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First, expatriate U.S. citizens who owned a direct or indirect interest in a Canadian corporation had to deal with an unfair transition tax on the amount of earnings and profits retained by the Canadian corporation as of the end of 2017. Now, the same corporations as well as others with greater than 50% U.S. ownership will have to deal with the Global Intangible Low Taxed Income (GILTI) which will impact most U.S. majority owners of Canadian corporations that utilize the Canadian small business deduction.
How the GILTI tax works
The GILTI tax is intended to impose a tax on the earnings of a CFC to the extent the earnings exceed 10% of the Qualified Business Asset Investment (“QBAI”) of the company and its corporate tax rate is below 26.25% where there are individual shareholders and 13.125% where there are corporate shareholders. The QBAI generally refers to the fixed assets used in the trade or business of the corporation. It does not include a proportionate share of investments of the excess earnings of the corporation in real estate partnerships and the like as said investments are not an essential part of the trade or business of the company.
The tax can run into thousands of dollars and can be particularly punitive to certain low capital businesses such as medical or other professional practices. Rather than focusing on the calculation of the tax, we will focus on potential solutions.
An obvious solution to the issue would be the renounce U.S. citizenship. The costs and benefits of a renunciation are beyond the scope of this discussion. Other potential solutions include:
- Foregoing the small business deduction in the CCPC.
- Restructuring the ownership of the corporation.
- Consider utilizing an unlimited liability company.
- Consider a Section 962 election.
A brief explanation of each of the above along with the advantages and disadvantages of each follows:
Foregoing the Small Business Deduction of the CCPC
CCPCs are entitled to a reduced tax rate of less than 15% on up to $500,000 of taxable income. Foregoing the lower tax rate will subject the CCPC to a 26.5% rate which is above the GILTI tax threshold of 26.25%.
Advantages:
A pristine, risk-free option. As a result of the integration of the Canadian tax system, the distribution of said after-tax dollars from the corporation will result in a lower net tax rate to the shareholder when eventually received by the shareholder.
Disadvantages:
Higher immediate corporate taxes result in the loss of the deferral of tax and any earnings on said deferral up until the date of ultimate distribution.
Restructuring the ownership of the corporation
As the GILTI only applies to CFCs, a restructuring could potentially reduce the U.S. ownership to below a majority thereby terminating CFC status.
Advantage:
No more GILTI tax.
Disadvantage:
There could be adverse Canadian and/or U.S. tax consequences and cost to any restructuring.
Consider utilizing an Unlimited Liability Company (“ULC”)
Three provincial jurisdictions in Canada allow for the creation of ULCs, which are available to non-residents of said jurisdiction also. A ULC is treated as a flow through entity in the U.S. and as a corporation in Canada. As a flow through entity, it will not be subject to the GILTI tax.
Advantages:
The GILTI tax should not apply and depending on the numbers, there may be sufficient excess U.S. foreign tax credits in the general limitation basket to offset the higher U.S. flow through income at lower rates from the lower Canadian income taxed at higher rates.
Disadvantages:
An analysis of the prospective foreign tax credits must be undertaken to ascertain viability. As well, there could be tax on any appreciated assets transferred unless structured properly. There are also certain liability exposures, depending on which jurisdiction the ULC is organized in, which may be unacceptable to those who are not otherwise covered by liability insurance like professionals.
Consideration of a Section 962 election
In general, the election can be used to reduce the tax on income from a CFC from the higher U.S. individual rate of up to 37% to the lower corporate rate of 21% which would reduce the GILTI tax also.
Many years ago, when the Section 962 election became law, the clear legislative intent was to ascertain that a U.S. individual subject tax on CFC earnings should not be subject to a greater tax burden than a U.S. corporation with CFC earnings. The U.S. practitioner community is divided on whether making this election can allow a U.S. expatriate owning a CFC to avail him or herself of the higher 26.25% threshold available to corporate owners rather than the 13.125% threshold available to individual owners of a CFC. There are a number of technical tax arguments weighing on each side of the discussion:
Advantage:
If it works, CFC income subject to a Canadian tax rate below 26.25% should be exempt from the GILTI.
Disadvantage:
The IRS has not, but could, release guidance refuting this approach. While the guidance may be challenged by a taxpayer, there is the risk that the IRS could succeed in applying the 13.125% threshold as opposed to the 26.25% threshold.
For more information, please contact your Zeifmans advisor today or Stanley Abraham, U.S. Tax Partner at 647.256.7551 or sa@zeifmans.ca.
