U.S. Estate Tax Developments For Canadians
Canada ended its estate tax system decades ago, and replaced it with the provincial probate system plus income taxation on the deceased’s final tax return. The probate fee is positioned largely as an administrative fee of the government to facilitate the transfer of deceaseds’ assets to their heirs. In BC, the fee essentially is 1.4% of the net asset value—a small number percentage-wise, but of course on a large estate, it can result in a big cheque being written to the government. The U.S., on the other hand, has retained an estate tax system, and it has provided a lot of political drama in Washington in the past few years.
Non-American citizens around the world may find themselves subject to U.S. income tax if they own American “things.” For instance, a Canadian will pay U.S. income tax on dividends from US stocks and also on rental profit and capital gains on U.S. situs real estate. These are common hold-ings for Canadians. Now these U.S. assets also may attract US Estate tax for Canadians.
The list of US situs assets include:
- Canadian mutual funds, whether structured as trusts or corporations
- Canadian ETFs
- Canadian index-linked notes
- American Depositary Receipts (stocks of non-U.S. companies listed in the U.S.)
- U.S. bank accounts
- U.S. treasury Bills
- U.S. government and corporate bonds which are exempt from U.S. with-holding tax under the bi-lateral treaty
- U.S. denominated Canadian bonds
The list of U.S. “flavoured” assets NOT caught in the U.S. Estate tax include:
· Shares of publicly traded U.S. corporations and U.S. listed ETFs held in :
- Non-sheltered trading accounts, whether inside or outside Canada
- Canadian sheltered accounts, ie RRSPs, RRIFs, TFSAs, RESPs and RDSPs
- Canadian alter-ego or joint partner trusts
- U.S. situs real estate
- Tangible property, like vehicles, art, boats
- Assets of a business conducted in the U.S.
- Shares of a U.S. private corporation
- U.S. retirement plans, eg Roth and IRA
The U.S. Estate tax is applied upon the request to transfer the title of U.S. situs assets from the deceased to the beneficiaries.
Determining one’s exposure to U.S. Estate tax has several parts:
1. Do I own any of the above listed items? If yes….
2. Will the fair market value of those items at death exceed $60,000 USD? If yes,….
3. Will the fair market value of all of my world-wide assets at death exceed a sum (currently $5.34M USD in 2014, and indexed over time)? If yes….
You indeed may have exposure to U.S. Estate tax if you own the US situs assets listed above.
4. The next step is to apply the USD market value of those assets at the date-of-death to a graduated estate tax rate table, with rates. starting at 18% and rising to 40% (!) for amounts over $1M.
5. There are a few deductions allowed against this U.S. Estate tax otherwise owing, including funeral expenses and estate administration costs and debts owing on U.S. real property (the last, either in whole or in part, depending upon the details of the asset security related thereto).
6. This amount is then mitigated by a “unified” tax credit provided under the Canada/U.S. Tax treaty, and prorated for the proportion of U.S. situs assets to total world-wide assets. The cred-it is large ($2,081,800 USD in 2014 and indexed annually).
7. The unified tax credit is doubled if there is a surviving spouse who is not a U.S. citizen. Note, however, that U.S. Estate tax law does not recognize common law or same-sex relationships for this extra credit.
8. Finally, you have arrived at your U.S. estate tax liability. However, some of this U.S. tax may be claimable as a foreign tax credit against the Canadian death taxes. There may be a catch to this though: for the U.S. estate tax to be recovered as a foreign tax credit, there must be some Canadian income tax owing on death specifically related to those same U.S. situs assets. There would be no foreign tax credit relief if those U.S. situs assets had not appreciated over time to cause a deemed capital gain at death in Canada, or if a surviving spouse acquired those assets on a tax-free deferred basis, which is very common.
If your estate gets past the second test above, then your executor must file a U.S. estate return, even if your estate fails the third test. This means that a return would need to be filed even though no U.S. estate tax is owing. U.S. filing deadlines are inconsistent with estate filing deadlines in Canada. The U.S. deadline is 9 months after death. Contrary to our system in Canada, the IRS typically grants deadline extension; however, any tax ultimately owing is still due at the nine month date!
Some fine points:
1. Joint tenancy assets are included at 100% with the deceased’s U.S. situs and world-wide assets, unless it can be proven that the other joint tenant contributed proportionately to the capital that acquired that asset. Domestically here in Canada, it is a very common estate planning strategy to add future beneficiaries (whether they be a spouse or adult child) inter-vivos into joint tenancy with assets of another party. In these cases, “proof of contributed capital” likely would fail.
2. Most life insurance policy death payouts must be included in world-wide assets.
Complicated…huh? On our website we have created a MindMap schematic diagram to make it easier to visualize.
Strategies to avoid or mitigate U.S. Estate tax exposure:
1. Stay under the limits, by fact and/or by strategy.
2. Own U.S. situs investments through Canadian intermediaries, eg Canadian mutual funds/ETFs, Canadian index-linked notes or ADRs (shares in non Canadian, non U.S. companies held through the NYSE).
3. Revisit your Canadian estate planning strategies re joint tenancies, designated beneficiaries for sheltered accounts and will provisioning.
4. Execute intervivos or death-bed gifting of U.S. situs assets to survivors. This would trigger gains taxation in that year, causing a cash outgo.
5. Digress from the normal strategy of passing non-sheltered assets tax-deferred upon death to a surviving spouse. Rather, deliberately cause some deemed capital gains in Canada on U.S. situs assets on the date-of-death return which will cause Canadian tax liability that will offset the U.S. Estate tax as a foreign tax credit.
6. Similarly to above, strategically elect to digress from the norm of rolling your RRSP/RRIF/TFSA on death to your spouse on a tax-deferred basis. Instead, deliberately cause some deemed capital gains on U.S. situs assets on the date-of-death return which will cause Canadian tax liability that will offset the U.S. Estate tax as a foreign tax credit. Note that this requires the sheltered account to pass to the survivor through a will, not directly as a “successor annuitant.” (This likely would require amendment to the elections on your sheltered accounts at your finan-cial institution). Note further the downstream implications of this strategy—the income from these assets now will become taxable annually to the successor, as they are no longer within a tax-sheltered account.
7. It is a very common estate planning strategy in Canada to place financial assets in joint tenancy in order to avoid the provincial probate fee upon death. If the joint tenants each have legitimate capital interests in the assets, it may be wiser to undo the joint tenancy and separate the assets into two individual accounts. This may, firstly, avoid the issue of falling into the U.S. Estate tax net or, secondly, of having to prove to the IRS that part of the account should not form part of the deceased’s asset reporting to the IRS.
8. Avoid owning U.S. situs real estate in joint tenancy. The long term result likely will be double U.S. estate taxation on half of the property value upon the death of the surviving spouse.
9. For U.S. situs stock holdings in non-sheltered accounts, consider transferring these assets to a Canadian corporation, which is outside the U.S. Estate tax law. This strategy solves one problem and creates several others. First, there is the cost of creating and maintaining a corporation. Second, to avoid deemed capital gains upon transferring the U.S. stocks, a formal rollover will need to be executed, which also costs professional fees. Third, Canadian tax complexity awaits upon death, when strategies will be needed to avoid Canadian double taxation.
The following chart may help you understand this complex matter … follow from left to right. (Click to enlarge to full-size)
It seems outrageous that U.S. Estate tax law can spread its tentacles out across the globe, most notably to include foreigners’ holdings of US public companies. Presumably, the U.S. stock exchanges, and the companies listed therein, benefit from the broader market made with more buyers and sellers participating from around the world. Effectively, this is a significant tax imposed by the U.S. for being the centre of the world’s capitalist system.
It fundamentally complicates foreigners’ domestic management of their estate planning and causes contradictory strategies between the domestic laws of the home country vis-à-vis these U.S. considerations. Canadian financial institutions are wringing their hands with glee, as one of the strategies is to re-organize one’s U.S. stock holdings through Canadian situs mutual funds or ETFs. This brings the trading of these vehicles back to the TSE instead of the NYSE, and allows the creating institutions to build a fee spread into the management of these new vehicles.
Trivest is working along with Nilson & Company to build a model and a program to look at this issue for clients. Be sure to pay attention to this in your estate planning! And…write your MP!