From dentists to farmers to construction business owners, any Canadian small businessman or professional who is a dual U.S. citizen or green card holder might get an unwelcome surprise at tax time this year, courtesy of the Tax Cuts and Jobs Act. This is due to the one-time transaction tax payable by U.S. persons who own at least 10 percent of voting stock in a privately held non-U.S. corporation, noted Marsha Dungog, director of U.S. tax law at Calgary-based Moodys Gartner.

“The transition tax is 15.5 percent of cash or cash equivalents, and 8 percent on non-tax assets,” she said. “A doctor who has a practice in Canada, and who has dual U.S.-Canada citizenship or a green card and $2 million of accumulated wealth in his corporation, would owe $300,000 from his corporation this year.”

In Canada, most professionals and small businesspeople who are also U.S. citizens do business through a private corporation, according to Dungog. “Up until last year, at least, they enjoyed very favorable tax treatment. [The Trudeau administration proposed last July to limit the favorable tax advantages of private corporations]. They were taxed at a much lower rate, it was possible to give yourself a tax-free dividend if it came from a capital dividend account, and the owner could get tax-free loans from the corporation. There was a lot of flexibility as to how corporations and shareholders manage capital and earnings, and the flow of funds from a corporation to its shareholder and vice versa. And perhaps most important, they can use them as an estate planning tool. When the time comes to pass on the corporation to their children, they can use a planning vehicle called an estate freeze to effectively transfer the future value that’s built up in the corporation to pass tax free to their children.”

Dual citizens with private corporations got the benefit of the foreign tax credit when they calculated their U.S. tax liability, but the transition tax appears not to be affected by the FTC, according to Dungog. “So far, the IRS has put out two notices on the transition tax, but those notices focus on E&P rather than the FTC,” she said. “They are helpful because the statute says the transition tax applies to cash and cash equivalents. It lists short-term loans as cash equivalents. ‘Short-term’ is one year or less, but in the notice issued on January 19, 2018 [Notice 2918-13], it also defines a demand note as being short-term. This could impact many private corporation shareholders, since if you’re the only shareholder of a corporation of course a loan to yourself would be on demand. So the notice lists this as a cash equivalent subject to the transition tax.”

Although the firm’s CPAs and attorneys followed the House and Senate hearings closely, the transition tax in its current form caught them by surprise.

“Nobody expected it to pass so quickly,” she said. “The only planning available – back-dating -- is not a legitimate practice!”

U.S. domestic corporate shareholders of a foreign corporation don’t get hit as hard as individuals, she observed. “The newly enacted dividend participation exemption regime is available only for corporations and not individuals who are U.S. shareholders,” she said. “They’re able to offset the transition tax inclusion amount with dividends.”

While waiting for clarification on the availability of the FTC to offset the transition tax, Dungog advises U.S. shareholders to “scrub” E&P. “Canadian tax uses the retained earning concept in place of E&P, and the two don’t entirely match,” she said. “We’ve found that many times they would transfer retained earnings on the Canadian book and plop it into Form 5471 Schedule J [“Accumulated E&P of a Controlled Foreign Corporation”]. Scrubbing E&P may reduce the amount subject to the tax considerably.”

“The one-time transition tax was supposed to be a ‘pay-to-play’ fee to get you into the dividend exemption regime – 100 percent dividend received deduction from a foreign corporation. But that doesn’t apply to you if you’re a U.S. individual. It’s like buying a ticket to the ball so you can enjoy waltzing around, but you end up being a wallflower because you’re not allowed to dance,” she said. “We’re waiting for Prince Charming to come along and rectify the situation. In this case, Prince Charming may be the IRS with a clarification on the foreign tax credit.”

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Roger Russell

Roger Russell

Roger Russell is senior editor for tax with Accounting Today, and a tax attorney and a legal and accounting journalist.