subsequently, the capital gains tax for people earning more than $1 million essentially would double.
Reed doesn’t anticipate those proposals will have much effect on U.S. citizens in Canada, who receive foreign tax credits for Canadian tax paid. “Most of them don’t pay much U.S. tax anyway,” he says.
However, Biden’s capital gains proposal may affect a business owner in Canada who is a U.S. citizen and selling a business for a substantial amount, Altro says. To address the potential problem, the business owner could give shares to a Canadian spouse, who then could sell the shares, Altro says, although this strategy isn’t simple.
Altro also notes that Biden’s proposed capital gains policy could apply to Canadians selling substantial U.S. property.
Business Owners and GILTI
More bad news for business owners: Biden proposes to double the minimum tax on profits earned by foreign subsidiaries of U.S. firms to an effective rate of 21% from 10.5%.
This tax on what’s known as global intangible low-tax income (GILTI) was introduced in the TCJA to tax multinationals’ income from intangible property. But the GILTI tax also affects U.S. citizens who own a business in Canada, including incorporated professionals: their corporate income may be taxed personally. Biden’s increase would make the GILTI tax more punitive.
Biden also proposes raising the corporate tax rate to 28% from 21%, which would affect the GILTI calculation.
“Many [U.S. citizens who own a business in Canada] may end up owing U.S. taxes because the U.S. rate will be in excess of the Canadian rate on the income that’s earned by the business,” Reed says. “[That excess income] would flow through to them [personally] and be taxed in the United States.”
While Canadian business owners can defer taxes on money left inside their corporations, doubling the GILTI tax makes that harder for a U.S. citizen who owns a business in Canada — and it’s already hard because these clients are subject to onerous anti-deferral rules applicable to passive income inside their corporations.
The GILTI increase “may wipe that possibility [of deferring taxes] off the table,” Altro says.
To help manage the impact of GILTI currently, U.S. citizens who own a business in Canada now use tools such as an election under Section 962 of the U.S. Internal Revenue Code or the high-tax exception. Your clients could still use those tools if the GILTI tax were increased, although the calculations will change, Altro says.
Certain clients can set up an unlimited liability company (ULC), which the Internal Revenue Service (IRS) considers a “disregarded entity.” In other words, “the corporation doesn’t exist from a U.S. perspective,” Altro says.
A ULC can work when unlimited liability isn’t a concern, such as for a holding company or doctor’s professional corporation (for which liability is covered by insurance).
Unfortunately, such a plan means the IRS will treat the business owner as a sole proprietor or a partnership (if partners are involved), meaning the owner won’t be able to defer taxes on income inside the corporation. The U.S. citizen who owns a business in Canada will be taxed on income annually in the U.S., Altro says, with the associated challenge of effectively managing income paid out of the corporation and foreign tax credits.
Given Biden’s proposed changes to capital gains taxes and corporate taxes, U.S. citizens in Canada who own businesses are at “significant risk” from the election’s outcome, Altro says.