How U.S. Tax Reform Affects Canadians by Jeffrey M. Mutnik, CPA/PFS and James W. Spencer, CPA
Posted on April 06, 2018 by Jeffrey Mutnik
The Tax Cuts and Jobs Act (TCJA) that reforms the U.S. Tax Code will have a significant impact on Canadians with businesses, investments, and residency in the United States beginning in the 2018 tax year. With these policy changes come a new way of thinking and a call for affected individuals and businesses to plan appropriately in an effort to minimize their tax liabilities going forward.
First, it is important to understand how the U.S. imposes tax on foreign individuals, regardless of their immigration status.
In most cases, the U.S. presumes foreign citizens to be nonresident aliens (NRAs), who are required to pay U.S. income taxes only on earnings that come from U.S. sources. Once foreign citizens apply for a green card or exceed the requisite days considered to have a substantial physical presence in the U.S., they will be considered resident aliens (RAs), who, like U.S. citizens, are required to report and pay taxes on their worldwide income. Conversely, foreign individuals’ exposure to the U.S. gift and estate taxes depends upon their domicile, or physical presence and intent to stay in the U.S. for an indefinite period.
Enhanced Estate Tax Unified Credit and Marital Deduction
The TCJA doubles the amount that U.S. taxpayers may exclude from gift and estate taxes, from US$5.49 million in 2017 to US$11.18 million in 2018 and through 2025. Therefore, Canadian domiciliaries who own U.S. situs assets (assets legally located in the U.S.), such as U.S. real property or shares in U.S. corporations, can now claim a larger pro-rated unified tax credit against U.S. estate tax. This combined with a larger marital deduction for the estates of married Canadian domiciliaries who own U.S. situs assets can result in an estate being subject to zero U.S. estate tax when the worldwide estate is no more than US$ 22.36 million. Previously, the threshold was US$ 10.98 million.
Reduced Individual Income Tax Rates for Nonresident Aliens
The TCJA reduces the top income tax rate on ordinary income from 39.6 percent in 2017 to 37 percent in 2018. These lower rates apply to nonresident aliens, such as Canadians who are neither U.S. citizens nor green card holders and who do not spend excessive days in the U.S. during a calendar year. For U.S. citizens and resident aliens, such as Canadians who are dual citizens or green card holders, the TCJA decreases the top tax rate on ordinary income (which includes the Net Investment Income Tax of 3.8 percent) from 43.4 percent to 40.8 percent. The long-term capital gains tax rate of 23.8 percent has not changed.
The TCJA eliminates the use of personal exemptions that U.S. citizens, RAs and NRAs could previously claim for themselves, their spouses or their dependents. However, the law nearly doubles the standard deduction that taxpayers may claim to reduce their taxable income from US$6,500 for individuals (US$13,000 for married couples) to US$12,000 (US$24,000 for married couples) starting in 2018.
Home Mortgage Interest
The TCJA limits the deduction that Canadians who are U.S. tax residents and have a principal residence located in the U.S. may claim for the interest paid on their home mortgage from US$1 million in 2017 to US$ 750,000 in 2018. This limit applies only to mortgage loans entered into after December 15, 2017; interest on loans that were entered into before this date can continue to be deductible up to the US$1 million limit.
In addition, the law puts a US$10,000 limit on the amount that Canadians and U.S. taxpayers may deduct for property taxes on their U.S. homes along with other deductible taxes (such as state income taxes and state sales tax).
Under the TCJA, Canadians who move to the U.S. beginning in 2018 will no longer be able to claim a deduction for any of their moving expenses, including the costs they incur to transport their belongings.
U.S. Real Estate Investment
Canadians who earn profits from renting U.S. real estate may be able to claim a deduction as high as 20 percent of their rental profits when they are organized as pass-through entities, such as partnerships, LLCs, S corporations and sole proprietorships, and their adjusted gross income (AGI) is below US$ 157,500 (US$ 315,000 for married couples). This would essentially reduce the highest tax rate for qualifying taxpayers from 37 percent to 29.6 percent. If AGI is above these limits, taxpayers may be able to claim a deduction up to the sum of 25 percent of paid W-2 wages plus 2.5 percent of their unadjusted investment basis in qualifying property, which includes tangible property subject to depreciation, held by a qualified trade or business, and used in the production of qualified business income.
Upon selling U.S. property after a holding period of more than one year, the highest tax rate that would apply to the gain from the sale would be the maximum long-term capital gains tax rate of 20 percent plus the Net Investment Income Tax of 3.8 percent.
Two additional tax benefits for real estate investors survived the negotiations of the new law, including the tax-deferred treatment of Section 1031 exchanges of like-kind real property that meet the requisite holding period restrictions. The law also preserves the preferential 20 percent long-term tax capital gains treatment of carried interest, or management fees and other forms of compensation paid to partners, managers and developers for a share of a business or project’s future profits, but limits it to apply solely to assets held for more than three years or sold after three years.
In addition, the TCJA calls for qualifying tangible property, including used property, acquired and put into service after Sept. 27, 2017, and before Jan. 1, 2023, to receive 100 percent bonus depreciation in the year of purchase. Without the new law, bonus depreciation would have been limited to 40 percent in 2018 and 30 percent in 2019.
Ownership of U.S. Corporations
With the passage of the TCJA, Canadian individuals and businesses that own shares in U.S. corporations will enjoy more after-tax profits, which may translate to higher dividends from those corporations. This is due to the law’s reduction of the corporate tax rate from 35 percent to 21 percent. When including state taxes, the rate drops from approximately 38 percent to approximately 25 percent.
However, to the extent that such U.S. corporations generate Net Operating Losses (NOLs) in years after 2017, those loss carryforwards will only be available to offset 80 percent of future corporate taxable income. This means that U.S. corporations will always pay U.S. tax on at least 20 percent of their taxable income, despite the magnitude of their post-2017 NOL carryforwards. Pre-2018 NOLs are not subject to this limitation.
Business Interest Deductions
Under the new tax law, corporations and other businesses will generally be able to deduct business interest expense up to a limit of 30 percent of EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) for years 2018 through 2021. In 2022, the deduction will be limited to 30 percent of EBIT (Earnings before Interest and Taxes).
Controlled Foreign Corporations (CFCs)
For many years, the U.S. has had a CFC Regime somewhat similar to the Canadian Controlled Foreign Affiliate (CFA) Regime, and the U.S.’s Subpart F rules have been somewhat similar to Canada’s Foreign Accrual Property Income (FAPI) rules. However, up until 2018, the U.S. has not had anything remotely similar to Canada’s Exempt Surplus Regime. With the passage of the TCJA, U.S. corporations (but not individuals) that own CFCs will be able to claim a Participation Exemption for dividends from those CFCs up to a certain level. The Participation Exemption Regime may be equated somewhat to Canada’s Exempt Surplus Regime.
However, in order to transition to the Participation Exemption Regime, U.S. corporations and individuals (including Canadians who are also U.S. citizens or U.S. RAs) that have direct or indirect ownership in CFCs will have to pay a one-time toll charge tax on all of the earnings they have accumulated from 1987 until 2017 (Pre-1987 Earnings are not subject to the tax).
To ease the burden of this one-time toll-charge tax, the U.S. provides affected taxpayers with two benefits:
(1) pay a favorable tax rate of between 17.5 percent and 8 percent depending on (a) the type of taxpayer and (b) how much of the CFC’s earnings have been reinvested in liquid vs. non-liquid assets, and
(2) the ability to elect to spread the payment of the one-time tax over an eight-year period with no interest charges on the deferred tax liability.
The first installment of the tax payments, which is due on or before April 17, 2018, is equal to 8 percent of the toll charge. Once taxpayers make the election and pay the first installment, they may take all of the pre-2018 earnings out of the CFC in the form of dividends, even though much of the payment of the toll charge tax has been deferred to subsequent years.
Canadian individuals who are also U.S. citizens or U.S. Resident Aliens may want to consider transferring their CFCs to a U.S. corporation to take advantage of the participation exemption for a certain amount of dividends received from the CFC as well as a 50 percent deduction for profits attributed to Global Low Taxed Income. However, this strategy should not be employed without consulting with a U.S. International Tax advisor.
About the Authors: Jeffrey M. Mutnik, CPA/PFS, is a director of Taxation and Financial Services with Berkowitz Pollack Brant Advisors and Accountants, where he provides tax- and estate-planning counsel to high-net-worth families, closely held businesses and professional services firms. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at email@example.com. James W. Spencer, CPA, is a director of International Tax Services with Berkowitz Pollack Brant, where he focuses on a wide range of pre-immigration, IC-DISC, transfer pricing and international tax consulting issues for individuals and businesses. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at firstname.lastname@example.org.