Planning for Canadian Family and Property
Additional Planning Requirements must be met when a United States Citizen is married to a Canadian, owns Canadian Property, or has a Canadian Relative
Canada is perhaps the foreign nation most intertwined with the United States in its geography, economy, sports and . . . estate planning. The United States and Canada share the world’s longest, undefended border. Canada is also our country’s largest trading partner. In addition, the National Basketball Association (NBA), National Hockey League (NHL) and Major League Baseball (MLB) all include teams from cities both north and south of the border.
From the estate planning standpoint, practitioners, particularly in New England and Florida, often have clients with different relationships to Canada. Depending upon the given circumstances, a person’s estate plan must be properly structured in order to achieve the greatest benefits under not only United States, but also Canadian, tax law. This article deals with three common issues in this area of international estate planning: first, how to plan for a multinational couple living in the United States is discussed; second, an overview of the tax results arising from a transfer by a United States citizen of Canadian real estate; and third, a comparison of the tax results of different options available to a United States citizen seeking to give United States property to a Canadian citizen family member.
(This article presumes reinstatement of the United States federal estate tax retroactive to January 1, 2010)
Planning FOR A Multinational Couple Living in the United States
When planning for a couple made up of citizens of two different countries, additional considerations must be made. If one spouse is a United State citizen and the other is a Canadian citizen residing in the United States one common, effective approach is to create a type of revocable trust with federal marital and credit shelter provisions, often referred to as an “A-B Trust,” that includes a special provision for property passing to the Canadian citizen. The A-B trust, or trusts, should hold all major United States assets, both joint and separate.
United States A-B Trust to hold United States Property
The A-B Trust
The A-B Trust is an estate planning arrangement designed to give individuals full use of the family’s economic wealth, while at the same time minimizing, to the greatest extent possible, the total amount of federal estate tax payable at the death of both spouses. A married couple can entirely eliminate estate taxes on the death of the first spouse by using a combination of the unlimited marital deduction and the estate and gift tax credit. In addition, the approach allows for there to be no, or at least significantly minimized, estate tax on the death of the second spouse. The marital deduction is a deduction allowed for property that passes by gift or inheritance to a person’s spouse. The estate and gift credit is a credit provided to every United States citizen and resident that can be used against estate and gift taxes.
The A-B Trust contains a series of steps, and ultimately results in the creation of multiple trusts. First, a person, known as the grantor, creates a revocable trust. He then transfers all of his high worth assets into the trust (remaining assets will pass into the trust at the time of the grantor’s death). During the grantor’s lifetime, assets may be freely transferred into and out of the trust, and any income from trust assets is taxed directly to the grantor.
The trust is structured so that, upon the death of the grantor, the trust assets are divided in accordance with a formula into two separate trusts. The first trust (the “A trust”), is for the benefit of the surviving spouse and the second trust (the “B trust”) is for the benefit of the grantor’s children or other beneficiaries, and the surviving spouse if necessary. The assets are distributed between these two trusts by first putting the amount equal to the estate tax exemption into the B trust, and any remaining amount into the A trust. The estate tax exemption will remove any estate tax on the assets transferred to the B trust because it applies regardless of to whom assets are transferred. Then, the marital deduction is applied to the assets transferred into the A trust, because that trust is solely for the benefit of the surviving spouse.
QDOT Provision for Non-United States Citizen Spouse
As mentioned above, the A-B Trust utilizes the estate and gift tax marital deduction. However, that deduction is not available for gifts to non-citizen spouses. If the United States citizen spouse were to pass away before the Canadian citizen spouse, her estate would not be entitled to the marital deduction and the A-B Trust would not be able to reach its ultimate potential.
However, while the unlimited marital deduction is not available for transfers made upon death to a non-United States citizen to a typical A trust, a marital deduction is available if the recipient of a bequest is instead a qualified domestic trust established for the benefit of the non-United States citizen spouse. In addition to meeting the normal A trust specifications, the trust must also follow several additional requirements. To qualify for the marital deduction, the QDOT places somewhat greater restrictions upon the surviving spouse’s ability to access trust assets.
As a general rule, any income from the assets in the trust distributed directly to the trust beneficiary will be taxed as income to the beneficiary, as if he held the assets himself. Also, any distributions of assets from the trust will be subject to an estate tax at the rate applicable to that of the deceased spouse who funded the trust. Finally, any property remaining in the trust upon the death of the surviving spouse will also be taxed at the predeceasing spouse’s marginal estate tax rate.
Canadian Tax Consequences Related to Canadian Property
The Canadian income tax system is applicable to Canadian residents on all income, but it is only applicable to non-residents of Canada to the extent of income earned in Canada. Unlike the United States, which taxes all of its citizens regardless of whether they live inside or outside the United States, Canada only taxes its citizens if they are also Canadian residents.1 The Canadian Income Tax Act does not explicitly define what it means to be a Canadian resident for tax purposes; however, Canadian courts and the Canadian Revenue Agency instead provide guidance. In short, a person’s residency is determined based upon a number of factors, including, but not limited to, whether his primary residence is in Canada, whether his spouse and/or children live in Canada, and whether he spends significant lengths of time in Canada.2 If a non-resident, a person is only taxed in Canada to the extent of Canadian source income.
In addition, Canada does not have an estate or gift tax, but does tax some gifts and inheritances through its income tax system.3 A capital gain tax is applied to a gift or bequest of property that has appreciated in value. If a gift or bequest of appreciated property is made, the donor is treated as having received proceeds equal to the difference between the property’s original cost and the property’s fair market value at the time of transfer. This is a tax on the donor, not the donee.4 Therefore, if a non-resident transfers Canadian real estate, either by gift or by will, that person is required to pay Canadian capital gains tax on the value of the difference between the original cost of the property and the fair market value of the property at the time the property is transferred.
Tax Consequences of Transferring Canadian Property to United States Trust
If the Canadian real estate owned by a United States resident is transferred to a United States trust, that transfer will be treated under Canadian tax law as a gift from that person to the trust. As a result, the property owner is required to immediately pay a capital gains tax in Canada on the difference between the property’s current value and its original cost, in the same manner as if he had sold the property.5 Likewise, subsequent gifts or sales will result in additional Canadian taxation. The amount of any Canadian tax paid may be used as a credit against the transferor’s United States tax liability in the year of transfer.6
Tax Consequences of Continuing to Hold Canadian Property Outright
In the alternative, if the property remains owned by the United States resident until his death, his estate will be required to pay a capital gains tax in Canada on the difference between the property’s current value and its original cost. However, if the United States resident’s spouse is still living and receives the property by will, that amount of Canadian income tax may be deferred until after her death. A treaty between the United States and Canada has extended this Canadian tax benefit to United States citizens and residents. Also, under the United States-Canada Income Tax Treaty, the amount of Canadian income tax paid may be used as a credit against the United States estate tax liability of either spouse’s estate.7
If the Canadian real estate remains held outright, a United States will should be sufficient to transfer the property at death. However, the bequest may be more efficiently streamlined if a Canadian will is executed to dispose of the Canadian property.
Whether to Transfer Canadian Property to a United States Trust
Every circumstance is different, and a number of factors will need to be considered when advising a person who owns Canadian real estate. In general, transfers of Canadian property into a United States trust will result in immediate taxation in Canada, similar to as if the property were sold to a third party. On the other hand, keeping the property out of the trust allows for greater future flexibility, for instance, to someday sell the property and then use a portion of the proceeds to pay the resulting income tax or give the property to other family members. Because Canadian tax law differs from tax law in the United States, there are not the same types of planning options available to reduce Canadian income taxes from dispositions of real estate as there are to reduce United States estate taxes. Canadian income tax will be incurred if the property is transferred from either of the spouse’s estates. However, while the property will also be included within each United States estate, a portion of the estate tax exemption can be applied to exclude it from taxation or the foreign estate tax credit may be used to offset the resulting United States estate tax.
Planning for a United States Citizen Owning Property in the United States but with Family Members in Canada
It may be the case that a United States citizen does not own property in Canada, but instead has children or other relatives who are Canadian citizens. A transfer of United States property to a Canadian beneficiary will have different results under the Canadian and United States tax systems, depending upon the gifting mechanisms used. Neither a direct gift, nor a distribution from a trust, will result in additional estate or gift taxation to a Canadian beneficiary. However, a trust distribution can result in income taxation to a beneficiary, which is a primary focus of this section.
United States Income Tax Treatment of Gifts, Grantor Trusts, and Non-Grantor Trusts
In the United States, the value of property acquired by gift is not includable in a person’s income.8
Trusts, for income tax purposes, are designated into one of two major categories, grantor trusts and non-grantor trusts. If a settlor possesses certain powers, the most common being a general inter vivos power of appointment or an income interest, than the trust is a grantor trust.9 Property held in a grantor trust is treated for federal income tax purposes as if it was owned by the settlor outright, and the settlor is taxed personally on trust income.10
The second category for tax purposes is a non-grantor trust. This type of trust is its own entity, separate and apart from the settlor, trustee and beneficiaries. Depending upon the way in which a non-grantor trust is structured, the trustee may or may not be allowed to invade principal for the use of the beneficiaries or accumulate income.11 With non-grantor trusts, any income from trust assets is attributable to the trust. However, if the trust distributes income to a beneficiary, the trust is allowed to take a deduction in the amount distributed, and the beneficiary is required to include the amount of income received in his or her own personal income.12
Tax Consequences Resulting from Annual Exclusion Gifts of Property from a United States Donor to a Canadian Donee
As previously discussed, Canada, as well as all of the Canadian provinces, does not have an estate or gift tax. In addition, similar to the United States, gifts and inheritances are not included within a donee’s income. However, Canada still taxes some gifts and inheritances through its income tax system.13 A capital gain tax is applied to a gift of property that has appreciated in value. If a gift of appreciated property is made, the donor is treated as having received proceeds equal to the difference between his basis in the property and the property’s fair market value at the time of transfer. This is a tax on the donor, not the donee.14 However, the Canadian income tax system is applicable only to Canadian residents on all income and non-residents only to the extent of income earned in Canada.15 Therefore, a gift made by a United States resident of United States property is not subject to any Canadian tax, and instead is subject only to gift taxation in the United States.
Tax Consequences to Canadian Beneficiaries of United States Grantor Trusts
For United States income tax purposes, the settlor of a grantor trust is treated as the real, direct owner of all trust income and assets. This means that the settlor is taxed individually on income as it is earned by the trust.16 In addition, for United States estate tax purposes, the value of all trust assets is includable in that person’s gross estate.17 Because a grantor trust is essentially a non-entity for tax purposes, distributions of United States assets from a United States grantor trust to a Canadian resident receive the same tax treatment as annual exclusion gifts from a United States resident to a Canadian resident. A gift or inheritance from a United States grantor trust of United States property to a Canadian resident is subject only to gift and estate taxation in the United States.
Canadian Tax Consequences to Canadian Beneficiaries of United States Non-Grantor Trusts
Unlike grantor trusts, a non-grantor trust is treated as a distinct legal entity, separate from its creator, under both United States and Canadian tax law.18 As discussed above, income retained by this type of trust is taxed as income to the trust, whereas income that is distributed to a beneficiary is taxed directly to that beneficiary. If trust property is distributed to a beneficiary, the distribution does not result in income tax.
The Canadian Income Tax Act contains several provisions that apply to trusts established in foreign countries, including the United States. These rules must be considered to ensure that a United States trust is not subjected to any additional, unnecessary Canadian taxation. The primary purpose of these sections is to prevent Canadian residents from moving income producing assets outside of Canada to avoid taxes. Therefore, these sections only apply to trusts that are treated as being resident in Canada. If a United States trust falls under any of these rules, it will be subject to Canadian income tax on all of its income, regardless of its source.19
First, under Canadian law, the residence of a trust is considered to be the residence of the trustee who manages or controls the trust’s assets. Therefore, if the managing trustee resides in Canada, the trust is also deemed a resident of Canada. On the other hand, if the managing trustee resides in another country, such as the United States, then, for Canadian tax treatment, the trust will be considered a resident of the United States.20 It is possible to have a trust with multiple trustees, some Canadian and some non-Canadian, be treated as a non-Canadian trust. However, the determination of the residence of a trust with multiple trustees will depend upon a number of factors, and it is advisable to avoid the possibility of Canadian residency treatment for a United States trust all together by only designating non-Canadian trustees.
Second, under Canadian law, certain trusts that are not residents of Canada may still be subject to Canadian taxes if certain conditions are met under section 94 of the Income Tax Act. In order to be treated as a resident trust under section 94, the trust must include a Canadian beneficiary and the trust must also have acquired its trust property, directly or indirectly, from a person who (1) is related to that beneficiary, (2) was a resident in Canada at any time in the 18 month period before the relevant tax year, and (3) was a resident in Canada for an aggregate period of 60 months before the relevant tax year.21 Therefore, so long as the trust settlor has never been a resident of Canada, the trust will be exempt from section 94, despite having a Canadian beneficiary that is related to the trust’s settlor.
In addition, the Canadian Income Tax Act gives favorable treatment to what it terms “personal trusts.” These special rules are applicable to both resident and non-resident trusts. A personal trust is, in general, a trust in which no beneficial interest was received for consideration.22 In other words, a personal trust consists of only gifted assets. So long as the trust consists of entirely gifted property, it will be treated as a personal trust.
Therefore, if a United States trust with Canadian beneficiaries has a United States trustee, is not funded by a person with significant residency connections to Canada, does not hold Canadian property and consists of entirely gifted assets, the trust will be considered a non-resident personal trust in Canada. As such, any Canadian beneficiary of such trust will only be required to include in his own individual income the amounts of income that were payable in that same year by the trust.23 Distributions of principal and accumulated income from prior tax years will be treated as a nontaxable transfers of assets.24
Finally, it is important to note that tax law, like many areas of the law, is ever-changing. In the past decade, there have been multiple attempts in Canada to amend Income Tax Act provisions related to trusts. However, if put into effect, these proposed changes would not substantively alter this analysis.25
United States Income Tax Consequences Arising from Distributions from Non-Grantor Trusts to Canadian Beneficiaries
A United States non-grantor trust with foreign beneficiaries may either distribute its income currently or retain that income for the current taxable year, and later distribute accumulated income to foreign beneficiaries.26 The United States income tax applies to United States non-grantor trusts on a worldwide basis. Therefore, all income, whether United States or foreign, is includable in a United States trust’s income.27
If a United States trust makes a current distribution to a Canadian beneficiary, the tax characterization of the distributed amount carries over to the Canadian beneficiary.28 However, if a distribution is deferred by the trust beyond the current year, the trust is the taxpayer for income received by the trust during the current year, rather than the Canadian beneficiary. Under these circumstances, the income is subject to United States income taxation in the hands of the United States trust.29
Also, under the Internal Revenue Code, a trustee is required to withhold tax from a trust’s United States source fixed or determinable annual or periodic income that is supposed to be distributed currently or that is paid or credited to a foreign beneficiary.30 The generally applicable withholding rate is 30 percent.31 However, the United States has signed bilateral income tax treaty with Canada. This treaty reduces or eliminates the otherwise required United States withholding tax depending on the type of income distributed to the Canadian beneficiary.32 Also, a Canadian beneficiary may be entitled to certain applicable United States income tax exemptions.33
As can be seen, the issues arising from a client’s relationship to Canada (through a spouse, other family members, or property ownership) requires additional planning considerations. However, so long as the particular aspects of each country’s tax law is understood and properly followed, a client should be able to achieve most, if not all, of the original goals, despite having to plan under two different legal systems.
(1) Income Tax Act, 1985 S.C., ch. 1 § 2 (Can.).
(2) Interpretation Bulletin, IT-221R3 (Consolidated), "Determination of an Individual's Residence Status," Dec. 21, 2001.
(3) Robert Couzin and Mark Novak, Business Operations in Canada, § IV, Part B (4th ed. 2009).
(4) Income Tax Act, 1985 S.C., ch. 1 § 69(1)(b) (Can.).
(6) 26 U.S.C. § 901 (2009).
(7) Convention with Respect to Taxes on Income and on Capital, U.S.-Canada, art. XXIX, Sep. 26, 1980.
(8) Comm'r v. Duberstein, 363 U.S. 278 (1960).
(9) 26 U.S.C. § 678 (2009).
(10) 26 U.S.C. § 677(a) (2009).
(11) 26 U.S.C. § 651 (2009).
(12) 26 U.S.C. § 662(a)(1) (2009).
(13) Robert Couzin and Mark Novak, Business Operations in Canada, § IV, Part B (4th ed. 2009).
(14) Income Tax Act, 1985 S.C., ch. 1 § 69(1)(b) (Can.).
(15) Income Tax Act, 1985 S.C., ch. 1 § 2 (Can.).
(16) 26 U.S.C. § 671 (2009).
(17) 26 U.S.C. § 2038 (2009).
(18) 26 U.S.C. § 645 (2009); Income Tax Act, 1985 S.C., ch. 1 § 104 (Can.).
(19) Income Tax Act, 1985 S.C., ch. 1 § 2 (Can.).
(20) Interpretation Bulletin IT-447, "Residence of a Trust or Estate," last updated Jan. 1, 1995.
(21) Income Tax Act, 1985 S.C., ch. 1 § 94(6) (Can.).
(22) Income Tax Act, 1985 S.C., ch. 1 § 248(1) (Can.).
(23) Income Tax Act, 1985 S.C., ch. 1 § 104 (Can.).
(24) Income Tax Act, 1985 S.C., ch. 1 § 105 (Can.).
(25) See e.g., Elie Roth, Canadian Taxation of Non-Resident Trusts: A Critical Review of Section 94 of the Income Tax Act, 52 Canadian Tax Journal 329, 350 (2004).
(26) 26 U.S.C. § 61(a) (2009).
(27) 26 U.S.C. § 871 (2009).
(28) 26 U.S.C. § 652(b) (2009); 26 U.S.C. § 662(b) (2009).
(29) 26 U.S.C. § 663(b) (2009).
(30) Treas. Reg. 1.1441-1.
(31) 26 U.S.C. § 1441(a) (2009).
(32) Convention with Respect to Taxes on Income and on Capital, U.S.-Canada, Sep. 26, 1980.
(33) 26 U.S.C. § 871(h) and (i) (2009).