Cross-posted from the citizenshipsolutions blog
Part 1: Responding to The Section 965 “transition tax”: “Resistance is futile” but “Compliance is impossible” https://t.co/HMUi0Nw1rU
— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) March 2, 2018
Introduction and background …
“This legislation is being interpreted by a number of tax professionals to mean that individual U.S. citizens living outside the United States are required to simply “fork over” a percentage of the value of their small business corporations to the IRS. Although technically “CFCs” these companies are certainly NOT foreign to the people who use them to run businesses that are local to their country of residence. Furthermore, the “culture” of Canadian Controlled Private Corporations is that they are actually used as “private pension plans”. So, an unintended consequence of the Tax Cuts Jobs Act would be that individuals living in Canada are somehow required to collapse their pension plans and turn the proceeds over to the U.S. government” -John Richardson
I have previously suggested that the Section 965 “transition tax” should not be interpreted to apply to Americans abroad. This argument was based largely on a “lack of legislative intention” coupled with the fact that individuals (whether in the USA or living abroad) do NOT get the benefits of the transition to “territorial taxation”.
These are difficult times for many Canadians who are the owners of Canadian Controlled Private Corporations. Canadian residents use Canadian Controlled Private Corporations (“CCPCs”) to operate small businesses and to create pension plans for their retirement. Importantly a Canadian corporation meets the definition of a “CCPC” only if it is controlled by residents of Canada. By definition all “CCPCs” are local to their owners. The use of “CCPCs” reflects the reality of Canadian tax laws going back to 1972. Governments the world over are taking steps to ensure that corporations cannot be used for the deferral or avoidance of taxation.
The election of the Trudeau Liberals resulted in the Government of Canada taking an interest in “Tax Reform” (or at least “tax reform” in relation to Canadian Controlled Private Corporations. On February 27, 2018 Finance Minister Morneau delivered the Liberals third budget. Although not widely publicized, the budget including major changes in how the passive income of CCPCs is to be taxed in Canada.
Of course those “CCPC” owners who have U.S. citizenship must also deal with the U.S. tax system. Interestingly, both the Government of Canada and the Government of the United States have the owners of “CCPCs” on their radar.
Canada – On the “Home front” (meaning in Canada) the Liberal Government of Justin Trudeau and Finance Minister Bill Morneau are targeting the “retained earnings” in their corporations. Specifically they believe that “retained earnings” that were subject to the lower small business tax rate provide an unfair tax deferral, resulting in more capital to invest, which allows for the creation of additional passive income. The February 27, 2018 Canadian budget is a direct response to this perception.
The United States – The “Homeland” has just passed the TCJA (“Tax Cuts Jobs Act”). One provision of the TCJA amended Internal Revenue Code Section 965 to impose a one time tax on the “United States shareholders” of “Deferred Foreign Income Corporations” (a “DFIC”). This tax is based on the “undistributed earnings” of corporations. The application of this tax to U.S. citizens living outside the United States is newsworthy, is debatable (and is being debated). The application of the Section 965 “transition tax (assuming the applicability of the tax to Canadian resident owners of “CCPcs”), would be a direct, retroactive tax on the “retained earnings” of Canadian Controlled Private Corporations. Notably these “retained earnings” were NEVER subject to U.S. taxation before (it’s retroactive). The mechanism that the U.S. Government is using to impose direct taxation on the retained earnings of “CCPCs” is to (1) attribute the corporate undistributed earnings to the individual shareholder and (2) impose taxation directly on the individual shareholder. For “Tax Geeks” (and those who want boring cocktail conversation), from a U.S. perspective this process of income attribution is called “Subpart F” income. (You can learn all about it by reading Internal Revenue Code Sections 951 – 965). I emphasize that a Subpart F inclusion (by definition) attributes corporate income to a “shareholder” without any realization event whatsoever.
Leaving aside the theory, the reality is that for many Canadian residents, the application of this Section 965 “transition tax” would operate to effectively “confiscate” their pension plans. “Confiscation” is what is really happening. But, “tax professionals” refer to this process of “confiscation” as a “Subpart F” inclusion.
An simple example of a “Subpart F” inclusion (assuming that the U.S. Section 965 “transition tax” applies to Canadian residents) …
John Smith lives in Canada and is a Canadian citizen. He was born in Canada to a U.S. citizen father. He is therefore considered to be a U.S. citizen living in Canada. John Smith also has a small business and over a 30 year period has managed to accumulate 1 million dollars of undistributed income in his corporation. He dutifully files his U.S. tax returns every year. Understand that this 1 million dollars of retained earnings was never subject to U.S. tax. On December 22, 2017 President Trump signed the TCJA which (according to a majority of “tax professionals”) retroactively subjects that 1 million dollars to a one time U.S. tax. So, John would be required to include 1 million on his U.S. tax return for a one time
confiscation tax. Note that there is no “taxable event” in Canada. So, in theory, John Smith would be required with respect to the 1 million dollars to FIRST pay tax on it in the United States and SECOND pay tax on it Canada. In other words, (assuming the applicability of the tax) it would amount to:
1. A U.S. tax on the undistributed earnings of a Canadian Corporation (Say what??) (this is accomplished through the “back door” by imposing the tax on the shareholder and not the corporation); and
2. Very likely “double taxation”. The sequence of events leading to the “double taxation” are:
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).
Bottom line: Both Canada and the United States have a very keen interest in the “retained earnings of Canadian Controlled Private Corporations”. It’s too bad that you have one.
The response of the “tax compliance industry” …
Karen Alpert (of “Fix The Tax Treaty“fame) in a comment to recent post about the Transition Tax, published at “Tax Connections” writes:
It is frustrating that much of the tax compliance industry seems to be just rolling over on both the transition tax and GILTI. They are writing articles that tell US expats that they must just comply, even when compliance will have a serious adverse effect on planned retirement savings and the financial viability of businesses owned by US expats.
Where are the tax professionals who are working on ways to get around a literal interpretation of the legislative language? Is Congressional intent irrelevant? Are there treaty positions that could be taken, or appeals that could be made to the Competent Authorities under the tax treaties that these TCJA provisions are contrary to the intent of the treaty? Are there other avenues to challenge this law in the courts? Is anyone pursuing change or clarification from Congress (or the IRS)?
Resistance is futile!
Think of it! The tax compliance industry is largely telling people that the Section 965 “transition tax” applies to them and they must surrender a good part of (what is for many) their pensions to the IRS. An interesting discussion of the “Resistance if futile” principle is found in the Facebook discussion in the following tweet:
Taxes, the @USTransitionTax, the news and #FakeNews – What is fake, what is real? Do the taxpayers or does the tax compliance industry get to decide which is which? Great Facebook discussion going on … https://t.co/j5txASpFdi
— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) March 1, 2018
Some “tax professionals” are behaving as though the United States is an “occupying power”, the “tax professionals” are the representatives of the United States and their role is to impose the “transition tax” on a conquered people (The “It’s U.S. law” principle.)
Compliance is impossible!
While the tax compliance industry continues the “Resistance is futile” drumbeat, Canadians with undistributed earnings in CCPCs are dealing with the reality that “compliance is impossible”. The reasons for the impossibility are both “contextual” and “logistical”. Both set of reasons are discussed in the 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.)
Contextual reasons that compliance is impossible …
– “Tax professionals” are just as confused about how to impose the tax on Canadian individuals, as individuals are about what is expected of them
– some modes of compliance (for example the Sec. 962 election will require records that may no longer exist
– few (if any) have financial statements that have been done according to U.S. accounting principles
– the rules are even less understood for those corporations do not have a December 31, year end
– there is a lack of agreement on what percentage of certain Canadian taxes can be used as a tax credit, etc.
Logistical reasons that “compliance is impossible” …
– assuming the application of the “transition tax”, as Charles Bruce of “American Citizens Abroad” fame notes, people may not have the money to pay the tax. After all, this is a retroactive tax with no “realization event”
– in order to find the money to pay the “transition tax”, the corporation would have to sell assets. The effect of the sale would be to generate further taxes and so on and so on …
– in order to find the money to pay the transition tax one could: First, renounce U.S. citizenship (meaning that one would no longer be subject to U.S. tax jurisdiction) and then Second, sell his/her principal residence in Canada (which would then be a tax free capital gain) and use the proceeds of the sale to pay the tax!
Readers should understand that the operation of the “transition tax” is the confiscation of the assets (and for some is their pension).
The “tax compliance industry” teaches that, when it comes to the Section 965 “Transition Tax”:
“Resistance is futile” (according to most tax professionals) and “Compliance is impossible”.
Rather than accepting that “Resistance is futile”, let’s consider how the Canada/U.S. Tax Treaty might impact this issue.
In closing please remember four basic points:
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 “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.
This concludes Part 1. In Part 2 I will explore how the U.S. Canada tax treaty may provide some protection from the Section 965 transition tax.
…and if they know nothing, tell them nothing
Plaxy – the technical explanation you’ve quoted deals with dividends. With the repatriation tax, there is no dividend. The US is taxing the undistributed earnings of a Canadian corporation. This position is arguing that the relevant taxpayer is the corporation, not the shareholder. US law is inventing a fictional transaction (a “deemed repatriation”) and attempting to tax funds that are sitting inside a Canadian corporation and have not been distributed to a US citizen.
Thank you Karen for steering us straight with your depth of knowledge and expertise. Your voice rises above the din, so to speak for me. As someone who is potentially affected by this tax it’s important to me that no time is wasted in going down blind alleys or lost in distractions that are better aimed at people unaffected by this law.
“This position is arguing that the relevant taxpayer is the corporation, not the shareholder. ”
Unfortunately it’s not the corporation that will be signing the return.
“US law is inventing a fictional transaction (a “deemed repatriation”)
Exactly. They deem that the money has been distributed to a US citizen, so that they can demand that the US citizen should send a percentage of the deemed-distributed money to the IRS. It doesn’t matter in the least that no distribution has actually taken place, because the US is ordering the US citizen to pretend that it has. So that they can “tax” it.
The IRS wouldn’t get sidetracked by arguments about the unreality of the imaginary basis of the whole charade. Why would they? The IRS would simply have a look at the attached 8833 and set about correcting the AGI in order to re-calculate the tax due, using the 1985-2017 E&P data the USC has so helpfully provided.
It’s up to the USC owner of the foreign corporation to decide whether they do or do not want to accept the US pretence that their corporation’s past earnings have been distributed to them. If they decide to go along with the pretence, for the sake of buying continued “good standing”, then they’ll need to send the IRS its cut.
Pretending to go along with the pretence and then trying to edit the playbook so that the story ends with the IRS not getting paid, is simply not going to work.
I suspect most USCs know that – or if they don’t understand it now, once they take a good hard look at 8833 and its underlying statute (26 CFR 301.6114-1), all will become clear.
The taxation of USCs who don’t reside in the United States is based on fiction. The US government deems them to be US residents even though they clearly are not. The US government then claims the right to tax them based on that fictional residence.
Seems to me that arguing that the tax shouldn’t apply because its based on a fictional event will be a non-starter with the IRS because all of US extraterritorial taxation is based on fiction. Fiction doesn’t bother them in the slightest. Anyone who has chosen to be compliant has, in effect, “bought into” the fiction and will likely find it impossible to argue to the contrary.
Yes I agree. It’s all fictional. Including, for USCs, the treaty which purports to avoid double taxation. As CBT is essentially double taxation and endorsed (for USCs) by the treaty which claims to prevent it.
One thing that has always boggled my mind is the propensity of governments to “deem” things. (And I’m not just talking about the US government; they all do it.) If a government “deems” black to be white, then legally speaking, from that point on black is officially white even though there is absolutely no basis in reality. (Talk about an exercise in creating alternative facts!)
I decided I could make this sort of silliness work for me. Being a self-relinquisher (i.e. there’s no way I’m going to pay $2350 for a CLN), I decided I’d just go ahead and unilaterally “deem” myself to no longer be a US citizen. Voila!….I’m no longer a US citizen and everything is working out just fine. I figure if they can do it, I can do it. And at least my “deeming” has the advantage that it is actually based on reality.
Every time I enter the US with my Canadian passport showing US birthplace, I’ve deemed myself to be Canadian only.
As far as CBT is concerned I think the deeming (and the willingness of at least some of the deemed-against to go along with it) is the only way it could ever be made to work.
It worked fine for decades, with most of us USCs completely oblivious. Then the Democrats lost sight of the deeming and behaved as if it was real.
After trying to understand this new tax, including reading here (http://www.taxwarriors.com/blog/mandatory-transition-tax-on-certain-deferred-foreign-income-part-i) I am close to giving up. It seems that the only sane thing to do, if possible, is to ignore it. I would argue that it would be ethical for compliance professionals to inform clients that ignoring something may be the most reasonable action. For instance if the US were to make a law saying that if you live in a foreign land you must, as a US Person, jump out the nearest window, would it be advised to do so? If you don’t, you’ll be breaking the law, but if you do you’ll be breaking your neck. Sending a huge portion of your life savings to Uncle Sam seems to me quite similar.
The Transition/Repatriation Tax fits the definition of “tribute”, when there is no benefit from what the tax is intended to provide.
US law already requires perjury. If you alter the jurat to tell the truth (e.g. if a US company issues a falsified Form W-2 to you and you try to declare that to the best of your knowledge and belief the W-2 is NOT true and correct) then the IRS confiscates your refund and adds penalties to boot.
US law already requires fabricating social security numbers. If you submitted an application for social security number for your non-resident alien spouse (which the IRS used to require before the IRS invented ITINs) and the Social Security Administration never granted nor rejected it, and the IRS rejected ITIN applications, and you try to declare SSN applied for and ITIN rejected, the US Department of Justice proves that no court has jurisdiction to review your confiscated refund and penalty. Even if the IRS accepted your honesty on this matter, the DOJ and courts don’t. I ended up fabricating an SSN for my wife and explaining why, the IRS accepted it, and even the DOJ admitted it might be acceptable, but the DOJ still wouldn’t let a court take jurisdiction.
So yeah, if you don’t commit suicide or murder, the DOJ can persuade a court that you didn’t demonstrate sincerity in your tax return so you should be penalized and have your refund confiscated.
The only way to invest safely in the US is to be a non-resident alien. Withholding from dividends and interest will be the correct amounts of tax … well sometimes anyway … and you don’t have to file a US tax return.
John Richardson has his name at the bottom of this e-mail campaign:
PETITION TO EXEMPT AMERICANS ABROAD
FROM THE REPATRIATION & GILTI TAXES
“They don’t care about Joe the Plumber’s savings but they do care about Apple’s. Once Joe pays, he becomes unmistakably liable to pay and can’t be allowed to keep his savings.”
Possibly Joe could have avoided the transition tax if by some miracle he had seen it coming back when the Subpart F rules were invented. He might have been able to make a “tick-the-box” election for his single-owner foreign corporation to be treated as a disregarded entity. That would mean (if I understand it correctly) that he would be liable for US tax on income from his foreign corporation (i.e. he would not benefit from the corporate exemption which was abolished by the TCJA), but consequently he would not now be in the line of fire for the Subpart F-based transition tax.
Unfortunately, being a plumber not a tax professional Joe may not have known about this option, and even if he did know about it, not being psychic he certainly couldn’t have known it might be his best choice.
If Joe the Plumber were psychic he would have renounced in 1984. Even if he didn’t own a company.
“If Joe the Plumber were psychic he would have renounced in 1984. Even if he didn’t own a company.”
Very true. And if Joe’s still not renouncing despite developments since 1984 which render paranormal powers unnecessary, perhaps he just doesn’t want to renounce.
Which is fair enough.