U.S. tax reform bills have significant impact on U.S. citizens in Canada and Canadian entities conducting business in the U.S.

Both houses of the U.S. Congress have passed different but similar U.S. tax reform bills. The differences will be reconciled by a joint committee of congress and the revised bill will be resubmitted to each of congress for approval before going to President Trump’s desk for approval.

It is likely, though not certain, that the reconciled legislation will be approved by both houses of congress. As the U.S. Senate had a closer vote for approval, many pundits believe that the final version of the bill will likely resemble the Senate’s bill.

Each bill is close to 500 pages. This correspondence will not address the entirety of the proposed legislation. Rather, it is a summary of the changes with the greatest impact on Canadian individuals and businesses doing business in the U.S.

Provision impacting Canadians

Individuals

• Deemed repatriation tax on retained earnings of foreign corporations owned by U.S. citizens.
• Increased child tax credit.
• Increased estate tax exclusion.
• More Canadian corporations owned with non-U.S. spouse to be considered Controlled Foreign Corporations (“CFCs”).
• U.S. beneficiaries of Canadian family trusts may have increased compliance requirements and a potential deemed repatriation tax potential.

Businesses

• Reduction of U.S. corporate tax rate to a 20% flat rate.
• Denial of interest and royalty payment deductibility to hybrid entities.
• Potential excise tax on intercompany payments.
• Sale of U.S. partnership interest previously not included in U.S. taxable income, now included.
• Elimination of NOL carrybacks and limitations on carryforwards.
• Acceleration of depreciation on U.S. real property.
• Like-kind exchange rules to be limited to real property used in a trade or business.
• Limitations on U.S. interest deductible based on worldwide interest deductible by the affiliated group.
• Denial of entertainment expenses.
• 100% write down non-real estate assets used in a trade or business.

Individual provisions

• A tax on the retained earnings of certain Canadian corporations owned by the U.S. individuals of up to 14.49% of undistributed retained earnings. This provision will be the subject of the separate newsletter.
• The estate tax exemption will be raised to US $10 million per person to be inflation adjusted post-2017.
• An increase in the Child Tax Credit from $1,000 per child to $2,000 under the Senate bill. Lower amounts are proposed in the Congressional bill. The phase out which currently begins at $110,000 for taxpayers who file “married filing joint” will be raised from $110,000 to $500,000. The earned income threshold for the refundable threshold will be lowered from $3,000 to $2,500 and the refundable amount will be adjusted for inflation. As well, the qualification for the credit will be raised from 17 to 18.
• A modification of the nonresident alien attribution rules for Controlled Foreign Corporations (“CFC”). What this means is that, under current law, if U.S. citizen husband and non-U.S. citizen spouse each owned 50% of a Canadian corporation, the corporation avoided CFC classification and its shareholder did not have to concern him or herself with filing a Form 5471 and potential Subpart F income inclusions on their U.S. tax returns. Under the proposed revision, non-U.S. citizen spouse’s interest in the Canadian corporation will be attributed back to U.S. citizen and all of the CFC filing and Subpart F rules will apply.
• In a rule intended to inhibit U.S. hedge funds use of certain types of foreign corporations to avoid U.S. inclusion, both houses of congress have modified the definition of “U.S. shareholder” to include a U.S. person who owns 10% or more of the value of the shares of all classes of stock of the corporation regardless of the percentage of vote owned. Under this rule, U.S. beneficiaries of a traditional 21-year Canadian family trust with minimal voting rights should review whether or not they will have to file certain forms and include certain income amounts prospectively.
• Reduction of U.S. federal corporate tax rate to a flat rate of 20%.
• Related party payments of interest and royalties to hybrid entities are denied under certain circumstances (i.e. income inclusion mismatch in other counts).
• Certain payments from U.S. taxpayers to foreign related parties would be subject to an excise tax is the foreign based multinational has gross receipts of at least $500 million for the three previous tax years and other criteria were satisfied.
• A codification of IRS Revenue Ruling 91-32 requiring a foreign taxpayer selling a U.S. partnership interest in an active business other than real estate to be subject to U.S. tax on the sale. Until now, most practitioners have advised and U.S. courts have sustained a provision whereby such gains were excluded from U.S. tax.
• According to the Senate bill, net operating loss (“NOL”) carrybacks will be disallowed and carryforwards will only be allowed up to either 90% or 80% of income, resulting in a potential effective 4% U.S. federal tax rate (i.e. (100% – 80%) * 20%) for corporations with U.S. net operating loss carryforwards.
• The accelerated depreciation on real property will be reduced from 39 years for nonresidential real property and 27.5 years for residential real property to 25 years for both. An election to decelerate depreciation to 30 years is provided. Coupled with the limitations on NOL carryforwards, foreign investors in U.S. real estate should consider steps to be taken to mitigate potential double taxation on real property.
• The like-kind exchange rules under section 1031 will now be limited to real estate used in a trade or business.

Business provisions

• There will be additional limitations on a U.S. subsidiary of a foreign corporation’s ability to deduct interest. Under a complex set of proposed rules, the interest would be reduced by the net interest expense of the domestic corporation multiplied by the debt-to-equity differential percentage of the worldwide affiliated group. To the extent that U.S. debt exceeds 110% of the worldwide group, there could be a disallowance which may be carried forward.
• Deductions for net interest expense of a corporation will be limited to the EBIDTA or cash flow (unclear) of the company multiplied by 130% for companies with annual gross receipts of more than $15 million (i.e. including worldwide affiliates). Disallowed interest can be carried forward. At the taxpayer’s election, the limitation would not apply to real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental operation, management, leasing or brokerage. The House version of bill will limit this rule to companies which are part of a group with less than $25 million in gross receipts. The Senate’s de minimis level is $15 million in gross receipts.
• The House’s bill included a 20% excise tax on certain payments made by a U.S. corporation for product purchases and non-interest-fees unless the foreign corporation elects to treat the amounts as subject to U.S. tax. The Senate bill does not include a similar provision.
• Entertainment expenses will be subject to a 100% disallowance.
• Enhancement of domestic depreciation to allow 100% write-off of non-real estate assets used in a trade or business.

Changes of little impact to Canadians

• Reduction of tax rates and increase of taxable income needed to trigger higher rates.
• Increase in the standard deduction and disallowance of medical expenses (under certain versions of the bill), state and local taxes expect for property taxes of up to $10,000, mortgage interest in excess of $500,000 of principal as opposed to the current $1 million threshold, tax preparation fees and other deductions.
• Investors in pass through entities will be subject to a maximum tax rate of 25% and possibly less depending on which, if any, version passes subject to certain modifications and limitations. The House version of the bill differentiates between active and passive investors whereas the Senate does not.
• A movement to U.S. based multinational corporations to a partial territorial system whereby prospective dividends will not be subject to full taxation as a dividend.
• U.S. taxpayers claiming a principal residence exemption must occupy the property for at least 5 of the 8 years prior to sale rather than 2 of the 5 years prior to sale.

 Both the House and Senate bills should have a profound impact on U.S. expatriates in Canada and Canadian-based multinationals doing business in the U.S. If, and when, the bill becomes law, we will provide further information.

Contact your Zeifmans advisor today, or Stanley Abraham, U.S. Tax Partner at sa@zeifmans.ca or 647.256.7551 should you have any questions.

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