By David S. Kerzner*
Susan has been successfully running her business in Canada since the mid-1980's through her privately owned services corporation which her advisors formed for her in Ontario. Over the years, she has enjoyed many benefits provided under the Income Tax Act, Canada, including the so called Small Business Deduction. During that time, she has accumulated millions of dollars in undistributed retained earnings in her company. Last year, she made a very large distribution, unbeknownst to her, that it largely belonged to the IRS. Susan has what I term US 'Tax Cancer'. The profits Susan was accumulating over the years became swallowed up in the insidious provisions of the Passive Foreign Investment Company Rules under the Internal Revenue Code (the "PFIC" rules). At a very high level, a corporation (and other entities such as a mutual fund) can be classified as a PFIC when the entity meets either an income or an asset test under the Code wherein too much of the income generated by the entity is passive (vs. active business income) or too many of the assets used by the entity generate passive income. The tax, interest, and penalty provisions under the PFIC rules can be financially decimating to an investor and the 'cancer' can strike in different ways (such as in an investment portfolio). Susan has always filed and paid her taxes on a timely basis in Canada. Although she may have had tax planning that made sense for a Canadian resident, her corporate tax strategy made no sense at all for a dual U.S.-Canadian citizen like her. Susan's dilemma was of course entirely preventable with timely and expert cross border/U.S. international tax advice. Now, her 'cancer' has to be 'tended to', but she can still get treatment, and survive.
What is US Tax Cancer and How Can I Avoid It?
I wish I could say thank goodness it's only money, and not a physical ailment, but the mental suffering and dumb anguish that Susan is going through is having a toll on her physical well being. Susan's struggle with a late stage diagnosis of a near devastating tax disorder is not unique. Regrettably, this 'disease' often lies in stealth mode until the patient obtains a proper 'tax screening'. Susan was doubly hit by the tax problem having a 'legacy' business which was in existence prior to a change in the law (the "PFIC/CFC overlap rule) in 1997 which was specifically targeted to ameliorate her situation. Unfortunately, there are many 'Susans' out there who suffer from various forms of potentially harmful and devastating consequences arising from a large number of tax anomalies between the Act in Canada and the Code in the U.S., that can and do exist in privately structured business and succession plans for U.S. citizens living in Canada. PFICs can also have a decimating impact on the investments held by U.S. citizens in Canadian and non-U.S. mutual funds. While an explanation of this problem is beyond the scope of this article, suffice it to say that it is not uncommon for professional fees relating to US tax compliance for PFIC distributions and dispositions to eviscerate any profits made relating to such investments. Americans holding interests in Canadian mutual funds, including through their RRSPs, need very careful advice from their U.S. tax advisors (which they may not have--yet).
The U.S. rules relating to investments in Canadian private corporations can have a dramatically different impact on the shareholders of these corporations than the Canadian rules. Often the benefits of the Small Business Deduction are illusory when subject to the U.S. anti-deferral rules like the 'Subpart F' regime. In certain cases, a taxpayer's foreign tax credit position (or other rules) may neutralize the sting of taking current income inclusions. In the case of service corporations, another nightmare lurking in the dark are a special body of tax rules, found in decades of case law and administrative rulings, and in the Code and its Regulations which in a nutshell empower the IRS to re-allocate income earned by the corporation to its shareholder under a variety of different economic doctrines. Did I mention the capital dividend account. I mean, what capital dividend account? The last time I looked in the Code, I didn't see one. How many blissful tax free distributions are made to U.S. shareholders who are not subject to Canadian tax on these distributions, come to find out say when they meet with a U.S. tax advisor (for the first time--or the first time in a long time) that yes they are, in the land of Lincoln, where the rules on distributions are different. Corporate life insurance? (Check it out). Have you a funded or unfunded executive compensation/retirement scheme in Canada? Better find out what the potential impact of the horrific 409A regulations under the Code may be to see if your 'asset' isn't a 'liability' under the Code. Another trap for the unwary that never ceases- Canadian 'style' estate planning for families with U.S. citizens (and U.S. assets, including U.S. securities), don't even get me started--Oy Vey (that's Yiddish for My Word!).
There simply isn't room enough to list all of the numerous asymmetrical dimensions between the worlds of Canadian corporate, finance, and estate taxation (not to mention insurance) and U.S. corporate, finance, and estate taxation. The best ways to deal with this situation are prevention if you are timely enough, or otherwise, detection at the earliest possible time.
2012 Offshore Voluntary Disclosure Initiative
A senior 'Bay Street' professional called me the other day saying he was going into the 2012 OVDI (Offshore Voluntary Disclosure Initiative), and was going to do it on his own. He was shopping for the cheapest advisor he could to complete his compliance. He wasn't interested in anything I had to say, and I really don't know why he called in the first place. The irony, is that if he would have asked for my two cents worth, I would have told him, that many of my tax controversy clients-for many years going back, are in their predicaments today because they did not go to the right advisors to begin with. As a result, cross border tax traps and problems (some of which I have alluded to above) which could have been avoided altogether or nixed in their embryonic stages went undetected entirely.
For those tax advisors that will be assisting clients with making a voluntary disclosure, it is helpful to explain to these individuals that the costs of compliance (professional fees and potentially taxes, interest, and penalties) may be significantly higher than what they are used to due to the client's facts, the complexities of the law, and the number of years covered.
As the US continues tighten the net on delinquent filers, expect to see more cases of US 'tax cancer' in your practices. As for Susan? I am glad to say the overall prognosis for her is good. She will make a recovery, and she will ultimately be cancer free. Can you say that about your U.S. clients?
*David Kerzner is a member of the Bars of New York and Ontario. David is also the Editor-In-Chief and Principal Co-Author of The Tax Advisor's Guide to the Canada U.S. Tax Treaty, a publication of Thomson-Reuters containing over 2,500 pages of commentary on the tax laws of Canada and the United States and published by the largest legal publisher in the world.
[1] Article in It’s Personal May/June 2012 published by Thomon-Reuters-Carswell
This article is for illustrative purposes ONLY and is NOT intended to be used for legal advice or as a substitute for timely and proper multi-jurisdictional and multi-disciplinary legal counsel.