Tax Alert – Canadian Implications to the Proposed U.S. Tax Reform – Part 3

November 2017

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On November 9, 2017, the Ways and Means Committee of the U.S. House of Representatives approved the Tax Cuts and Jobs Act (the “Act”), and the U.S. Senate Joint Committee on Taxation released its initial proposed version of the Act. Both versions of the Act outline the tax changes for individuals, businesses, exempt organizations, and foreign taxpayers.

In our September Tax Alert, Canadian Implications of the Proposed U.S. Tax Reform – Part 2 on the previously released Trump Framework, we discussed how the Framework could impact 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 with respect to certain key proposals laid out in both the House and Senate versions of the Act.

The Impact on Canadian Businesses Doing Business in the U.S.

Corporate and Pass-through Tax Rates

The House and Senate Acts would both reduce the corporate tax rate from 35 percent to 20 percent; however, the Senate Act reduction would not take effect until 2019. The rate reduction is consistent with the Trump Framework discussed in our previous Tax Alert. Under the House Act, investors in pass-through entities such as S corporations, partnerships, and limited liability companies (“LLCs”) treated as partnerships will be taxed at a maximum rate of 25 percent. However, the Act limits the 25 percent rate on certain groups such as investors that “materially participate” or professional service providers particularly for income that would otherwise be considered salary or wage income which would be taxed at regular rates. The Senate Act takes a different approach by providing a 17.4 percent deduction for “qualified business income”. The deduction will be limited to half of the actual amount of wages the pass-through entity pays to the owner of the business. Similar to the House Act, professional services providers will have limited access to this deduction.

The key difference between the House and Senate Acts is that the House Act makes a distinction between passive and active participation and the Senate Act does not. However, it is clear that both Acts want to lower the taxes for business income from pass-through entities. As we mentioned in previous Tax Alerts, 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.

Capital Expensing

Prior frameworks promised to allow full expensing of capital assets. The House and Senate Acts propose to keep that promise by allowing businesses to depreciate 100 percent of the cost of new qualifying depreciable assets for the next five years. However, the Senate Act will also change the life of non-residential property from 27.5 years down to 25 years.

The changes are consistent with previous frameworks which expand capital expensing in order to increase business expansion. These changes will also provide an incentive to Canadian businesses that want to expand their activities in the U.S., or enter the U.S. market for the first time.

Modification of Net Operating Loss Deduction

Both Acts call for a limit on the net operating loss deduction a corporation can take in a tax year. The net operating loss deduction would be limited to 90 percent of the taxpayer’s taxable income for that year. Additionally, the Act will repeal all net operating loss carrybacks except for certain special one-year carrybacks for small businesses and farms and will allow net operating losses to be carried forward indefinitely with adjustments to preserve their future value.

Canadian corporations that have historic net operating losses and are now profitable will need to assess their tax exposure if these provisions become law.

Limit on Like-Kind Exchanges

Both Acts narrow the assets that would qualify for a deferred asset swap to real property only.

Contributions to Capital

The House Act would require corporations or partnerships to include capital contributions as gross income unless additional equity is issued. This provision could adversely affect Canadian businesses that seek to capitalize related party debt owing to U.S. subsidiaries.

Limitation on Treaty Benefits

New provisions in the House Act would limit treaty benefits on withholding rates for U.S. sourced payments such as interest, dividends or rents that are deductible in the U.S. A 30 percent withholding rate would apply to any such payment where the payment is made to an entity that shares a common foreign parent, unless a treaty rate reduction is available had the payment been made directly to the common foreign parent.

Interest Deductibility Limitations

Both the House and Senate Acts would limit interest deductions for all businesses regardless of their form to 30 percent of adjusted taxable income. However, under the House Act, businesses with average gross receipts of $25 million or less would be exempt from these interest limitation rules. The Senate Act will allow the unused deduction to be carried forward indefinitely.

From an international perspective, the House Act will repeal the current “earnings stripping” rules and will add an additional interest deductibility limitation for an international reporting group. A U.S. corporation’s interest deduction would be limited to 110 percent of its “allocable share” of the group’s net interest expense based on the U.S. corporation’s share of EBITDA compared to global EBITDA.

A Canadian parent company with a subsidiary may face adverse effects if the subsidiary is highly leveraged and has a small amount of business activity as compared to the parent. The potential result would be for a Canadian parent company to have interest income in Canada with little or no interest deduction in the U.S.

The Senate bill has a proposal that would limit deductions for payments that relate to hybrid instruments and to hybrid entities. The House bill does not have a similar provision. This could impact Canadian corporations that have financed U.S. operations with hybrid instruments, as a U.S. deduction would be denied.

Partial Territorial Tax System

Under current U.S. tax law, U.S. corporate taxpayers are taxed on a worldwide basis. Both the House and Senate Acts include provisions that move the U.S .tax system more towards a territorial tax system. The House Act will exempt foreign source dividends paid by a 10 percent U.S. owned foreign corporation, however businesses will be subject to a deemed repatriation tax of 14 percent on cash and 7 percent on other non-cash assets. The Senate Act would only create a 10 percent repatriation tax rate for cash and 5 percent tax rate for other assets. In addition, the House Act would impose a 10% tax on a U.S. corporation on “high returns” of its subsidiaries if those returns are not reinvested in the foreign subsidiaries.

The move to a territorial system along with lower tax rates is intended to make the U.S. more competitive on the world stage.

Tax on Certain on Payments to Foreign Corporations

From an international perspective, the House Act would impose a 20 percent excise tax on certain payments by a U.S. corporation to a related foreign corporation unless the foreign corporation elects to treat the payments as income connected to the U.S. and subject to U.S. taxes. The new House provision would apply to payments for importing products or for any non-interest fees paid to a related foreign corporation. The Senate Act does not have a similar provision.

These provisions may have a significant effect on Canadian exporters to the U.S. These provisions will most likely increase the cost of Canadian goods that are exported to the U.S.

The Impact on Canadian Individuals Subject to U.S. Tax

Income Tax Rates

The House Act proposes four tax brackets for ordinary income ranging from 12 to 39.6 percent, whereas the Senate Act proposes seven tax brackets ranging from 10 to 38.6 percent. Under both proposals, the top tax bracket applies to taxable income in excess of $500,000 ($1,000,000 for married couples filing jointly).

Under both Acts, tax brackets for qualified dividends and long-term capital gains would continue to range from 0 to 20 percent, breaking at income levels similar to current rules.

In most situations, U.S. average tax rates would continue to be lower than average Canadian tax rates, in which case most Canadian taxpayers subject to Canadian tax on their worldwide income would continue to find that their overall tax liabilities are driven by Canadian tax.

Itemized Deductions and Personal Exemptions

Consistent with the Framework, both the House and Senate Acts still propose to increase the standard exemption for U.S. citizens and green card holders to $12,000 ($24,000 for married couples filing jointly), and eliminate personal exemptions and most itemized deductions.

The most notable itemized deduction slated to be eliminated is state and local taxes, a highly controversial proposal that continues to be the subject of much debate by lawmakers and lobbyists. Under the House Act, a deduction for real estate property taxes would still be permitted, but only to a maximum of $10,000.

Itemized deductions for mortgage interest and charitable contributions would be preserved under both Acts. However, the House Act would generally limit mortgage interest deductions to the interest on up to $500,000 of debt (reduced from $1,000,000), and both Acts would allow cash contributions to be deducted up to 60 percent of adjusted gross income (increased from 50 percent).

Canadians who are nonresident aliens of the U.S. are currently eligible to claim personal exemptions, but are ineligible to claim standard deductions, and must therefore itemize their deductions. The result of the elimination of personal exemptions and the itemized deduction for state and local income taxes may be that these taxpayers are subject to U.S. tax on income such as U.S. employment income and U.S. net rental income without the benefit of any offsetting deductions or exemptions at all.

Shareholders of Canadian Private Corporations

The proposed changes in these tax reform bills that move the U.S. towards a territorial taxation system for businesses would also generally apply to U.S. citizens and green card holders resident in Canada who have shareholdings of over 10 percent in Canadian private companies.

U.S. taxation of corporate profits prior to distribution to U.S. shareholders as dividends is currently generally limited to situations where the corporation generates “passive” income, such as income from a portfolio of marketable securities. The proposed provisions would also potentially apply to corporate income from active business. As a result, U.S. shareholders living in Canada may be prematurely compelled in a wider variety of situations to distribute corporate income to themselves via dividends to generate corresponding Canadian personal tax and avoid double taxation.

Principal Residence Exclusion

Under both proposed Acts, U.S. citizens and green card holders selling their Canadian principal residences are still eligible to exclude from taxable income the first $250,000 of the resulting gain ($500,000 for married taxpayers filing jointly). However, to qualify for the full exemption, it is proposed that one must occupy the property for at least 5 of the 8 years prior to sale, rather than only 2 of the 5 years prior to sale. Since the capital gain is typically fully exempt from Canadian tax, this proposed change increases the likelihood that the sale of a Canadian home will result in U.S. tax for a Canadian resident.

Alternative Minimum Tax (AMT)

The House and Senate Acts both propose to repeal the AMT, consistent with the Framework. For many U.S. citizens and green card holders, this would result in net tax savings, since the AMT is not always eligible to be reduced by foreign tax credits for Canadian tax paid, nor is it creditable against Canadian tax.

Estate and Gift Tax

The House and Senate Acts both propose doubling the estate tax exemption and lifetime gift tax exemption from $5 million to $10 million for 2018, subject to inflation adjustments. The House Act takes this a step further for years after 2023 by repealing the estate tax altogether, and reducing the gift tax rate from 40 to 35 percent. Both Acts propose to continue allow heirs to benefits from a “bump” in the cost basis of inherited assets up to the fair market value of the property at the date of death such that capital gains only apply on the growth in value of the property from that point forward.

U.S. citizens facing exposure to estate tax on their worldwide assets and noncitizens facing exposure to estate tax on their U.S. situs assets such as U.S. real estate and U.S. marketable securities may find that their exposure to estate tax is significantly reduced or eliminated under the new provisions, perhaps reducing or avoiding the need for complex planning initiatives to counteract the exposure to tax.

Conclusions

There are still significant steps in the legislative process that need to occur for any law to be enacted. The House of Representatives and the Senate must first pass their respective bills and come to an agreement on one bill. Even though the Trump administration is maintaining that their goal is to pass a final bill before the end of the year, whether they will be able to achieve this is still uncertain given the current climate in Congress.

In addition to reconciling differences in both Acts, the proposed changes must have an overall cost of $1.5 trillion over the next ten years in order to pass the bill in the Senate with a simple majority (51 votes) rather than a supermajority (60 votes). Furthermore, it is a possibility that certain provisions in the legislation will be subject to sunset clauses that will require the legislation to expire after 10 years and revert to the law that existed prior to the Act. Despite these uncertainties, both versions of the Act certainly give further insight as to the direction of any proposed changes to U.S. tax law.

If you have questions regarding how the proposed U.S. tax reforms in the recently announced draft bills 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 November 14, 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.