Category Archives: Canada/US tax issues

CANADIANS SHOULD THINK TWICE BEFORE USING U.S. 1031 EXCHANGES

Just about everyone who deals with U.S. real estate investments hears about “1031 exchanges” at one time or another.

For the few who have not, it is, essentially, a mechanism whereby a gain on the sale of real estate may be deferred for tax purposes by acquiring a new property.

Canadians investing in U.S. real estate are often intrigued by this concept. The closest thing we have to it would be “replacement property” rollovers[1]. Although the mechanics of a Canadian “replacement property” rollover are far simpler than a 1031 exchange[2], the circumstances under which they are available are far more limited. In general, a “replacement property” rollover is only available with respect to properties that are used in a (non-rental) business or properties that have been the subject of an “involuntary” type disposition, such as an expropriation. The wider scope of 1031 exchanges makes Canadians quite envious!

Often Canadians facing a big gain on U.S. real estate will structure a 1031 exchange and just assume that the Canadian tax authorities will respect the deferral of the gain, just like the IRS. Not true! Canada will want tax on the gain when the property is sold, since it would be very rare for a U.S. 1031 exchange to qualify as a “replacement property” rollover in Canada.

Furthermore if the gain is ultimately taxed in the U.S. years later when the newly acquired property is sold, it is quite possible that the U.S. taxes payable then will not be fully creditable in Canada because of the fact that the gain for Canadian tax purposes will be much lower than it will be for U.S. tax purposes. Hence, there is potentially an element of double taxation.

In contrast, if the property were sold without the 1031 exchange, it would be quite possible that the U.S. taxes would be a “wash” in Canada because they would be fully creditable against the Canadian taxes. Hence the 1031 exchange would achieve nothing.

An exception might be where the property is held by a Canadian corporation. Because of the fact that capital gains of a corporation are fully taxed in the U.S., the U.S. tax rate could be much higher than the Canadian tax rate and there would be some substantial (net) tax savings achieved from a global perspective. In an extreme case, the U.S. federal tax rate on the gain could be as high as 35%[3], whereas the rate in Canada could be as low as 12.5%[4].  However, one would have to consider what would happen when the new property is sold in the future. The gain for U.S. tax purposes will be higher than for Canadian tax purposes and the potential for foreign tax credit will thereby be reduced. The tax deferral may not be worth the potential for double tax. On the other hand, if corporate tax rates in the U.S. really are substantially reduced in the future, as a result of Trump’s proposals or otherwise, the 1031 exchange could still turn out to be a winning strategy.

What about a situation where the U.S. real estate is held in a controlled U.S. corporation? Here again, I find Canadian shareholders often fail to “look before they leap” and use a 1031 exchange when selling corporate property. If the capital gain resulting from the sale results in “foreign accrual property income” (“FAPI”), the tax deferral in the U.S. will come, to a certain extent, at the expense of higher Canadian taxes at the shareholder level. This is because there will be no “foreign accrual tax” available to offset the inclusion in income of FAPI.

[1] Under section 44 of the Income Tax Act (“the Act”)

[2] In Canada no actual “exchange” is required. There is only a requirement to acquire a replacement within a certain period of time.

[3] Plus, potentially “branch profits tax”, under section 884(a) of the IRC, of 5% of the remaining 65%, bringing total to 38.25%. In addition, state taxes could also apply.

[4] If earned by a corporation that is not a “Canadian-controlled private corporation”.

INTERNATIONAL TAX ASPECTS OF CANADIAN TAX PROPOSALS RE PRIVATE CORPORATIONS

On July 18, 2017, Canada’s Finance Minister Bill Morneau released a document entitled Next Steps in Improving Fairness in the Tax System by Closing Loopholes and Addressing Tax Planning Strategies. This was no surprise-the Minister had hinted at this some months ago at a tax conference. In a nutshell, the Minister, and his many left-leaning… Continue Reading

CANADIANS MOVING TO U.S. WITH CANCOS SHOULD CONSIDER “S CORP. BAILOUT”

Many Canadians who move to the U.S. are the sole shareholders of a Canadian corporation (“Canco”) that is either used for investment purposes, or which has substantial retained earnings generated from an active business. In such cases, they will generally face a Canadian tax hit when they leave (“departure tax”) in the form of a… Continue Reading

TRUMP CORPORATE TAX CUTS COULD TRIGGER CANADIAN TAX ON DIVIDENDS FROM U.S. SUBS

Shhhh! There is a dirty little secret that not many people know or talk about. A large percentage of U.S. subsidiaries (“Usco”) of Canadian companies (“Canco”) are actually resident in Canada based on traditional rules for determination corporate residency that are mainly derived from UK tax cases. This is because their “central management and control”… Continue Reading

TRUMP’S CORPORATE TAX PROPOSAL MAY HAVE FAPI CONSEQUENCES FOR CANADIANS

Donald Trump’s proposal to lower U.S. federal corporate tax rates to 15% will be welcome news for Canadians who are shareholders of a profitable U.S. corporation (“Usco”). However, in certain cases, the Canada Revenue Agency will have its hands outstretched for a piece of the tax savings. In cases where Usco is a “controlled foreign… Continue Reading

CANADIAN CORPORATIONS DOING BUSINESS IN U.S. VIA LLCs FACE BIG TAX PENALTY!

A Canadian corporation (“Canco”) which earns profits from carrying on business in the U.S. through a “permanent establishment” (“PE”) there will generally be subject to US federal taxes on its income derived from that PE. In addition to the normal federal income taxes on that income, as well as possibly state taxes, there is the… Continue Reading

CANADIANS CAN DEDUCT US TAX PAID RE LLCs EVEN IF NO INCOME REPORTED

As a general rule, a Canadian resident can claim of credit against his/her/its Canadian income tax liability for foreign income taxes paid (“foreign tax credit”-“FTC”). The rules relating to claiming FTCs are generally found in section 126 of the Income Tax Act (“the Act”). Unless the foreign tax is related to a business carried on… Continue Reading

CANADIANS WITH FOREIGN REAL ESTATE CORPORATIONS CAN FACE SURPRISING FAPI ISSUES

A Canadian resident who is a shareholder of a “controlled foreign affiliate” (“CFA”) will have special Canadian tax issues if that CFA earns “foreign accrual property income” (“FAPI”). Any corporation that is not resident in Canada (“Forco”) will be a CFA of a particular Canadian resident if it is controlled by that Canadian resident.  However,… Continue Reading

U.S. RESIDENTS PROVIDING SERVICES IN CANADA CAN HAVE A DEEMED PE

As a general rule, a U.S. resident carrying on business in Canada will be exempt from Canadian income tax on any profits from that business unless there is a “permanent establishment” (“PE”) in Canada. This is provided in Article VII(1) of the Canada-U.S. Tax Convention (“the Treaty”). There are exceptions to this general rule. The… Continue Reading

CANADIAN TAXATION OF DEATH BENEFITS FROM A U.S. IRA

A Canadian resident would not normally expect to pay any Canadian income tax on an inheritance received from a family member living in the U.S. However, that is exactly what can happen if a Canadian resident receives a payment as a beneficiary of a (conventional) Individual Retirement Account (“IRA”). That is because of the fact… Continue Reading