The Tax Times: TCJA'S IRC §965 - Transition Tax Results in Double Tax in Canada (& Other Countries)

According to Moodys Gartner, the transition tax on businesses, introduced by the US Tax Cuts and Jobs Act 2017, may cause some Canadian-resident US individuals with a substantial unexpected US tax liability. They will have to pay the tax without being able to claim it as a tax credit against their Canadian income, unless the Ottawa government decides to allow them relief from this double taxation.

Generally, under the TCJA every US citizen individual who controls “a non-US corporation (or who owns an interest in a non-US corporation controlled by US persons) has to pay a one-time tax on the retained earnings of those corporations either as a lump-sum or in installments spread out over eight years. This one-time tax is commonly referred to as the Transition Tax, and it can leave those affected Canadian residents with a substantial (and unexpected) US tax liability.

The Transition Tax generally works as follows: US citizens and US businesses that own a controlling interest in a foreign corporation,,such as Canadian corporations, are deemed to receive a dividend equal to the corporation’s retained earnings. These shareholders are subject to US tax on the deemed dividends at two different rates – the retained earnings of the corporation reflected by cash assets are subject to a 15.5% effective rate and non-cash assets at an 8% effective rate. When the retained earnings are distributed to the shareholder in the future as a dividend they are not taxed again by the US, though they are subject to tax in Canada.

To illustrate the application of the Transition Tax, assume that Ms. A is a US citizen and resident of Canada. She owns 100% of the shares of CanadaCo and thus controls CanadaCo. The only assets of CanadaCo throughout 2017 was cash of US$1m. Ms. A will be deemed to have received a dividend of the US$1m and therefore will subject to a Transition Tax liability in the US of $155,000. Ms. Acan choose to pay the resulting tax liability over 8 years or pay it in a lump sum.

In most cases, the Transition Tax will not be available as a tax credit in Canada for two reasons:

The Transition Tax applies to the shareholder even if the Canadian corporation has not actually declared a dividend meaning that there is no “source” of income against which to credit the Transition Tax.
Under Canadian law, dividends received by a shareholder from a Canadian corporation are classified as Canadian source income and therefore the resulting Canadian tax liability is not eligible to be credited for the US tax paid. The general Canadian principle is that US taxes will be creditable only if the income received is US sourced.

At the 2018 Society of Trust and Estate Practitioners (STEP) conference held in Toronto, the Canada Revenue Agency (CRA) confirmed that a Canadian resident shareholder’s Canadian tax liability would not be eligible for a credit to offset the Transition Tax paid (see question #12 of the CRA Roundtable Questions & Answers here). Accordingly, this can lead to double taxation for these unfortunate Canadian residents.

The allowance of a domestic tax credit for foreign tax paid on domestic income is specifically found in the Article XXIV of the Canadian/US Tax Treaty which provides relief by deeming the source of some types of income to be foreign, thereby enabling the use of FTCs to offset the Canadian or US. tax otherwise payable.

Another possible solution would have been for CanadaCo to pay out an immediate dividend of the same amount in 2017, as the income would be included on the personal returns in both countries in 2017.

This Law May Have Unintentionally Created an Incredible Burden for Tens of Thousands of US Owned Small Businesses in Canada.

This problem may also be faced by US citizens living in other countries besides Canada, since most other industrialized countries will not consider this transition tax nor other types of accrued Subpart F income, as taxable in their country:

The 965 deemed distribution is taxable in the U.S. in 2017, but there is no taxable event in the country of residence and therefore no tax paid in the country of “tax residence”.
There is no credit allowed for the U.S. tax paid on the individual’s 2017 foreign tax return where he/she actually lives.
When the amount of the 2017 IRC §965 inclusion is later distributed to the US shareholder, that distribution is taxed in the foreign jurisdiction a second time.
Therefore, unless the US/Country of Residents tax treaty provides a solution, the §965 inclusion amount will be taxed twice, first by the United States in 2017 and then by the country of residence upon distribution in years after 2017.