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The Tax Cuts and Jobs Act: No Respite for Americans Living Abroad


​​​​​​The U.S. keeps looking to people abroad to pay tax. For a long time, it was the Alternative Minimum Tax. Now there are more “gotcha” taxes waiting in the wings.

The U.S. is the only country in the world that taxes citizens on their worldwide incomes on the same basis as residents.1 There was some hope the U.S. would join the rest of the world and move to residency-based taxation. There was growing momentum, with Grover Norquist, President of Americans for Tax Reform, and the U.S. Chamber of Commerce, supporting the move. It has been Republican policy since 2014.

It is sad to see this change was not made. Americans abroad (including in Canada) will continue to be subjected to the same U.S. tax and filing requirements.

Americans abroad with corporations

Recently, Kevin Brady, the current chairman of the U.S. House Ways and Means Committee, introduced the Tax Cuts and Jobs Act [HR 1]. It contains all sort of goodies, but it also contains a revenue-raising measure that will hit hard at some Americans living in Canada who hold shares in Canadian corporations.

These rules are particularly challenging where those individuals have closely-held corporations. This practice is quite common around the world, but especially so in Canada.

The U.S. has a controlled foreign corporation (CFC) regime, much like those of other countries. It is designed to protect capital export neutrality – a fancy way of saying ‘we don’t want Americans to set up companies in the Cayman Islands to earn tax-free investment income.’

This is a sensible and necessary policy. The problem arises when combined with citizenship-based taxation: many American professionals living in Canada using Canadian corporations in the ordinary manner can get double taxed.

Under the current rules, in most cases, it is possible to do a small amount of work tracking how funds are earned, used and distributed to avoid double taxation. But two new proposals in the Tax Cuts and Jobs Act inadvertently catch many of these people. These are the “Foreign High Return Amount” and treatment of prior year earnings.

Foreign High Return Amount

The way the U.S. makes foreign investment companies unattractive is by ensuring the foreign company`s investment income is included in the income of the domestic shareholder. This treatment is extended to some other types of “mobile” income. The U.S. calls this “Subpart F” income.

The U.S. is about to add another category: foreign high returns. The basic idea is if your foreign subsidiary earns especially high returns on its investment, then 50 percent of that will be treated just like Subpart F.2

The foreign high return amount is the company’s income, less a base return. The base return is the U.S. short-term applicable federal rate (now 1.27 percent), plus 7 percent, multiplied by the U.S. tax basis of qualified business assets (which are tangible assets only).

For a capital-intensive business, this may not be a problem. But for a services business (say, consulting or medicine), or one that is simply doing very well, this new rule will play havoc with owner-manager planning. This is particularly true with U.S.-citizen professionals in Canada who have corporations.

The purpose of this new rule is to limit the ability of U.S.-based multinationals to shift active business income offshore, and thereby avoid U.S. tax.

There does not appear to be any exception for corporations paying sufficient tax in the local country, as there is for most types of Subpart F.3

This rule is problematic, simply because it takes no account of the business realities in different locales. It simply assumes (a) an arbitrary threshold for high income, and (b) that the existence of high-income subsidiaries means the U.S. parent is shifting profit abroad.

That’s bad enough, but the rule – meant for U.S. multinational corporations - inadvertently catches U.S. citizens abroad who are using corporations located in the same countries as which the individuals live.

Election to pay tax at corporate rates

The U.S. allows an individual to made an election to pay tax on subpart F income at corporate tax rates. It allows for a foreign tax credit for the foreign corporate tax (which is not ordinarily allowed to an individual). Upon distribution, there is a second layer of personal tax.4

It is not clear whether this election will be available in respect of high-return income.

With the new, lower U.S. corporate tax rate (20 percent), the corporate foreign tax credit may often reduce the U.S. tax. This may not work completely where the corporation is eligible for the Canadian Small Business Deduction, because the Canadian corporate rate will be only 9-17 percent. Even then, the foreign tax credit appears to be limited to 80 percent of the foreign tax actually paid, with no carryovers.5 And it can’t be combined with (“cross-credited” against) other higher-taxed income.

The personal foreign tax credit should offset the second layer of tax (as is currently the case).

Prior year earnings

Retained earnings, measured on a U.S. tax basis (called “earnings and profits”) as of the last year end prior to January 1, 2018, will be treated as subpart F income. This income will be subject to tax at a rate of 12 percent for cash and near-cash, and 5 percent for other assets. The tax can be paid in eight annual instalments.

Again, to avoid double taxation, it may be necessary to have the corporation pay out dividends, generating Canadian personal tax to use as a foreign tax credit. These foreign tax credits are restricted in a complicated manner.

Not yet law

These provisions are not yet law and the scope could be narrowed prior to enactment. There are groups you can contact, such as American Citizens Abroad, if you wish to discuss the impact of this provision.​

​​Table 1I​n this example (assuming 100% ownership by the U.S. shareholder), s/he would include $237,595 in U.S. income, whether or not the amount was distributed by way of dividends. Such an inclusion could create up to $94,000 of U.S. tax.

The U.S. allows a foreign tax credit in respect of Canadian tax. This would be “general basket” income, so it gets mixed in with salary and other items. Dividends from the corporation would create Canadian tax that would help offset this tax.

If there were insufficient Canadian tax, the foreign tax credit would not offset this amount, and the owner would pay U.S. tax. This U.S. tax would not be creditable in Canada. Effectively, this provision would force many owners to cause corporations to pay out dividends larger than they would otherwise wish, reducing the benefit of using a Canadian corporation.

For more information, contact Kevyn Nightingale, CPA, CA, CPA (IL) TEP, at 416.596.1711 or [email protected]

1 Eritrea taxes citizens worldwide, but uses the local country’s tax return for assessment.
2 TC&JA §4301
3 IRC §954(b)
4 IRC §962
5 TC&JA §4101​​