Phillips Nizer LLP Articles
Article-Taxation of Bequests and Lifetime Gifts Made by Individuals with Ties to the United States and Canada (with Reference to the 1995 Protocol to the United States-Canada Income Tax Convention) (March 2005)
Introduction.
The distinctive challenges associated with the taxation of bequests and lifetime gifts made by individuals with ties to both the United States and Canada arise from the fact that the United States has an estate tax and a gift tax and Canada has neither form of tax. Instead, Canada imposes an income tax on Canadian residents (and others owning certain property located in Canada) on fifty percent (50%) of the appreciation on all property either owned at death or given away during lifetime. While the Convention Between the United States of America and Canada With Respect to Taxes on Income and Capital, signed September 26, 1980 and entered into force on August 16, 1984 (the "Treaty") and the 1995 (Third) Protocol to the Treaty (the "Protocol") smooth out many of the wrinkles created by these two different regimes of taxation, taxpayers can still benefit from planning in order to minimize tax.
This paper is intended to provide an overview of the tax issues faced by individuals with connections to both the United States and Canada when they give property away either during lifetime or at death. While this paper addresses certain income tax issues as they relate to gifts and bequests of property, it is not intended as a general overview of income tax issues faced by individuals with connections to both the United States and Canada.
Part I of this paper discusses the U.S. estate tax system as it applies to citizens and residents of the United States and also to individuals who are not citizens or residents of the United States. Part II discusses the Canadian system of taxing property on the death of a Canadian resident and certain non-residents of Canada. Most of the remainder of this paper identifies tax issues facing the four major classifications of individuals with ties to both the United States and Canada. Part III discusses the tax treatment of citizens or residents of the United States who die owning real property or other property classified as "Canadian Property" under the Canadian tax laws. Part IV discusses the tax treatment of United States citizens who die resident in Canada. Part V discusses the tax treatment of Canadian residents that are not citizens of the United States who die owning certain United States property. Part VI discusses the tax treatment of Canadian citizens who die resident in the United States. Part VII discusses the tax treatment of gifts of certain United States property made by Canadian residents and gifts of certain Canadian property made by citizens and residents of the United States. Part VIII discusses benefits of the Treaty as they relate to charitable gifts and bequests.
I. Overview of the United States Federal Estate, Gift and Capital Gains Taxes.
The United States imposes estate and gift taxes on the "gratuitous" transfer of property.[1] The gift tax is imposed on such transfers made during lifetime and the estate tax is imposed on transfers made at death. The estate and gift taxes are generally based on the fair market value of the property transferred at the time of transfer, whether during lifetime or at death, and the greater the amount of property transferred the higher the marginal tax rate.
The tax rates applicable to transfers of property, whether during lifetime or upon death, are currently between 18% and 48%, depending on the size of the estate. The top marginal estate and gift tax rate (on cumulative transfers exceeding $2 million) is scheduled to decrease by 1% per year until it reaches 45% in 2007. [2]
The estate tax differs from an inheritance tax, which is popular in many countries. In an inheritance tax the tax rate is based on the family relationship between the transferor and the transferee of the property rather than on the basis of a uniform rate schedule.
The mechanical computation of estate tax in the United States adds up the value of all property that the decedent owned (and certain other property) at the time of his death. This amount is known as the "gross estate". The gross estate is reduced by certain allowable deductions and then a taxable amount is calculated based on the tax rate. Various credits (including the so-called "unified credit", a credit for state death taxes, a credit for tax on prior transfers, and a credit for foreign death taxes paid) then reduce the tentative tax to arrive at a net tax that is due.
One deduction that reduces the "gross estate" is the marital deduction, which allows decedents to pass an unlimited amount of property to a spouse that is a citizen of the United States without incurring estate tax on the property transferred to the surviving spouse. Decedents can only pass property to a surviving spouse who is not a citizen of the United States without incurring estate tax if the property passes to a special trust called a qualified domestic trust or "QDOT" for the benefit of the surviving non-United States citizen spouse.
Other deductions against the estate tax are also permitted for certain expenses such as funeral expenses, administration expenses, claims against the estate, and debts of the decedent. A deduction is also allowed for bequests to a wide variety of charitable organizations, including non-U.S. charitable entities. [3]
If an individual is a citizen of the United States or a resident of the United States for purposes of the estate tax or the gift tax (such person being referred to as a "U.S. Taxpayer") he or she is subject to estate tax on his or her worldwide assets and gift tax on gifts of any of his or her worldwide assets, as the case may be. Subject to the provisions of an applicable treaty, if an individual is not a citizen of the United States and is not a resident of the United States for purposes of the estate tax and the gift tax (such person being referred to as a "non-U.S. Taxpayer") he or she is subject to estate tax only on the transfer of certain property that is located or deemed to be located in the United States called "U.S. situs property," and he or she is subject to gift tax only on the transfer of real property and tangible property that is located in the United States.
The concept of residence for U.S. federal estate and gift tax purposes is different from the concept of residence for U.S. income tax purposes.[4] Thus, it is possible to be treated as a resident of the United States for income tax purposes but not to be treated as a resident of the United States for estate and gift tax purposes. Residence for purposes of the estate and gift tax is defined as a person who is domiciled in the United States. A person acquires domicile by living in a place, even for a brief period, with no present intention of moving away. Residence alone, without the intent to remain, does not constitute domicile. Residence for estate and gift tax purposes is based on the facts and circumstances of a particular case. However, certain facts and circumstances are often determinative. For example, possession of a green card (permanent resident of the United States) is highly indicative of United States residence for purposes of the estate tax. Some other factors considered when making a determination of residence for U.S. federal estate and gift tax purposes are (i) duration of stay in the United States, (ii) size, cost and nature of decedent's homes and whether owned or rented, (iii) location of expensive and cherished personal possessions, (iv) location of decedent's family and close friends, (v) places where decedent maintained church and club memberships and participated in community affairs, (vi) location of business interests, (vii) declaration of residence made on visa applications, wills, and other documents, and (viii) visa status.
With respect to the estate tax, the major difference between U.S. Taxpayers and non-U.S. Taxpayers is the determination of the property that is included in the calculation of the tax base or "gross estate". Under the U.S. federal estate tax, a U.S. Taxpayer's worldwide assets are included in that person's "gross estate", while only the U.S. situs property of a non-U.S. Taxpayer is included in that person's "gross estate". Similarly, under the U.S. federal gift tax, gifts of any of a U.S. Taxpayer's worldwide assets are subject to gift tax in the United States while only gifts of real property and tangible property located in the United States by non-U.S. Taxpayers are subject to gift tax in the United States. However, tax treaties often effectively change the types of property that will be subject to estate and gift taxes in the United States.
Another important distinction between a U.S. Taxpayer and non-U.S. Taxpayer is that the total credits available to non-U.S. Taxpayers are much less that the total credits available to U.S. Taxpayers. For example, a very significant credit, sometimes referred to as the unified credit, currently allows U.S. Taxpayers to pass up to $1,500,000 free of estate tax.[5] Absent treaty relief, non-U.S. Taxpayers are entitled to a credit against estate tax in lieu of the unified credit that allows them to transfer only $60,000 worth of U.S. situs property free of estate tax. In addition, absent treaty relief, a non-U.S. Taxpayer does not receive a foreign death tax credit in the United States. In addition, while U.S. Taxpayers have a credit that allows them to pass up to $1,000,000 free of gift tax during their lifetimes non-U.S. Taxpayers have no similar credit against U.S. gift taxes.
The following assets are considered U.S. situs property, and are included in the gross estate of non-U.S. Taxpayers for U.S. federal estate tax purposes:
• Real property located in the United States;
• Tangible personal property located in the United States;
• Shares of stock in United States corporations, including residential cooperative
corporations;
• Mutual funds organized in corporate form in the United States;
• Cash deposits with United States brokers, money market accounts with United States
mutual funds, cash in United States safety deposit boxes;
• Debts of United States obligors other than bonds issued after July 18, 1984; and
• Cash value of life insurance owned by a non-United States person on the life of another if
the policy was issued by a United States life insurance company.
It is unclear whether interests in United States partnerships are U.S. situs property.
In reviewing these items of U.S. situs property, it is at least as important to be aware of the property that is not considered U.S. situs property. If U.S. situs property is owned by a non-United States corporation the United States Internal Revenue Service has a policy of not looking through the non-United States corporation to make a determination that the corporation is U.S. situs property as long as the corporation is not a sham and the property rights of the shareholders and the corporation are respected. The act of acquiring U.S. situs property through a non-United States corporation effectively converts U.S. situs property into non-U.S. situs property for purposes of the estate tax. Similarly, acquiring real property or tangible property located in the United States through a non-United States corporation effectively converts this property into intangible property for purposes of the gift tax. This provides a significant planning technique to non-U.S. Taxpayers for estate and gift tax purposes because it effectively removes these assets from the United States tax base.
Life insurance proceeds paid by a United States insurer on the life of an individual who is neither a resident nor a citizen of the United States is not U.S. situs property. Bank accounts, checking accounts, savings accounts, time deposits and certificates of deposit maintained with United States banks are treated as if they are not located in the United States and are therefore for tax purposes not U.S. situs property and are exempt from U.S. federal estate tax.
For U.S. federal gift tax purposes U.S. situs property consists of only real property located in the United States and tangible property located in the United States.
The U.S. federal income tax does not impose tax liability on the deemed disposition of assets upon death or when a gift is made. However, the United States taxes citizens and residents for income tax purposes on the sale of capital assets on the difference between the amount realized (i.e., sales proceeds) from the asset and the asset's adjusted basis (i.e., adjusted cost – generally increased for capital improvements and decreased for depreciation). The tax rates applicable to capital gains depend upon how long the asset was held. Capital gains attributable to sale of assets held for less than one year are treated as "ordinary income" and are taxed at the same rate as the seller's other income. Capital gains attributable to sale of assets held for more than a year are taxed at a 15% rate (5% for individuals in the 10% and 15% income tax brackets decreasing to 0% after 2007).
Individuals who acquire an asset from a decedent (either by bequest, devise, inheritance or some other statutorily permitted ways) are generally entitled to increase the basis of such asset to the asset's fair market value on the date of the decedent's death.[6] As a result, all of the pre-death appreciation on an asset received from a decedent is never taxed by the income tax system.[7] Although the tax rates on capital gains are generally much less than the tax rates on ordinary income, the step-up in basis at death still provides significant income tax savings to persons who inherit property.
II. Overview of Canadian Taxation on Death.
Effective at the end of 1971 Canada abolished its federal estate and gift taxes and replaced them with a system of taxation of capital gains, including a tax on deemed dispositions at fair market value on certain events such as death, making a gift or becoming a nonresident of Canada. Fifty percent (50%) of all of capital gains (net of capital losses) incurred on these deemed dispositions are included in the income of a decedent in the year of death and in the income of a donor in the year the gift is made, as the case may be. In 2004 Canadian income tax rates applicable to individuals are between 16%, for the first $35,000 of income, and 29%, on income above $113,804.
In most circumstances the Canadian income tax system taxes "residents" of Canada. The Canadian system of taxing income based on residence is quite different from the income tax system of the United States, which taxes both residents of the United States and citizens of the United States, regardless of where they reside.
Canadian law provides that an individual will be treated as a resident of Canada for income tax purposes if he or she is physically present in Canada for 183 days or more in a calendar year or if he or she is "ordinarily resident" in Canada, which could occur if a person with a habitual abode in Canada is not physically present in Canada at any time during a calendar year. For Canadian tax law purposes, residence is a question of fact, based on various factors, some of which may be (i) having a dwelling place suitable for year round occupation available to him or her, (ii) whether his and her spouse and dependants live in Canada, and (iii) where his or her personal property is located.
In addition, U.S. Taxpayers who are not Canadian residents are also subject to Canadian income tax on sales and deemed dispositions of certain types of "taxable Canadian property," such as real property located in Canada, shares of Canadian companies deriving their principal value from real property located in Canada, an interest in a partnership, trust or estate, the value of which is derived principally from real property situated in Canada, and personal property forming part of the business property of a permanent establishment resident in Canada (each of which is hereinafter referred to as "Canadian Property Taxable to U.S. Persons"). Other types of taxable Canadian property include resource property (i.e., property related to natural resources), shares of nonpublic Canadian companies, and interests greater than 25% of publicly traded Canadian companies.[8] Thus, for example, if a nonresident of Canada dies while owning real property located in Canada this property is subject to the income tax on the deemed disposition of such property at death.
III. Tax Treatment of a U.S. Tax Resident or Citizen Who Dies Owning Canadian Property.
As discussed above, Canada taxes 50% of the appreciation on deemed dispositions of real property located in Canada upon death as income when that property is owned by decedents who are not residents of Canada. The U.S. federal estate tax system taxes all property, wherever located, that is owned by United States citizens and residents at the time of their death. While the U.S. federal estate tax provides a credit against foreign death taxes paid, this credit is limited to death and inheritance taxes and not to income taxes. As a result, before 1995, instead of receiving a credit for the Canadian capital gains tax paid on the deemed disposition of the property at death, a United States citizen or resident decedent owning real property located in Canada could only claim a deduction against U.S. federal estate taxes for capital gains taxes paid to Canada. Thus, without additional relief, a United States citizen or resident decedent who owned real property located in Canada would have been subject to additional (or double) tax with respect to such property upon his or her death.
Fortunately, the Treaty provides relief from this potential additional (or double) taxation. While Paragraphs 1, 2 and 3 of Article XIII of the Treaty provide that Canada can tax citizens and residents of the United States on gains from the alienation of Canadian Property Taxable to U.S. Persons, the Protocol effectively eliminates any additional (or double) tax on such property. Article 19 of the Protocol added a new Article XXIX B to the Treaty. Paragraph 7 of Article XXIX B provides that income tax paid to Canada on the deemed disposition of Canadian Property Taxable to U.S. Persons upon the death of a citizen or resident of the United States is treated as a foreign death tax for purposes of the U.S. federal estate tax and, therefore, the United States must give a credit against the U. S. federal estate taxes imposed on the Canadian property for the income tax paid to Canada attributable to the deemed disposition. While it may be possible to structure property ownership in a manner that could avoid the Canadian income tax on a deemed disposition of Canadian Property Taxable to U.S. Persons, it would appear that in most situations this would be unnecessary because the credits provided by the Treaty ensure that the citizen or resident of the United States will pay no more total tax than if the property were located in the United States.
Canadian tax law also provides for a rollover of property that is transferred to a Canadian surviving spouse at death. In effect, if a decedent leaves real property to a surviving spouse who is resident in Canada for purposes of the Canadian income tax that property is treated as being disposed at death by the decedent at the cost basis of the property (as opposed to the fair market value of the property at the time of death). No gain or loss is recognized upon death when a decedent transfers real property located in Canada to a surviving spouse who is resident in Canada. Instead, the gain will be deferred until the earlier of the disposition of the property by the surviving spouse or the deemed disposition of the property by the surviving spouse (via death, gift, etc.). When a decedent is a resident of the United States immediately before death Paragraph 5 of Article XXIX B of the Treaty, as added by the Protocol, extends this deferral benefit to such decedent's surviving spouse by providing that such surviving spouse is treated as a resident of Canada for purposes of this rollover.
When real property located in Canada has been left to a trust for the surviving spouse of a decedent who was a citizen or resident of the United States a similar rollover is also possible. Paragraph 5 of Article XXIX B of the Treaty, as added by the Protocol, provides that if the trustees who are citizens or residents of the United States or domestic United States corporations request the Canadian competent authority, the authority may agree, subject to terms and conditions satisfactory to it, to treat the trust as being resident in Canada for such time as it stipulates. This, in effect, could allow a rollover of the real property upon transfer to the trust until the earlier of an actual disposition of the property by the trust or a deemed disposition of the property.
If a rollover of real property located in Canada occurs because the property is transferred to a surviving spouse or a trust upon the death of the decedent and the property is disposed of before the death of the surviving spouse, Canadian capital gains tax may be due before U.S. federal estate tax would be due. It would appear that the only way to resolve this potential lost credit against U.S. federal estate taxes would be through relief granted by the competent authorities of Canada and the United States.
A common (non-tax driven) estate planning technique in the United States is the use of revocable trusts to hold property. This technique is not intended to save taxes but, instead, is used to simplify property management and to avoid the probate process. The contribution of real property located in Canada to a revocable trust by a citizen or resident (for income tax purposes) of the United States triggers the deemed capital gains tax for Canadian income tax purposes without an offsetting foreign (income) tax credit in the United States because the U.S. income tax treats a transfer to a revocable (grantor) trust as a non-event for tax purposes. A tax neutral way to use a revocable trust to own real property located in Canada would be to acquire the property through the revocable trust instead of having the individual purchasing the property acquire the property and then transfer it to a revocable trust later when the property has appreciated.
Another common estate planning technique is for a Last Will and Testament to "pour over" all of a decedent's property to a revocable trust. Under Canadian law the transfer of real property located in Canada by a decedent's will to a revocable trust would be invalid if the revocable trust could be amended under state law without the formalities required for a will execution. [9]
IV. Tax Treatment of U.S. Citizens who Die as Canadian Residents.
The analysis for citizens of the United States who die as residents of Canada is similar to that of citizens of the United States who own real property located in Canada, except that the worldwide assets of a Canadian resident are subject to the deemed disposition regime at death. Before the Protocol the Canadian income tax attributable to the deemed disposition of a Canadian resident's worldwide property at death was treated as a deduction for U.S. federal estate tax purposes, instead of as a credit, against U.S. federal estate tax. This created a very significant additional (double) tax issue on death. Paragraph 7 of Article XXIX B, as already discussed, provides partial relief from this problem with respect to property situated outside the United States by making the Canadian income tax attributable to the deemed disposition of a U.S. citizen's property situated outside the United States eligible for the statutory U.S. foreign death tax credit.
When a citizen of the United States dies resident in Canada owning U.S. situs property, Canada is obligated to give a tax credit under Paragraph 6 of Article XXIX B of the Treaty against the Canadian income tax imposed on the deemed disposition of such U.S. situs property for the U.S. estate tax attributable to such property. However, the amount of the income tax credit that Canada must give is limited to the estate taxes that would have been payable to the United States if the individual were not a citizen of the United States. The concept appears to be that, between the Paragraph 6 credit given by Canada against its income tax for estate taxes paid to the United States on the U.S. citizen-Canadian resident's U.S. situs property and the Paragraph 7 credit given by the United States against its estate tax for the Canadian income tax paid on the U.S. citizen-Canadian resident's property situated outside the United States, the estate of the U.S. citizen-Canadian resident decedent should effectively avoid double taxation despite the tax liabilities to the two countries.
The benefits of Paragraphs 6 and 7 of Article XXIX B of the Protocol are summarized in the following:
Paragraph 7 of Article XXIX B of the Protocol:
Provides a credit against U.S. estate tax for Canadian deemed income tax attributable to property situated outside the U.S.
Paragraph 6 of Article XXIX B of the Protocol:
Provides a credit against Canadian income tax imposed on the deemed disposition of property situated in the U.S. at death as if the decedent was a non-U.S. citizens not domiciled in the U.S. for the U.S. estate tax attributable to such property.
V. Tax Treatment of Canadian Residents Who Are Not Citizens of the United States Who Die Owning U.S. Situs Property.
Before the Protocol Canadian Residents who were not United States citizens who died owning U.S. situs property had serious additional (or double) taxation problems. The Canadian income tax did not provide any relief from U.S. federal estate taxes payable with respect to U.S. situs property because the foreign tax credit provisions of the Canadian income tax law allowed credits only for foreign income taxes, and not for foreign transfer taxes. A deemed disposition on death of a vacation home located in the United States that was owned by a Canadian resident would lead to Canadian income tax liability on the deemed disposition and a corresponding U.S. federal estate tax liability with no credit.
As discussed in Part I, non-U.S. Taxpayers are only subject to U.S. federal estate tax with respect to U.S. situs property. The Treaty, as amended by the Protocol, provides significant benefits to Canadian residents who die owning U.S. situs property.
Paragraph 2 of Article XXIX B of the Treaty provides that Canadian residents are entitled to a unified credit against U.S. federal estate tax equal to the greater of (i) the unified credit allowed to individuals who are neither residents nor citizens of the United States under the U.S. federal estate tax, which is currently $60,000, and (ii) a pro-rated portion of the unified credit available to citizens and residents of the United States based on the value of that the decedent's gross United States estate bears to the value of the decedent's gross worldwide estate. For example, if the value of the decedent's gross worldwide estate is $4,000,000 and the value of the decedent's gross United States estate is $2,500,000, the decedent will be entitled to a credit of $347,375 (i.e., $2,500,000/$4,000,000 (x) or times $555,800, which is the credit on $1,500,000) which will allow the decedent to pass up to $1,003,842 of U.S. situs property free of U.S. federal estate tax. This means that a Canadian resident will not be subject to U.S. federal estate tax if the value of his worldwide assets is less than the amount of the unified credit, which is currently $1,500,000.
Paragraphs 3 and 4 of Article XXIX B provide that, in lieu of claiming a marital deduction (and setting up a Qualified Domestic Trust if the surviving spouse is not a citizen of the United States), a marital credit is available to estates of decedents who were residents of Canada at the time of death with respect to U.S. situs property transferred to a surviving spouse who is a resident of either the United States or Canada. This additional credit is limited to the lesser of (i) the unified credit discussed in the previous paragraph allowable to Canadian residents who die owning U.S. situs property, and (ii) the amount of additional estate tax which would otherwise be imposed on the property left to the spouse, if such property were subject to estate tax.
Paragraph 8 of Article XXIX B of the Treaty provides that if the value of the gross worldwide estate (not reduced by debts) of a Canadian resident does not exceed US$1,200,000, only United States real property interests (in general consisting of interests in real property located in the United States and United States corporations owning United States real property interests) and personal property forming part of a United States permanent establishment, and not other forms of property, will be included in the Canadian decedent's United States gross estate, and therefore be subject to the U.S. federal estate tax after the application of the credits previously discussed in this Part. It appears that this provision of the Treaty will not provide any benefit to Canadian residents when the unified credit is greater than $1,200,000, as it is now, because, as discussed above, Paragraph 2 of Article XXIX B of the Treaty provides that a Canadian resident will not be subject to U.S. federal estate tax if the value of his gross worldwide estate is less than the amount of the unified credit, which is currently $1,500,000.
In addition, where there is still a U.S. federal estate tax on the estate of a Canadian resident decedent, Paragraph 6 of Article XXIX B of the Treaty provides a credit for the United States federal estate tax paid against any Canadian income tax due on U.S. situs property on the deemed disposition that occurred in the year of death equal to the lesser of the two taxes. If the value of the U.S. situs property is significantly greater than its cost basis immediately prior to the death of the decedent, this credit can be useful to the Canadian decedent. However, if there has been no significant appreciation of the U.S. situs property at the time of death, the credit provided for in Paragraph 6 is not very useful because there would be little or no Canadian income tax on the deemed disposition at death against which to offset the U.S. estate tax payment.
Historically, many Canadian residents who owned U.S. situs property planned to avoid U.S. federal estate tax by holding the U.S. situs property through a Canadian holding company. However, Canadian law provides that in order to comply with certain rules regarding Canadian corporations the Canadian shareholders must essentially ignore the corporate structure. This could, potentially, lead to arguments by the United States Internal Revenue Service to disregard the Canadian companies when determining whether Canadian decedents owned U.S. situs property at the time of death. As a result, care should be taken in employing this technique in an effort to eliminate U.S. situs property from the gross estate of Canadian decedents.
In addition, the following techniques are often used by non-U.S. Taxpayers in order to reduce or eliminate U.S. federal estate tax.
• Minimize contacts with the United States to avoid becoming a U.S. Taxpayer for estate tax purposes.
• If an individual intends to become a U.S. Taxpayer he or she can engage in certain transactions before attaining U.S. resident status that could significantly reduce any eventual U.S. transfer tax liability. For example, subject to the benefits of the Treaty, an individual who is a non-U.S. Taxpayer is only subject to gift tax on U.S. real and tangible property. The individual can transfer U.S. intangible assets and non-U.S. assets before becoming a U.S. Taxpayer, with the result that these transfers will never be subject to the U.S. federal gift or estate tax.
VI. Tax Treatment of Canadian Citizens who Die Resident in the United States.
Since Canada taxes income based on residence, a Canadian citizen who dies resident in the United States would be exempt from the Canadian income tax on the deemed disposition of his worldwide assets because this tax only applies to a resident of Canada. However, this individual would be subject to Canadian income tax on a deemed disposition of any taxable Canadian property, subject to the terms of the Treaty. The same Canadian citizen would, however, be subject to U.S. federal estate taxes on his worldwide assets if he was treated as a U.S. Taxpayer at the time of his death.
VII. Gifts of U.S. Situs Property by Canadian Residents and Gifts of Canadian Property Taxable to U.S. Persons by United States Taxpayers.
While the U.S. federal gift tax law provides a credit for gift taxes paid by non-U.S. Taxpayers, gifts of real property and tangible property located in the United States made by Canadian residents who are non-U.S. Taxpayers are subject to the income tax on deemed dispositions by Canada without an offsetting credit in the United States. As was the case with the U.S. federal estate tax before the Protocol became effective, the Canadian income tax on deemed dispositions imposed on gifts is not a gift tax that is creditable under U.S. law. Thus, if a Canadian resident makes a gift of U.S. situs property not only will a gift tax liability be imposed by the United States, but no credit is available to ameliorate the additional (double) taxation attributable to the gift. Similarly, a gift of Canadian Property Taxable to U.S. Persons by a U.S. Taxpayer will be subject to both U.S. federal gift tax and Canadian income tax on the deemed disposition without any relief from the additional (double) taxation.
One solution to this problem for Canadian residents is to structure gifts so that they are not gifts of U.S. situs property. For example, a gift of real property located in the United States could be structured as a gift of the shares of a Canadian holding company that acquired the real property located in the United States, as discussed above, instead of making a direct gift of the real property located in the United States. With respect to a U.S. Taxpayer, if a gift must be made of Canadian Property Taxable to U.S. Persons, it would be more efficient to make a gift of property with little or no appreciation to minimize the Canadian income tax liability with respect to the deemed disposition upon making the gift.
VIII. Treaty Benefits Related to Charitable Contributions and Bequests.
When property passes upon an individual's death to a charitable organization Paragraph 1 of Article XXIX B of the Treaty effectively treats not-for-profit organizations from both the United States and Canada as a not-for-profit organization from the country of which the decedent died a resident. This provision is used to allow charitable bequests made to not-for-profit organizations in the country other than that of the decedent's residence to be eligible for an U.S. federal estate tax deduction and, with certain restrictions, a Canadian income tax credit, whichever is appropriate.
Under the U.S. tax law the United States does not permit individuals to claim an income tax deduction for contributions to foreign charities. In a similar fashion, Canadian income tax law provides that only charitable contributions made to registered Canadian charities (i.e., approved Canadian charities that are resident in Canada and that were either created or established in Canada) are creditable against Canadian income tax liability. However, the Treaty allows certain deductions for contributions made by United States citizens or residents to charitable organizations located in Canada and for contributions made by Canadian residents to charitable organizations located in the Untied States.
Under Paragraph 5 of Article XXI of the Treaty, for U.S. tax purposes, contributions by a citizen or resident of the United States to a Canadian charity (treated as an exempt organization by Canada and eligible to be treated as a United States charity if it were located in the United States) are generally eligible for the charitable deduction in an amount not to exceed that percentage of the United States citizen's or resident's Canadian income that could be deducted if the percentage limitations under the Internal Revenue Code were applied to the Canadian income alone.[10] For example, if a citizen of the United States has United States source income equal to $100,000 and Canadian source income equal to $50,000, he is limited to a deduction of $25,000 for gifts of cash to a Canadian charity. However, in the case of contributions to a Canadian college or university at which the United States citizen or resident or a member of his family is or was enrolled, the amount that can be deducted is not limited to the United States citizen's or resident's Canadian income but rather to the general limitations applied for contributions to domestic charities. Paragraph 6 of Article XXI of the Treaty provides similar rules with respect to Canadian taxes for Canadian residents who make contributions to United States charities.
Conclusion.
While the Treaty provides significant relief from additional (or double) taxation, planning is necessary to ensure taxes are minimized when an individual with ties to both Canada and the United States makes either a gift during his lifetime or a bequest upon his death.
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**Article presented at the New York State Bar Association International Estate Planning Institute, March 10 - 11, 2005.
1 In addition to the gift and estate taxes, the United States also imposes a federal generation-skipping transfer ("GST") tax. Generally, the GST tax applies when a transfer is made to a recipient who is two or more generations below that of the transferor. A transfer to or for the benefit of a grandchild or more remote descendant is a typical example. Another example would be a transfer to a trust for the lifetime benefit of a child that upon the child's death, continues for the benefit of the child's children. The GST tax is imposed at the maximum federal estate tax rate, currently 48%. There is a GST tax exemption which equals the amount of the applicable exclusion amount (i.e., $1,500,000 in 2004). The GST tax exemption is currently scheduled to rise (and then decline) in tandem with the applicable exclusion amount.
2 In 2010 the highest rate for gift taxes is scheduled to be reduced to the highest rate for income taxes.
3 However, for U.S. income tax purposes, absent treaty relief, a tax deduction is only available for contributions made to U.S. charitable organizations.
4 An individual is a resident of the United States for income tax purposes if he or she is a citizen of the United States or a tax resident of the United States for income tax purposes. A tax resident of the United States for income tax purposes is a permanent resident under the United States immigration laws (a green card holder) or someone who meets the substantial presence test. In general, the substantial presence test provides that a person is a United States resident for income tax purposes if a person (1) is present in the United States for more than 183 days during a year or (2) is present in the United States for at least 31 days in the current year and was also present in the United States for more than an average of 183 days over the current year and the past 2 years where days in the prior year are counted as 1/3 of a day and days of the second most recent year are counted as 1/6 of a day.
5 The unified credit is scheduled to increase to $2 million in 2006 and $3.5 million in 2009. In 2010 the U.S. federal estate tax is scheduled to disappear for one year and be reinstated in 2011 with a unified credit of $1 million.
6 The stepped-up basis rules are scheduled to be eliminated for decedents who die after 2009, to be replaced by a modified carryover basis at death regime. The modified carryover basis regime will allow the basis of up to $1,300,000 (or $3,000,000 for property received by a surviving spouse) worth of assets to be stepped-up to the date of death value. This repeal of the stepped-up basis regime is timed to coincide with the elimination of the estate tax in 2010. If the laws are not changed and the estate tax is repealed in 2010 and the modified carryover basis at death regime is enacted it would appear that in the aggregate less taxes would be imposed on death because the estate tax rate (currently 48%) is much greater than the rate of tax on capital gains (currently 15%).
7 These assets, however, will be included in the decedent's gross estate at their date of death value.
8 However, with respect to individuals with ties to Canada and the United States, Article XIII of the Treaty provides that Canada cannot tax any gains from the sale or deemed disposition of any type of Canadian property that is owned by residents of the United States other than Canadian Property Taxable to U.S. Persons. As a result, residents of the United States that die owning most forms of Canadian property or make gifts of most forms of Canadian property are exempt from Canadian taxation.
9 Florida law provides that a revocable trust cannot be amended without the formalities required for the execution of a Will. Thus, it would appear that a pour over of real property located in Canada by the Will of a Florida domiciliary should be effective for Canadian purposes.
10 In general, under the U.S. federal income tax contributions of cash to public charities and other similar charitable institutions are limited to 50% of the donor's adjusted gross income. Gifts of capital assets to these entities is limited to 30% of the donor's adjusted gross income. Gifts to private non-operating foundations and certain organizations such as public cemeteries and war veterans organizations are limited to 30% of adjusted gross income for cash and 20% of adjusted gross income for gifts of capital assets. Amounts in excess of these limitations can be carried forward for a total of five years.
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