Many high-net-worth Canadians have a significant portion of their net worth tied up in Canadian corporations due to the tax deferral and other benefits these structures provide. Additionally, many of these families have beneficiaries who are US taxpayers (either US citizens resident in Canada or US residents). This situation—lots of value in a corporate structure; US beneficiaries—gives rise to potential US estate tax and US income tax issues. The estate tax issues are the easy ones as it applies to cross-border estate planning, and Canadian tax and estate planners are typically well-informed of the planning options (e.g., sheltering the inheritance of US resident beneficiaries from the US estate tax at their deaths through the use of dynasty trusts). However, the income tax issues appear to be poorly understood. This article explores how to address the US income tax issues that can arise, which are often easily solved with steps taken pre-death, but vexing post-death.
To start out, it is worth a brief refresh on the standard Canadian post-mortem planning. At the second spouse to die, there will be a capital gain on the shares of the Canadian corporate interests. This presents an inherent double (or triple) tax exposure since that capital gains tax payable at death does not reduce the tax that is owed when the corporate surplus is withdrawn from the corporation, nor does it reduce the capital gains tax that the corporation would owe when it disposes of its assets. To rectify this, Canadian tax law specifically permits different types of corporate re-organizations such as the loss carryback, the pipeline, bump planning, or a combination of the three. Such techniques are fairly standard, if not always straightforward.
The complexity of these post-mortem plans is magnified when there is a US beneficiary in the mix. The US federal tax system has a complex series of income tax rules that apply when a US taxpayer has an interest in a foreign corporation, even if that interest is indirectly held through a foreign trust or estate. These are intended as “anti-deferral” rules and were designed to apply to US multinationals such as Apple and Exxon. Their application in this context is strange from a policy perspective, but unambiguous from a technical perspective.
These rules fall into two broad categories. The controlled foreign corporation (“CFC”) rules can apply when a more than a majority (by vote or value) of the foreign corporation is owned by US taxpayers. Second, the passive foreign investment company (“PFIC”) rules can apply where the foreign corporation is not a CFC and has passive income or assets that exceed certain thresholds. The nuances of the PFIC and CFC rules fill pages of statutes, regulations and case law. Without engaging with all that detail, three key points stand out. First, both rule sets look through any and all foreign intermediary entities such as trusts or estates and connect the US taxpayers directly with the corporations immediately upon the Canadian parent’s death. Second, both rule sets can create US tax even without an income distribution by taxing the US beneficiary personally on corporate income. Third, both rule sets are punitive in nature, and their application is based on the substance of the arrangement, not the form of the estate planning documents.
How the CFC and PFIC rules interact with standard Canadian post-mortem planning will differ in each situation. What starts as a fairly standard domestic Canadian re-organization becomes mired in cross-border complexity.
A recent court case filed in Ontario Superior Court illustrates the above issues. The deceased was a high-net-worth Canadian owning two Canadian corporations with considerable asset appreciation. Two thirds of his beneficiaries were US residents. The standard US estate tax protections were put in place. A standard Canadian post-mortem plan was executed, and the US beneficiaries owed close to USD $3 million of US income tax on top of the Canadian tax paid by the estate and the companies. Had some simple planning been done before death, the US tax owing would be zero.
Frequently, these issues can be solved or at least mitigated by converting the Canadian companies to unlimited liability companies (“ULCs”) prior to the death of the Canadian parents. A ULC is a type of Canadian corporation that is not a corporation in the US income tax system. As such, the PFIC and CFC rules simply do not apply. The conversion to a ULC is a non-event in Canada, but it bumps the cost basis in both the ULC interests and the underlying assets for US purposes. ULC planning must be carefully integrated with the US estate tax planning, however, as a ULC no longer serves as a corporate blocker for any US-situs assets it may hold.
In sum, the key issue for US beneficiaries of high-net-worth Canadian estates is not protecting the kids from the US estate tax. That is easily identified and solved for and only really applies at the death of the beneficiaries so is not a top-of-mind concern. The income tax issues, on the other hand, apply immediately and are often a nasty surprise—but one that can often be avoided with a simple pre-death ULC conversion.