The Tax Cuts and Job Act (the “Act”) has passed Congress and has been signed into law by President Trump. The Act is the most far-reaching tax reform in the US since the Tax Reform Act of 1986. In our series of tax alerts, we have tracked the progress of tax reform and its potential impact on Canadian businesses with U.S. operations, and Canadian individuals who file U.S. tax returns.
In Part 4 of our series on U.S. tax reform, we outlined the more significant provisions of the Act, and we provided our first impressions on the potential impact on Canadian businesses with U.S. operations, and Canadian individuals who file U.S. tax returns.
Watch our on demand webinar where we discussed the implications of the tax reform for corporations and individuals.
Business Tax Measures
Corporate income tax rates – flat 21 percent tax effective Jan 1, 2018. Unlike Canada, the U.S. has historically had a graduated corporate income tax regime. Under law through December 31, 2017, U.S. corporate tax brackets range from 15 to 35 percent. The Act provides for a 21 percent flat corporate tax rate effective for taxable years beginning after December 31, 2017.
U.S. corporate taxes have generally been higher than Canadian corporate taxes, often resulting in excess/unused foreign tax credits, complex intercompany transactions, or other planning to minimize taxable income in the U.S. A 21 percent flat corporate tax rate will simplify future corporate expansions into the U.S., and will necessitate a rethink for Canadian businesses with existing U.S. operations.
Flow-through entities – 20 percent deduction for qualified business income. A 20 percent deduction is available for “qualified business income” earned through a flow-through entity, i.e. partnerships, S corporations, and limited liability companies. Given the top marginal tax bracket for individuals is also reduced (discussed below), this 20 percent deduction results in a top marginal rate on qualifying business income of 29.6 percent.
Because Canadian personal and corporate income tax rates are generally higher than their U.S. equivalents, this measure may not result in tax savings for Canadian residents. However, this reduced tax rate for business income earned through a flow-through may entice highly mobile Canadian entrepreneurs to relocate to the U.S. to live and start new businesses.
Deductibility of interest – capped at 30 percent of EBIT until January 1, 2022, 30 percent of EBITDA thereafter. For taxable years beginning after December 31, 2017, an interest deduction against business income is subject to a cap for taxpayers whose annual gross receipts from a U.S. trade or business are generally more than $25 million. The limitation for taxable years beginning after December 31, 2017 and before January 1, 2022 is effectively 30 percent of earnings before interest and tax (“EBIT”). For taxable years beginning after December 31, 2021 the limitation will effectively be 30 percent of earnings before interest, tax, depreciation and amortization (“EBITDA”). Interest deductions that are disallowed by this rule are carried forward indefinitely.
Canadian businesses have often used internal financing to minimize U.S. tax. This may be unnecessary given the reduction in U.S. corporate tax rates. While there may be tax and non-tax reasons to use internal financing to fund U.S. expansion, these new limitations may result in non-deductible interest.
100 percent deduction for certain capital expenditures – includes second-hand property. Property placed in service after September 27, 2017 and before 2027 is entitled to special depreciation equal to the entire cost. This rule applies to the purchase of both new and used property. The special depreciation generally does not apply to real property used in a real estate business.
For Canadian businesses looking to acquire business assets in the U.S., whether through a branch or a corporate subsidiary, it is now even more important to evaluate the benefits of an asset purchase versus a share purchase.
NOL carryforward deductions capped at 80 percent of taxable income, no carryback but indefinite carryforward. Net operating loss (“NOL”) carryforward deductions are limited to 80 percent of taxable income (before the NOL deduction). This rule applies to losses incurred in taxable years beginning after December 31, 2017. Additionally, the 2-year carryback of losses is eliminated.
It is not uncommon for Canadian and U.S. current year loss recognition or loss carryforward rules to differ, causing potential mismatches in income recognition and creditability of foreign taxes for cross-border businesses. This change causes another such instance where cross-border taxpayers and their advisors need to be mindful.
Personal Tax Measures
Tax rates – top rate reduced. Only the Senate’s bill had a modest top marginal rate reduction, from 39.6 to 38.5 percent. Somewhat surprisingly, the Act reduces these rates further, moving the top marginal rate down to 37 percent for single filers with income over $500,000 and for married taxpayers filing jointly with income over $600,000. This rate structure is in force for 2018 taxable year, and will revert back to 2017 rates in 2026.
With the Canadian combined federal/provincial top rate exceeding 50 percent in many provinces, the lower U.S. tax rates is of limited benefit to Canadian residents, as they ultimately pay the higher of the U.S. and Canadian taxes on that income. But it may become more attractive for high net worth mobile Canadians to relocate to the U.S. given the direction of the U.S. tax system compared to the recent proposed increases in Canadian personal taxation for private businesses.
Standard deduction – almost doubled. In 2018, the standard deduction for individuals filing U.S. tax returns and not electing to itemize deductions increases from $12,700 to $24,000 for married taxpayers filing jointly, and from $6,350 to $12,000 for single filers. Personal exemptions are eliminated.
This change may either increase or decrease U.S. taxes for U.S. citizens and green card holders living in Canada, depending on their circumstances. Canadians filing U.S. nonresident tax returns have historically been ineligible to claim the standard deduction, so the lack of personal exemptions results in more situations where tax is owing.
State and local taxes – itemized deduction to a cap of $10,000 – foreign income taxes uncapped, foreign real property taxes not deductible. For 2018 through 2025, state, local, and foreign income taxes continue to be eligible for itemized deductions. However, in the case of U.S. state and local income and property taxes, the deductionis limited to $10,000 ($5,000 for married taxpayers filing separately). Foreign income taxes that are not eligible for a foreign tax credit can be itemized as a deduction without a cap. Foreign real property taxes cease to be deductible altogether. An anti-abuse rule provides that prepaid state and local income taxes are treated as paid on the last day of the taxable year to which they relate to determine the applicability of the cap.
U.S. taxpayers who have historically itemized a deduction for Canadian real property taxes may consider prepaying these property taxes before the end of 2017 (if permitted by their municipality) as there does not appear to be a similar pre-payment anti-abuse rule applicable to foreign real property taxes.
Mortgage interest deduction – existing mortgages grandfathered; new debt capped. Up to now, mortgage interest on qualified residence indebtedness up to $1 million and on home equity loans up to $100,000 has also been available as an itemized deduction for U.S. citizens and green card holders living in Canada. Under the Act, for 2018 through 2025 this deduction would only be available for interest paid on acquisition indebtedness up to $750,000 and interest on home equity loans no longer qualifies. Acquisition indebtedness incurred on or before December 15, 2017 is not subject to the limitations. After 2025, the limit on acquisition indebtedness will return to $1 million.
The U.S. mortgage interest deduction is available for interest paid on mortgages on qualified residences located outside of the U.S. The Act does not change the definition of “qualified residence” for this purpose.
Alternative minimum tax - exemption increase. The alternative minimum tax (AMT) provides a parallel tax system with restrictions on deductions and different tax rates. AMT applies only if it exceeds regular tax, and only on that incremental increase. The exemption amount is $84,500 for married taxpayers filing jointly, and $54,300 for single filers. However, for the years 2018 through 2025, the AMT exemption amount increases to $109,400 for married couples filing jointly, and $70,300 for unmarried single filers. Income thresholds for phase-out of these exemptions would also increase.
The Act is not as favourable as the original House bill, which proposed a complete repeal of AMT. However, the increase to the exemption should provide some relief to Canadians. The AMT is typically not creditable on the Canadian tax return, so a reduction in AMT will be a true tax savings.
Estate and gift tax – doubling of exemption. Currently, the lifetime exemption amount is $5 million, indexed for inflation. The Act follows the Senate bill and provides, for estates of decedents dying and gifts made after 2017 and before 2026, for the doubling of the lifetime exemption amount to $10 million. The $10 million is indexed for inflation occurring after 2011.
The exemption amount increase is welcomed news for U.S. citizens and non-citizens in Canada alike. The increased exemption limits the application of the estate tax to their worldwide assets and U.S. situs assets, respectively, and provides significantly more flexibility for estate planning.
International Tax Measures
Sale of certain U.S. partnership interests by non-residents taxable in the U.S. Since at least 1991, the IRS has been of the view that the sale of partnership interests by a foreign person is taxable in the U.S. as “effectively connected income” to the extent the partnership is engaged in a U.S. trade or business (through a permanent establishment (“PE”) if a tax treaty applies). The Act codifies this historical interpretation into statutory law and overturns a recent case that called into question that IRS’s long-standing position.
Canadians owning U.S. business assets through a partnership need to be mindful of U.S. taxation of gains on sales of partnership interests where the partnership is engaged in a U.S. trade or business through a PE.
Transition tax on previous earnings of CFCs. As the U.S. is moving to a territorial system with respect to its outbound tax system, a transition tax will be imposed with respect to not-previously-taxed post-1986 earnings and profits (“E&P”) of controlled foreign corporations (“CFCs”). The inclusion mechanics are complex and are intended to result in a 15.5 percent rate of tax for not-previously-taxed post-1986 E&P that is held in the form of cash and cash equivalents and an 8 percent rate of tax on not-previously-taxed post-1986 E&P that has been reinvested in non-cash assets.
Transition tax can potentially apply to U.S. citizens resident in Canada who own as little as 10% of the shares of Canadian corporations. Planning possibilities are limited given the retroactive measurement date for E&P and asset composition (November 9, 2017).
10 percent surtax on U.S. corporations making base-eroding deductible payments to foreign related parties. The Act imposes a “base erosion minimum tax”. Though complex, it is very generally a 10 percent tax on a measure of income after adding back certain payments that are considered to be eroding the U.S. tax base. This tax is only applicable to corporate U.S. taxpayers with 3-year average annual gross receipts of at least $500 million and (very generally) at least 3 percent of their allowable deductions being base-eroding payments.
This rule applies to Canadian multinationals. Mid-market Canadian corporations with U.S. operations need to monitor this complex provision to determine its application.
Non-capital-intensive returns in CFCs – global intangible low-taxed income (“GILTI”). A U.S. shareholder’s pro rata share of CFC earnings above a benchmark 10% return on capital invested in tangible assets is included in U.S. shareholders’ income under the subpart F anti-deferral rules. For corporate U.S. shareholders, the Act provides a 50 percent deduction (37.5 percent reduction for taxable years beginning after December 31, 2025). Corporate U.S. shareholders are also entitled to an 80 percent indirect foreign tax credit for foreign taxes paid on such GILTI.
For U.S. citizens resident in Canada owning private corporations, this subpart F income inclusion has the potential to be detrimental to normal business operations. An otherwise active business operated through a Canadian corporation earning high returns on invested capital (particularly a service corporation with little invested capital) could be subject to GILTI. Canadian corporations owned by a U.S. citizen in such a scenario may be able to exclude these earnings from subpart F income under the “high tax kickout” rules, provided that Canadian corporate tax rates are at least 90 percent of U.S. corporate tax rates (i.e. 18.9 percent) with the new 21% rate provided in the Act.
Hybrid transactions and entities – U.S. deduction denial. The Act denies U.S. deductions for interest or royalties paid or accrued to a related party where (1) there is no corresponding inclusion to the related party under foreign law; or (2) the related party is allowed a deduction for such amount under foreign law.
On its surface, U.S. interest deductions in both cross-border repurchase (“REPO”) and so-called “tower structures” could be denied under these rules. Canadian taxpayers with hybrid financing or hybrid entities paying or receiving interest or royalties that would otherwise be deductible in the U.S. should review their structures.
If you have questions, please contact our U.S. Tax practice Leaders in Canada:
Partner, U.S. Corporate Tax Leader
Partner, U.S. Personal Tax Practice Leader
Partner, GTA Group U.S. Corporate Tax Practice Leader
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 December 22, 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.