Canada: International Estate Planning After US Tax Reform

The following article was published in the Canadian Tax Highlights Volume 24, Number 4, April 2017

During the 2016 U.S. presidential campaign then candidate Donald J. Trump and the Republican National Committee ("RNC") outlined similar plans to repeal the U.S. estate and gift tax regimes. Since the inauguration earlier this year (and as of the date of this paper) no fewer than four bills have been introduced into Congress that eliminate or substantially modify the estate and gift tax. However, while Trump and RNC platforms were similar, the proffered bills differ widely on their treatment of the gift tax, the generation skipping tax, basis rules, valuation rules under § 2701 – § 2704, and the application of any of the rules to individuals who are non-domiciliaries of the U.S. for transfer tax purposes. 

The estate and gift tax became part of U.S. law in 1916, and its application encircles and envelops the entire body of U.S. tax law.  By current count there are 161 sections of the Code that include the term "gift" and excluding § 2001 – § 2801 there are 114 sections that include the term. In the Treasury Regulations there are 583 regulation sections that include the term "gift," and 490 times excluding the regulations referring to § 2001 – § 2801. Thus, any significant estate and gift reform will have far-reaching and profound consequences to U.S. tax law in general.

At this point it is anyone's guess what the U.S. estate and gift tax rules will look like at the end of the Trump administration's first year. However, in light of the Republican control of congress and President Trump's staunch opposition to the estate and gift tax it is a safe bet that changes, if not outright repeal, will occur in the near future.

If we assume, as I believe we must, that we will see significant changes to the estate and gift tax, I believe it to be a fruitful exercise to examine some of the less obvious areas of international estate planning that may be affected by changes to the estate and gift tax regime.

International estate planning issues that may be affected by US estate tax repeal

A.            Net worth test of "Covered Expatriate" under § 877(a)(2)(B).

Pursuant to § 877A(a) the U.S. expatriation tax regime applies to "Covered Expatriates." § 877A(g)(1) defines Covered Expatriate to include expatriates who meet certain triggers. The American Jobs Creation Act of 2004 (AJCA) introduced § 877(a)(2)(B), which triggers the expatriation tax regime if the expatriate's net worth is greater than US $2m on the date of expatriation.

Notice 97-19 provides guidance on the determination of the net worth trigger of § 877(a)(2)(B). In particular, the Notice provides:

For purposes of the net worth test, an individual is considered to own any interest in property that would be taxable as a gift under Chapter 12 of Subtitle B of the Code if the individual were a citizen or resident of the United States who transferred the interest immediately prior to expatriation. For this purpose, the determination of whether a transfer by gift would be taxable under Chapter 12 of Subtitle B of the Code must be determined without regard to sections 2503(b) through (g), 2513, 2522, 2523, and 2524.

Thus, the Notice imports gift tax concepts for determining whether the net-worth trigger of the expatriation regime is tripped.  If the gift tax is eliminated this particular portion of the Notice is negated. 

However, even if the reference to gift tax under the Notice is negated, elimination of the gift tax would essentially eviscerate the net-worth trigger of the expatriation regime because an expatriate would be able to gift away assets to bring his or her net worth under the US $2m threshold. Of course gifting limits, or a deemed disposition regime would curtail this type of planning

B.             Gifts and bequests from expatriates under § 2801.

In addition to the expatriation tax regime that applies to covered expatriates under § 877 and § 877A, the § 2801 also imposes an inheritance tax on certain gifts and bequests received by U.S. persons by Covered Expatriates.

If the gift tax is eliminated then there will be fewer individuals that will be classified as Covered Expatriates and, therefore, fewer individuals subject to the inheritance tax of § 2801.

C.             U.S. reporting of gifts from foreign individuals under § 6039F.

While the gift and estate tax may be modified in the near future, there is no indication that U.S. persons' obligation to report significant gifts from non-U.S. persons will be eliminated. Under current U.S. law gifts received by U.S. persons are generally not included in income per § 102.  Notwithstanding the fact that there is no income tax inclusion, § 6039F still imposes a reporting obligation, and significant penalties for failing to file the Form 3520 when due.

D.            Estate Freezes under Ch. 14 (§ 2701 – § 2704).

In Canada, the use of estate freezes to transfer future appreciation of assets from one generation to the next is a very common strategy. With notable exceptions this type of planning was legislated out of existence in the U.S. with the implementation of the special valuation rules of § 2701 – § 2704.  If the estate and gift tax were completely repealed U.S. citizens abroad, and especially in Canada may be able to avail themselves of this extremely effective planning strategy. It is worth noting, however,  that on January 10, 2017 by Rep. Kristi Noem (R-SD) and Sanford Bishop Jr. (D–GA), introduced a bill to repeal the estate tax. That bill retains both the gift tax and the special valuation rules under Chapter 14. 

E.             International divorce involving either U.S. property or U.S. persons under § 2516 and § 1041(d).

When a U.S. citizen spouse divorces a non-U.S. resident spouse, many are surprised to learn that the transfer to the non-U.S. resident spouse triggers the gain to the U.S. citizen (or resident) transferor per § 1041(d).  This is also the result when two non-U.S. resident (citizen) spouses transfer U.S. property pursuant to divorce.

These individuals are even more surprised to learn that certain property settlements may be subject to gift tax if not made within the requisite period of time. § 2516 provides that when husband and wife enter into a written agreement relative to their marital property rights, and divorce occurs within the 3-year period beginning on the date one year prior to such agreement is entered into (whether or not the agreement is approved by the divorce decree) any transfers of property are deemed to be for full and adequate consideration. If the transfer is made outside of that 3-year period, the deeming rule does not apply, and there is a risk that the transfer will be classified as a gift.

Classification of the transfer between the soon-to-be former spouses poses a significant problem when one individual is not a U.S. citizen or resident; or when the individuals are neither U.S. citizens nor U.S. residents. This is because the transfer could be subject to the gift tax at 40 percent, which under the Canada-U.S. Treaty is not eligible for a pro-rata portion of the unified credit. 

If the U.S. gift tax were eliminated and not replaced with a deemed disposition tax (like Canada) this trap would be eliminated, and most divorcing spouses would seek to avail themselves of favorable treatment afforded by classification of transfer by gift and not the rules that result from classification as transfer for value.

F.             Below-market loans under § 7872.¹

In Canada married couples do not file joint returns, and there may be income attribution from one spouse to another if a gift is made, the proceeds of which produce income.  A common strategy in Canada to avoid this result is to have one spouse make a loan to the other spouse at the Canadian "Prescribed Rate," which is roughly the equivalent of the short-term applicable federal rate (AFR). 

If the Canadian Prescribed Rate is lower than the AFR there can be U.S. gift-loan consequences per § 7872. If the gift tax is repealed then this strategy could be executed by U.S. citizens in Canada without the negative U.S. gift tax consequences addressed in more detail in the article cited in footnote 2.

G.            Gifts by non-U.S. domiciliaries of U.S. situs tangible property under      § 2105.

• 2105 imposes U.S. gift tax when a non-U.S. domiciliary (defined in Treasury Regulation 20.0-1(b)(2)) makes a gift of U.S. situs property which includes property that is physically located in the United States. Under the U.S.-Canada Treaty, gifts of U.S. property are not afforded a pro-rata portion of the unified credit.

If the gift tax is repealed, and if the repeal applies to non-U.S. domiciliaries, this gift tax trap will evaporate.  We typically advise our clients that if they spend their holidays in the U.S. and exchange significant gifts, they should document the delivery and acceptance prior to arriving in the U.S.

One of my favorite client stories relates to the non-U.S. individual who spent the holidays in NYC and purchased his companion (also a non-U.S. individual) a    US $2m diamond ring. Since we were consulted ahead of time, we could document the client's intent to purchase the ring and loan it to the companion in the U.S.  Only after they returned to their home country, the client made the gift to the companion. 

H.            Gifts received by U.S. persons of foreign currency – basis under §1015.

When a wealthy non-U.S. individual makes a gift to a U.S. person of foreign currency, two questions arise: first, was the foreign currency located in the U.S. and therefore U.S. situs for gift tax purposes?² If the gift tax were repealed the donor would not have to be concerned about the U.S. gift tax issues, however absent repeal of 6039F the donee would have a reporting obligation.

The second question is the basis that the recipient takes in the gifted currency.      § 1015 provides the basis rules for gifted property, including foreign currency.  For practical purposes it may be impossible to determine the donor's basis in the gifted currency.

I.               Purported Gifts" received by U.S. persons from foreign partnerships and corporations under § 672(f).

Under § 672(f) and Treasury Regulation 1.672(f)-4 a distribution to a U.S. person from a corporation or partnership of which the individual is not a partner or shareholder is a "Purported Gift" and subject to reclassification as income and not a gift exempt from taxation.  So far, there is no indication that the Purported Gift rules would be addressed in estate and gift tax reform.

J.              Gifts by U.S. persons of PFIC stock Proposed Regulation 1.1291-3(b)(1).

Proposed regulation 1.1291-3(b)(1) provides that the gift of PFIC stock is a taxable disposition for purposes of excess distribution calculation. These regulations are proposed and do not carry the weight of law. It remains to be seen whether U.S. estate and gift tax reform will attempt to finalize the position taken in the Proposed Regulations.

If the estate and gift tax reform does adopt the provisions of the Proposed Regulations, this will have significant adverse effects to U.S. persons who own PFICs and attempt to transfer them to family members as part of their succession plan.

K.            Qualified Disclaimers under § 2518.

Under the provisions of § 2518 and the regulations, property that is gifted to a person, either in life or at death, can be disclaimed which results in the property skipping the disclaimant as though the individual has predeceased the decedent (or grantor).  If the person does not follow the formalities of the statute, the property is generally classified as a gift from the person. 

Under current law foreign beneficiaries of U.S. property frequently run afoul of these rules because they simply are unaware of rigid requirements, and the consequences of being offside. The result can be that the foreign beneficiary is deemed to have made a gift of U.S. situs property in his or her attempt to disclaim, which results in the imposition of the U.S. gift tax.

If the U.S. gift tax were repealed then the onerous gift tax consequences of non-qualified disclaimers by non-U.S. domiciliaries would be eliminated. It remains to be seen, however, if this non-qualified disclaimer would trigger income tax under the estate and gift tax reforms.

L.             Recapture of overall foreign loss under § 904(f)(3)(B)(i).

Section 904 of the Code provides certain limitations on the ability of a U.S. person to take the foreign tax credit afforded by § 901, and requires a recapture of overall foreign loss when property, under certain circumstances, has been disposed of.  Under § 904(f)(3)(B)(i) property that has been gifted is deemed to have been "disposed of," which can trigger foreign tax credit recapture.

It remains to be seen whether the pending changes to the U.S. estate and gift tax reforms will also eliminate the foreign tax credit limitation of § 904(f)(3)(B)(i).

CONCLUSION

The U.S. estate and gift tax is an integral part of U.S. tax law, and few argue that its excision would have a profound effect on tax planning for succession (which should be obvious) but also for income tax planning and international tax planning. Whatever devil lurks in the details of U.S. estate and gift tax reform, there are certain areas within international estate planning that will certainly be affected, though the magnitude of which depends on where the devil appears.  I hope this article has highlighted many of those less-obvious areas, though in light of the pervasiveness of the U.S. estate and gift tax, I'm sure it has fallen short.  In spite of its inevitable short-comings I hope I have highlighted areas that international estate planning practitioners will monitor, analyze, and provide comments.

Footnotes

1. For a full U.S. analysis of this issue see Roy A. Berg and Kim G.C. Moody "U.S. Tax Effects of Canadian Prescribed Rate Loan Strategy." 2014 World Wide Tax Daily 14-41 (January 22, 2014).

2. The IRS has determined that currency and cash are tangible, rather than intangible, personal property (see Treasury Regulation Section 25.2511-3(b)(4); G.C.M. 368560 (September 24, 1976; unpublished)).  In Private Ruling 7737063, the IRS ruled that "...Cash is tangible property for purposes of Section 2501(a)(2) of the Internal Revenue Code.  Therefore, if the decedent (a non-resident alien) made a gift of cash within the United States, the transfer is subject to the gift tax under Section 2511(a) of the Code."  
On the other hand, if the transfer of funds occurs outside of the United States, the gift should not be subject to United States gift tax.  In Private Ruling 8120030, the IRS indicated that the transfers of cash by a non-resident to three irrevocable trusts situate outside of the U.S. were not subject to gift tax.   

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