Tax Alert – Canadian Implications to the Proposed U.S. Tax Reform – Part 2

October 2017

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On September 27, 2017, the Trump administration and Congressional Republican leaders released a document known as Unified Framework for Fixing Our Broken Tax Code (the “Framework”), which will serve as an outline for tax legislation that Republicans hope to pass later this year. The Framework offers some details on the Republicans’ plan to reduce and simplify taxes, but leaves many critical decisions to Congress.

In our April Tax Alert – Canadian Implications of the Proposed U.S. Tax Reform on the previously released Trump Plan, we discussed the potential impact of tax reform on Canadian companies that do business in the U.S. and individuals living in Canada that are subject to U.S. taxation. In this Tax Alert we are providing updated commentary to reflect the proposals laid out in the Framework.

The impact on Canadian business

Lower tax rates

The Framework proposes to reduce business tax rates from 35% to 20% for corporations, and from 39.6% to 25% for business profits earned through pass-through entities (partnerships, limited liability companies and S corporations). Although these rates are higher than the Trump Plan’s 15% rate for both corporate and pass-through income, the Framework shows the Republicans’ intention to significantly reduce business taxes.

As we indicated in our April Tax Alert, a lower U.S. tax rate will be favourable to Canadian businesses, as it will allow for greater activity to be conducted in the U.S. without attracting additional taxes.

Border adjustment tax

The good news for Canadian businesses is that the border adjustment tax (‘BAT”) was not included in the Framework. This is a relief for Canadian exporters who sell goods and services into the U.S., as the BAT would have made Canadian goods more expensive in the U.S.

Interest deductibility

The Framework provides that interest deductibility would be limited, although there are no details on how limited interest deductibility will be, and whether existing debt would be grandfathered. Many Canadian companies have used debt financing to expand in the U.S. or to acquire U.S. companies. Debt financing achieves several tax planning goals: (1) an interest deduction at a U.S. corporate tax rate that is currently higher than the Canadian rate, and (2) repatriation of income from the U.S. without having to pay a dividend that could be subject to 5% or 15% dividend withholding tax.

The proposal to limit interest deductibility could adversely impact Canadian parent companies that have leveraged their U.S. subsidiaries. One potential impact is that a Canadian parent will continue to accrue interest income on loans to U.S. subsidiaries, while the U.S. subsidiaries will not have a corresponding interest deduction. Canadian parent companies may need to refinance their U.S. subsidiaries’ capital structure to avoid this negative impact.

Other provisions

As expected, the Framework calls for immediate deduction of the full cost of business equipment, but only for equipment acquired during the next five years. This would favor any U.S. corporate taxpayer that is seeking to expand in the U.S. market. This could provide an incentive for Canadian businesses to expand in the U.S. at the expense of expanding in Canada.

The Framework calls for a shift to a territorial tax regime for U.S. parent companies that operate outside the U.S. This is intended to make U.S. multinationals more competitive in the global marketplace and put them on the same playing field with many countries, like Canada, that also have territorial regimes. A territorial regime, coupled with a lower corporate tax rate, could provide U.S. multinationals with a competitive advantage in the global marketplace.

The impact on Canadian individuals subject to U.S. tax

Lower tax rates

The Framework calls for lower personal tax rates and provides that the current seven tax brackets be reduced to three: 12%, 25% and 35%. This is unchanged from the Trump Plan, other than the bottom bracket had been originally proposed to be 10%. Although the top rate would be reduced from the current 39.6% to 35%, President Trump has stated that the Framework is not intended to provide tax relief to the top 1%. In fact, the Framework does also provide leeway for a higher fourth tax bracket to be established.

The foreign tax credit system that is in place to prevent double taxation for those subject to both Canadian and U.S. taxation on any given item of income generally results in Canadians ultimately paying tax at the higher of the two countries’ average tax rates. In typical cases where average tax rates in Canada exceed those in the U.S., a reduction in U.S. tax rates may have little or no impact on a Canadian’s overall tax burden, since it is already largely being driven by Canadian tax rates.

Changes to deductions, exemptions, and credits

The Framework calls for the elimination of most itemized deductions, with the notable exceptions of mortgage interest and charitable contributions. In particular, the proposed elimination of the deduction for state and local taxes would potentially increase the U.S. tax applicable to Canadians who work or invest in high tax states such as New York and California.

Furthermore, the standard deduction is proposed to be roughly doubled (from $6,300 to $12,000 for single taxpayers and $12,600 to $24,000 for married individuals filing jointly). To offset this, personal exemptions for individuals and their spouses (currently $4,050 each) would be eliminated.

The Child Tax Credit is proposed to be increased, as are the income thresholds above which the credit is phased out. To offset this, personal exemptions for dependents (currently $4,050 each) would be eliminated. The refundable portion of the credit would still be limited to $1,000. Lower income U.S. citizens and green card holders living in Canada often qualify for the refundable credit, which helps incentivize the filing of their tax returns annually.

These changes could collectively result in either a net increase or decrease in U.S. tax for any given Canadian subject to U.S. tax. Again, a Canadian’s overall tax liability may not be impacted significantly by these changes if it is being driven by Canadian tax rates.

Elimination of alternative minimum tax (AMT) and estate tax

As in the Trump Plan, the Framework still calls for the repeal of the AMT and estate tax. As mentioned in our April Tax Alert, these two taxes can potentially add significantly to the overall tax burden of Canadians, regardless of how high their average Canadian income tax rates may be.

Elimination of net investment income tax (NIIT)

The Trump Plan indicated that the 3.8% NIIT was to be repealed, but the Framework is silent on this matter. The applicability of NIIT to U.S. persons living in Canada is a controversial area, and in many cases it has added to these individuals’ overall tax burden since its adoption in 2013.

In recent months, the Republicans have been unsuccessful in their attempts to repeal the Affordable Care Act (a.k.a. Obamacare) and replace it with alternative legislation not including the NIIT. However, particularly given that the NIIT is designed to apply only to relatively high-income individuals (who are not being explicitly targeted for tax relief under the Framework), the NIIT is perhaps no longer on the chopping block.

Commentary

As the U.S. is proposing to lower business tax rates, Canada is looking to increase taxes, particularly on privately-held companies. The impact of the U.S. lowering tax rates and eliminating the estate tax, while Canada increases taxes, may cause Canadian businesses and Canadian entrepreneurs to relocate to the U.S. Canadians may not expect tax parity with the U.S., but when the differential in tax rates grows, Canadians who are mobile seek to structure their affairs to minimize the impact of higher taxes.

In the event of significantly lowered U.S. tax rates, the Canadian government will need to react to allow Canadian corporations to continue to be competitive in the global marketplace and to provide incentives for Canadian entrepreneurs to remain in Canada.

If you have questions regarding how the proposed U.S. tax reforms in the recently announced Framework might affect you or your business, please contact our U.S. Tax practice Leaders in Canada:

Dan Lundenberg  
Partner, U.S. Corporate Tax Leader 
Jason Ubeika
Partner, U.S. Personal Tax Practice Leader
John McCrudden
Partner, GTA Group U.S. Corporate Tax Practice Leader
Gil Lederhos
Partner, West Group U.S. Corporate Tax Practice Leader









Learn more about our U.S.Tax practice.


The information in this publication is current as of October 3, 2017.

This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.