cross-posted from citizenshipsolutions blog

by John Richardson

Beginning with the conclusion (for those who don’t want to read the post) …

For the reasons given in this post, I believe that there are grounds to argue that the imposition of the Sec. 965 “transition tax” on Canadian resident/citizens DOES violate the Canada U.S. tax treaty. It is my hope that this post will generate some badly needed discussion on this issue.

If you are an individual who believes you may be impacted by the “transition tax”, you should consider raising this issue with the Competent Authority. I would be happy to explore this with you.

Need some background on the Sec. 965 “U.S. transition tax”?

The following tweet references a 7 part video series about the Internal Revenue Code Sec. 965 “Transition Tax” created by John Richardson and Dr. Karen Alpert.

Understanding the @USTransitionTax – the possible implications for small for small business owners who do NOT reside in the United States – A 7 part video series with John Richardson and Dr. Karen Alpert https://t.co/MfsK7ArrcL

— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) February 13, 2018

(Video 6 gives examples of what various approaches to “Transition Tax Compliance” might look like.)

A reminder of what the possible imposition of the “transition tax” would mean to certain Canadian residents

My comment to the article on the @USTransitionTax that appeared in today's Financial Times https://t.co/zBdXxk8nGz. The actual article is here https://t.co/Ch99owa1Ri pic.twitter.com/Bt0Vems8t2

— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) February 5, 2018

Interesting article that demonstrates the impact of the U.S. tax policy of (1) exporting the Internal Revenue Code to other countries and (2) using the Internal Revenue Code to impose direct taxation on the “tax residents” of those other countries.

Some thoughts on this:

1. Different countries have different “cultures” of financial planning and carrying on businesses. The U.S. tax culture is such that an individual carrying on a business through a corporation is considered to be a “presumptive tax cheat”. This is NOT so in other countries. For example, in Canada (and other countries), it is normal for people to use small business corporations to both carry on business and create private pension plans. So, the first point that must be understood is that (if this tax applies) it is in effect a “tax” (actually it’s confiscation) of private pension plans!!! That’s what it actually is. The suggestion in one of the comments that these corporations were created to somehow avoid “self-employment” tax (although possibly true in countries that don’t have totalization agreements) is generally incorrect. I suspect that the largest number of people affected by this are in Canada and the U.K. which are countries which do have “totalization agreements”.

2. None of the people interviewed, made the point (or at least it was not reported) that this “tax” as applied to individuals is actually higher than the “tax” as applied to corporations. In the case of individuals the tax would be about 17.5% and not the 15.5% for corporations. (And individuals do not get the benefit of a transition to “territorial taxation”.)

3. As Mr. Bruce notes people will not easily be able to pay this. There is no realization event whatsoever. It’s just: (“Hey, we see there is some money there, let’s take it). Because there is no realization event, this should be viewed as an “asset confiscation” and not as a “tax”.

4. Understand that this is a pool of capital that was NEVER subject to U.S. taxation on the past. Therefore, if this is a tax at all, it should be viewed as a “retroactive tax”.

5. Under general principles of law, common sense and morality (does any of this matter?) the retained earnings of non-U.S. corporations are first subject to taxation by the country of incorporation. The U.S. “transition tax” is the creation of a “fictitious taxable event” which results in a preemptive “tax strike” against the tax base of other countries. If this is allowed under tax treaties, it’s only because when the treaties were signed, nobody could have imagined anything this outrageous.

6. It is obvious that this was NEVER INTENDED TO APPLY TO Americans abroad. Furthermore, no individual would even imagine that this could apply to them without “Education provided by the tax compliance industry”. Those in the industry should figure out how to argue that this was never intended to apply to Americans abroad, that there is no suggestion from the IRS that this applies to Americans abroad, that there is no legislative history suggesting that this applies to Americans abroad, and that this should not be applied to Americans abroad.

7. Finally, the title of this article refers to “Americans abroad”. This is a gross misstatement of the reality. The problem is that these (so called) “Americans abroad” are primarily the citizens and “tax residents” of other countries – that just happen to have been born in the United States. They have no connection to the USA. Are these citizen/residents of other countries (many who don’t even identify as Americans) expected to simply “turn over” their retirement plans to the IRS???? Come on!

Some of theses thoughts are explored in an earlier post: “U.S. Tax Reform and the “nonresident corporation owner”: Does the Section 965 “transition tax apply”?

And now, on to our “regularly scheduled programming”: The possible use of the U.S. Canada Tax Treaty to as a defense to the U.S. “transition tax”

In Part 1 of this series, I wrote: “Responding to the Section 965 “transition tax”: “Resistance is futile and compliance is impossible“. I ended that post with a reminder that the imposition of Section 965 “transition tax” on Canadian residents has (at least) four characteristics:

1.The U.S. Transition Tax is a U.S. tax on the “undistributed earnings” of a Canadian corporation; and

2. Absent deliberate and expensive mitigation provisions, the U.S. transition tax contemplates the “double taxation” of Canadian residents who hold U.S. citizenship.

3. The “transition tax” is a preemptive “tax strike” against a corporation in Canada. Historically Canada would have the first right of taxation over Canadian companies.

4. The U.S. Transition Tax creates a “fictitious” taxable event. It is not triggered by any action on the part of the shareholder.

The purpose of this post is to argue that the Canada U.S. tax treaty may be a defense to the application of the Section 965 “Transition Tax”

Part A – Exploring what a “Subpart F” inclusion really is

Part B – The Canada U.S. Tax Treaty: Relevant provisions

Part C – Impact of the “Savings Clause”

Part D – The Interpretation of the tax treaty: WHO interprets the treaty and HOW is the treaty to be interpreted

_________________________________________________________________________

Part A – Exploring what a “Subpart F” inclusion really is

Exploring what the “transition tax” really is …

Under the Internal Revenue Code of the United States, the “transition tax” is a “Subpart F” income inclusion. The purpose and effect of the “Subpart F” rules are to attribute income earned by a foreign corporation to the U.S. shareholder(s) of that corporation. This is achieved by creating a “legal fiction” that creates “fake income”. This “fake income” is then “attributed to the individual shareholder” (even though the U.S. shareholder did NOT actually receive the income). This attribution of the corporate income (which the United States cannot directly tax) to the individual (which the United States can tax), allows the United States to impose direction taxation on a “foreign corporation” by imposing direct taxation on the U.S. shareholder instead.

To put it another way:

The Subpart F rules exist for the sole purpose of finding a way to impose taxation on a “foreign corporation”. In this case the Subpart F rules are being used to impose taxation on the “undistributed earnings” of the Canadian corporation. This is achieved by simply attributing the corporate earnings to the individual “United States Shareholder”.

To summarize, the effect of the 965 “transition tax”, is …

The application of the Section 965 “transition tax” would be that the United States would impose taxation on the “undistributed earnings” of a CANADIAN corporation. This is achieved by first creating a “pretend transfer” of the corporate earnings to the individual U.S. shareholder and then imposing taxation on the “individual shareholder”. The effect of this would be to create a situation that would eventually result in “double taxation”. Each of these factual realities must be independently considered in terms of the Canada U.S. “tax treaty”.

Part B – The Canada U.S. Tax Treaty: Relevant provisions

The U.S. Tax On The “Undistributed Earnings” of a Canadian Corporation and the tax treaty

S. 5 of Article X of the Canada U.S. Tax Treaty read as follows:

5. Where a company is a resident of a Contracting State, the other Contracting State may not impose any tax on the dividends paid by the company, except insofar as such dividends are paid to a resident of that other State or insofar as the holding in respect of which the dividends are paid is effectively connected with a permanent establishment or a fixed base situated in that other State, nor subject the company’s undistributed profits to a tax, even if the dividends paid or the undistributed profits consist wholly or partly of profits or income arising in such other State.

To the extent that we are talking about a company incorporated in Canada, it seems clear that S. 5 of Article X of the treaty means that the United States cannot impose a tax on the Canadian company’s “undistributed profits”.

It appears that the Section 965 “transition tax” exists for the sole purpose of imposing U.S. taxation on the “undistributed profits” of the Canadian company. The fact that the taxation is accomplished by creating a fiction that attributes the income to the shareholder does NOT change this reality. WHAT one does, is different from HOW one achieves the goal.

WHAT the transition tax is: The U.S. tax is being imposed on the “undistributed earnings” of a Canadian corporation.

HOW the tax is implemented: The mechanism for collecting the tax is, through the “legal fiction” of using Subpart F to characterize the “undistributed earnings” as “fake income”, and then to attribute the “undistributed earnings” to the income of the individual shareholder. This is what “Subpart F” inclusions have always been. Therefore, it is reasonable to argue that all “Subpart F” inclusions violate the Canada/U.S. tax treaty.

The argument that the “transition tax” violates S. 5 of Article X of the treaty is NOT dependent on the “citizenship” of the shareholder of the Canadian company. The treaty appears to prohibit the United States from imposing taxation on the “undistributed earnings” of any Canadian company period. Since a Canadian company is NOT a “U.S. citizen”, arguments based on the “savings clause” (discussed below) have no applicability.

The U.S. Tax On The “Undistributed Earnings” of a Canadian Corporation and “double taxation” of the individual shareholder

In Part 1 I explained how the “transition tax” would lead to “double taxation”. As a reminder the sequence of events leading to the “double taxation” is summarized as follows:

Re: The question of double taxation

As a reminder, we are discussing the “transition tax” applied to individual shareholders who are “tax residents” of other countries and subject to taxation in those countries.

Here is the order of events as contemplated by the Internal Rev. Code 965:

1. Inclusion of retained earnings in income of U.S. shareholder and U.S. tax paid on that deemed distribution.

2. The 965 deemed distribution is taxable in the U.S. but there is no taxable event in the country of residence and therefore no tax paid in the country of “tax residence”.

3. There is no credit allowed for the U.S. tax paid (in the year the transition inclusion is made) on the individual’s tax return where he actually lives.

4. When the amount that was the 965 distribution is later distributed in the country of tax residence the individual is taxed on that amount a second time.

The amount 965 inclusion is taxed twice (first by the United States and then by the country of residence).

One of the purposes of the Canada U.S. Tax Treaty is (sort of) to avoid double taxation. Article XXIV of the treaty includes:

Article XXIV

Elimination of Double Taxation

1. In the case of the United States, subject to the provisions of paragraphs 4, 5 and 6, double taxation shall be avoided as follows: In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof), the United States shall allow to a citizen or resident of the United States, …, as a credit against the United States tax on income the appropriate amount of income tax paid or accrued to Canada; …

The sequence of events caused by the “transition tax” leads to “double taxation” because of “timing differences” when income is received. The “double taxation” arises because there is NO ACTUAL INCOME REALIZATION event that triggers taxation. Rather the United States has created a “fictitious” taxable event in the United States when there is no corresponding taxable event in Canada. This leads to the absurd and perverse situation where:

• there is an income inclusion (“fake income”) in the United States and not in Canada (generating ONLY U.S. tax); and
• there is a later “real income” inclusion in Canada and not in the United States (generating ONLY Canadian tax)

Interestingly, the United States is creating a “fictitious” taxable event to take a preemptive tax strike against a pool of Canadian source capital. The effect is to “sneak up” and “tax it away” before there is a corresponding “taxable event” in Canada.

It is the “timing mismatch” (let’s go in and tax before Canada would impose a tax) that leads to “double taxation”.

How should the “tax treaty” be interpreted when the United States creates a “fake income” inclusion?

In the case of an “actual distribution” of “real income” …

It is clear that if the “undistributed earnings” were actually distributed, there would be no “timing mismatch”, which would mean that:

– taxes would be paid in Canada; and

– those taxes paid in Canada would be used as a credit to offset U.S. taxes.

In the case of a “deemed distribution” of “fake income” …

It is my respectful submission that the proper interpretation of the U.S. Canada Tax Treaty should be that:

If the United States creates a “deemed distribution” of “fake income” that the shareholder ought to be able to take as a credit against U.S. tax, the amount of Canadian tax that would have been paid in to Canada on that same income. My interpretation is supported by the language in the treaty that specifically allows a credit for taxes either “paid or accrued to Canada”. It would be a gross perversion of the stated purpose of Article XXIV to allow the United States, through the creation of a fictitious event, to create a situation that results in double taxation.

(Interestingly the situation of a fictitious event is considered in S. 7 of Article XIII which appears to deal with “fictitious capital gains” in the context of a “Departure Tax”. My point is that this does reflect an intention on the part of the treaty drafters to NOT allow “fictitious events” to create unreasonable tax burdens on individuals.)

Part C – Impact of the “Savings Clause”

Does the “savings clause” found in S. 2 of Article XXIX (the “Savings Clause”) mean that the United States can impose taxation on the “undistributed earnings” of the company? How would such an argument be made?

To review:

I am making two separate and independent arguments for why the Sec. 965 “transition tax” violates the Canada U.S. tax treaty. The “savings clause” does not apply (and is therefore irrelevant) to each argument.

What is the “savings clause”?

In general the “savings clause” is a provision in almost all U.S. tax treaties that allows the United States to impose U.S. taxation, according to U.S. rules on residents of the other country, that the U.S. considers to be U.S. citizens. In practical terms it is a mechanism that allows the United States, under the guise of “citizenship-based taxation” to impose indirect taxation on the economies of any country, by imposing direct taxation on the residents and citizens of other countries. The “savings clause” makes the definition of “U.S. citizen” important and relevant. Most treaties do include various “exceptions to the “savings clause”.

Bottom line: In most cases, U.S. citizens do NOT get the benefits of U.S. tax treaties!

What does the “savings clause” in the Canada U.S. tax treaty say?

Article XXIX

Miscellaneous Rules

2. Except as provided in paragraph 3, nothing in the Convention shall be construed as preventing a Contracting State from taxing its residents (as determined under Article IV (Residence)) and, in the case of the United States, its citizens (including a former citizen whose loss of citizenship had as one of its principal purposes the avoidance of tax, but only for a period of ten years following such loss) and companies electing to be treated as domestic corporations, as if there were no convention between the United States and Canada with respect to taxes on income and on capital.

3. The provisions of paragraph 2 shall not affect the obligations undertaken by a Contracting State: