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 deemed disposition of the shares of Canco at fair market value[1]. This would normally result in a taxable capital gain and a tax liability. This tax would either have to be paid as part of the tax applicable to the final year of residency, or security acceptable to the Canada Revenue Agency (“CRA”) would have to be provided[2].
In addition, the Canadian expat can face a second tax hit when he or she wants to withdraw funds that were part of the value of the shares on departure, so there is a form of double taxation that can often result. Generally, this second Canadian tax hit will be Part XIII tax at a rate of 15% on the resulting actual or deemed dividends[3].
The alternative would be to reduce the value of the Canco shares while still resident by taking a dividend. This eliminates the departure tax; but results in a generally higher level of taxation due to the fact that dividends are taxed at a much higher rate than capital gains.
There is a technique that I often recommend, which I have dubbed the “S Corp. Bailout”. This can lower this second hit to only 5%. Where substantial dollars are involved, this 10% differential can be significant.
This technique would be particularly appropriate where the expat has no continuing need for Canco, and would be happy to wind it up.
Under this technique, the expat would transfer his or her shares in Canco to a U.S. S corporation (SCo)[4] shortly after moving to the U.S. It is assumed that the expat will not elect to defer the payment of any “departure tax” applicable to the gain on the Canco shares[5].
Following that, Canco would be wound-up[6]. Because the shares were transferred to the SCo, the rate of Part XIII tax on the deemed dividend would be reduced to just 5%[7].
Furthermore, for U.S. tax purposes, there should be no material amount of gain on the liquidation of Canco. This is because of the fact that an election can be filed, pursuant to Article XIII(7) of the Treaty, so that the expat, and hence SCo, would have a cost base of the Canco shares equal to the fair market value of such shares immediately before departure.
In the event that the expat does not wish to liquidate Canco, consideration should be given to converting it to an Unlimited Liability Company (“UCC”) governed by one of Alberta, British Columbia, or Nova Scotia. In that way, distributions could be made by Canco to SCo which would not be treated as dividends for U.S. tax purposes.
In this regard, from a Canadian tax perspective, the same results could be obtained by using a U.S. C corporation, rather than SCo. However, it is assumed that, from a US tax perspective, an S Corporation would be a preferable entity in which to maintain the capital received from Canco[8].
[1]Paragraph 128.1(4)(b) of the Income Tax Act (“the Act”)
[2]Subsection 220(4.5) of the Act
[3] Article X(2)(b) of the Canada-U.S. Tax Convention (“the Treaty”)
[4] This could include a U.S. Limited Liability Company (“LLC”) that has elected under the U.S. “check the box” regime to be treated as a corporation, and which has made an S corporation election
[5] It is also assumed that the Canco shares are not “taxable Canadian property”, and, hence, there would not be any compliance issues under section 116 of the Act.
[6] Resulting in a deemed dividend under subsection 84(2) of the Act for any amount distributed beyond the “paid up capital” of the Canco shares.
[7] Article X(2)(a) of the Treaty-based on the long-standing position of the CRA that U.S. S corporations may be viewed as residents of the U.S., for the purposes of the Treaty, even though they are not (normally) “liable to tax” for U.S. federal tax purposes.
[8] Of course, this could all change if there is major corporate tax reform in the U.S.
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