canadian tax journal / revue fiscale canadienne (2014) 62:1, 197 - 219
International Tax Planning
Co-Editors: Pierre Bourgeois* and Michael Maikawa**
Estate Planning: US-Resident Beneficiaries
of a Canadian Estate—Part 1
Mathieu Ouellette and Jennifer Warner***
Estate planning offers taxpayers a means of distributing their assets, subsequent to
death, in a way that minimizes tax liabilities for both the deceased and their beneficiaries.
Serious obstacles can arise if the estate has non-resident beneficiaries and a significant
portion of its value is derived from shares of a Canadian investment corporation. The
authors of this two-part article examine Canadian and us tax implications for a Canadian
resident who wishes to bequeath shares of a Canadian investment corporation to
beneficiaries that include both Canadian and us residents. In part 1, the authors review
how the residence of an estate is determined pursuant to Canadian rules and us tax
rules, the application of us anti-deferral rules, and the resulting unexpected tax liabilities
for us-resident beneficiaries. In part 2, they will discuss the use of unlimited liability
corporations and other planning strategies that may be used to mitigate the overall tax
burden on the deceased and their beneficiaries.
Keywords: Estate planning n controlled foreign corporation n non-resident n
beneficiaries n distributions n United States
C o n te n t s
Introduction
Tax Considerations upon the Death of a Canadian Shareholder
Residence of the Estate of the Deceased
Residence of an Estate Under Canadian Tax Laws
Section 94—Deemed Canadian-Resident Trust
Residence of an Estate Under US Tax Law
Foreign Estates
Application of US Anti-Deferral Rules
Controlled Foreign Corporations
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198
198
198
200
203
203
205
205
* Of PricewaterhouseCoopers LLP, Montreal.
** Of PricewaterhouseCoopers LLP, Toronto.
*** Of Bessner Gallay Kreisman LLP, Montreal.
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Subpart F Income
Passive Foreign Investment Companies
Foreign Tax Credit
Conclusion
(2014) 62:1
207
209
218
219
Introduction
Estate tax planning is an effective tool in reducing the potential tax liabilities that
arise upon death. Traditional Canadian tax-planning structures address the Canadian
tax implications for the deceased, the estate, and Canadian-resident beneficiaries.
Many families have members who have emigrated from Canada to the United
States. However, naming us residents as beneficiaries of a Canadian estate may have
unexpected tax consequences for both the estate and its beneficiaries. These consequences can be significant, particularly if a Canadian resident transfers shares of a
Canadian investment corporation to his or her estate upon death and the corporation is subsequently wound up.
Effective estate planning can mitigate exposure to Canadian and us taxation in
such circumstances. Planning begins with an understanding of the tax rules in both
countries that may apply to the deceased shareholder, the estate, and the beneficiaries. In this two-part article, we present a comprehensive analysis of the rules that
affect cross-border estate planning and suggest some strategies for minimizing the
tax impact of those rules.
Ta x Consider ations upon the Death
of a C anadian Shareholder
Residence of the Estate of the Decea sed
The residence of an estate must be established to determine which jurisdiction will
tax the estate on its worldwide income. In 2012, the Supreme Court of Canada clarified the determination of a trust’s residence in Fundy Settlement v. Canada,1 better
known (and referred to herein) as the Garron case. The Income Tax Act 2 contains
provisions that can deem a trust to be a resident of Canada. In the United States,
the Internal Revenue Code3 defines the term “foreign estate” and has established
guidelines to determine the residence of an estate.
Residence of an Estate Under C anadian Ta x L aws
Until Garron, Canadian tax authorities generally had determined that for Canadian
tax purposes, a trust or estate would have only one place of residence, determined by
the residence of the majority of the trustees. This principle was established through
1 2012 SCC 14.
2 RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as “ITA”).
3 Internal Revenue Code of 1986, as amended (herein referred to as “IRC”).
international tax planning  n  199
jurisprudence, notably Thibodeau Family Trust v. The Queen.4 Later, the Canada Revenue Agency (cra) echoed this approach in guidelines issued in Interpretation Bulletin
it-447, “Residence of a Trust or Estate.”5 These guidelines state that the residence
of an estate is
a question of fact to be determined according to the circumstances in each case. However, a trust is generally considered to reside where the trustee, executor, administrator,
heir or other legal representative . . . who manages the trust or controls the trust assets
resides.6
Despite the guidelines and case law before Garron, much uncertainty in establishing the residence of a trust remained.
In Garron, the Supreme Court of Canada established that to determine residence, trusts are subject to the same management and control tests as corporations.
Thus, for the purposes of the Act, a trust or estate resides where “its real business is
carried on,”7 this being the place where the decisions for the trust or estate are
made,8 making that location significant for an estate.
To avoid negative tax implications for the estate and its beneficiaries in the context of cross-border estate planning, the country of residence of the estate must be
determined at the outset. The following example illustrates a possible pitfall where
an estate is not considered to be a resident of Canada.
Suppose Mr. Candad is a Canadian resident and the sole shareholder of Investco,
a Canadian corporation, all of the activities of which consist of holding investments.
Investco was incorporated under the provisions of the Canada Business Corporations Act 9 and is located in Quebec. Investco generates passive income because its
assets comprise mainly marketable securities and other investments. Mr. Candad
has three children over the age of 18. Two of those children, u and s, are us residents; the third, c, is a Canadian resident.
Mr. Candad wants to distribute the total value accumulated in Investco to his
children. His will stipulates that Investco is to be wound up upon his death and that
the total proceeds are to be distributed equally among the three children.
Assume that Mr. Candad’s will also provides that his us-resident children will
constitute the majority of acting executors of the estate, and the executors will administer the estate from the United States. As a result, the estate will be considered
a non-resident estate for Canadian tax purposes. Once an estate has been determined to be non-resident, newly enacted ita section 94 can deem the estate to be a
4 [1978] CTC 539 (FCTD).
5Interpretation Bulletin IT-447, “Residence of a Trust or Estate,” May 30, 1980.
6 Ibid., at paragraph 1.
7De Beers Consolidated Mines, Ltd. v. Howe, [1906] AC 455, at 458 (HL), quoted in Garron, supra
note 1, at paragraphs 8 and 15.
8Garron, supra note 1, at paragraph 15.
9 RSC 1985, c. C-44, as amended (herein referred to as “CBCA”).
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Canadian resident for the purposes of calculating its taxable income.10 As a consequence, the estate will be limited in its ability to deduct from its taxable income a
portion of the amounts distributed to any non-resident beneficiary.11 Furthermore,
a resident contributor and resident beneficiaries are jointly and severally, or solidarily,
responsible with the trust for the payment of any taxes owed by the trust.12
Section 94—Deemed Canadian-Resident Trust
If the central management and control tests conclude that a trust is not resident in
Canada, ita section 94 can deem the trust to be a resident of Canada for the purposes of computing part i tax. Pursuant to subsection 94(3), if, without reference to
section 94, an estate or a trust is determined to be a non-resident and the trust or
estate has a Canadian-resident contributor or beneficiary, the trust will be taxed as
a Canadian resident and must include in its taxable income all Canadian-source
income as well as foreign accrual property income earned by the trust or estate during
the year.
For the purposes of section 94, a non-resident trust will be deemed to be a
Canadian-resident trust for the purposes of computing part i tax if
n
n
n
the trust is determined to be a non-resident of Canada pursuant to the criteria
established through jurisprudence;
the trust is not an “exempt foreign trust”; and
at the end of the particular year of the trust, there is either a “resident contributor” to the trust or a “resident beneficiary” under the trust.
Subsection 94(3) may not apply to an “exempt foreign trust”13 or an “exempt
person,”14 or in the case of a contribution that is considered to be an “arm’s length
transfer.”15 A testamentary trust is not specifically identified in subsection 94(1) as
an “exempt foreign trust” and therefore can be deemed to be a resident trust under
subsection 94(3) if the necessary conditions are met. Examples of exempt foreign
trusts include trusts established exclusively for charitable purposes and trusts whose
income and capital are to be used for the care of a physically or mentally infirm dependent individual who is not resident in Canada.
“Exempt persons” for the purposes of section 94 are persons who are exempt from
tax pursuant to ita subsection 149(1); as such, they are excluded from the definitions
of “contributor” and “resident beneficiary,” discussed below. Thus, if a contribution
10 ITA subsection 94(3).
11 ITA subsection 104(7.01).
12 ITA paragraph 94(3)(d).
13 See ITA subsection 94(1), the definition of “exempt foreign trust.”
14 See ibid., the definition of “exempt person.”
15 See ibid., the definition of “arm’s length transfer.”
international tax planning  n  201
to a trust is made by, or a beneficial interest is given to, an “exempt person,” the rules
under section 94 may not deem the trust to be a Canadian resident.
An “arm’s length transfer” or loan of property to a non-resident trust is not
considered to be a contribution to the trust. In respect of a testamentary trust, the
deceased is a contributor to the trust and a transfer of property from the deceased
is not considered to be an “arm’s length transfer,” because the transfer constitutes a
contribution made by way of gift or for no consideration. Therefore, this particular
exception to the application of the rules determined under section 94 will not apply
to a testamentary trust.
A “contributor” is defined as “a person (other than an exempt person but including a person that has ceased to exist) that . . . has made a contribution to the trust.”16
A “resident contributor” is “a person that is . . . resident in Canada and a contributor to the trust” (with certain exclusions).17 A “beneficiary” includes “a person or
partnership that is beneficially interested in the trust.”18 A “resident beneficiary” is
“a person (other than a person that is . . . a successor beneficiary under the trust or
an exempt person) that is . . . a beneficiary under the trust” provided that such person
is resident in Canada and there exists a connected contributor to the trust,19 as defined in subsection 94(1).
The cra has issued a technical interpretation that provides the following comments on the meaning of “resident contributor”:
[T]o be a “resident contributor,” the person must be resident in Canada and a “contributor.” The definition of “contributor” indicates that, a deceased natural person will
continue to qualify as a contributor because of the reference to a person that has
ceased to exist. However, the concept of residence necessarily implies that the person
must be in existence. Therefore, a deceased natural person would no longer be a resident
of Canada and hence the definition of “resident contributor” . . . would not be met.20
Although the “resident contributor” condition is not met if the contributor is deceased when the contribution is made, the rules of section 94 could still apply if at
least one beneficiary is a Canadian resident. The technical interpretation continues
by stating:
A person will be a resident beneficiary under a trust if:
the person is a “beneficiary” of the trust,
the person is not an “exempt” person,
n the person is not a “successor beneficiary,”
n
n
16 See ibid., the definition of “contributor.”
17 See ibid., the definition of “resident contributor.”
18 See ibid., the definition of “beneficiary.”
19 See ibid., the definition of “resident beneficiary.”
20 CRA document no. 2012-0448681E5, January 4, 2013.
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the beneficiary is resident in Canada, and
there is a “connected contributor” to the trust. . . .
For the purpose of these rules, a beneficiary is broadly defined to include anyone
who is “beneficially interested” in the trust. “Beneficially interested” has an extended
definition under the Act and includes persons named as beneficiaries, persons who
have contingent rights as beneficiaries, and even persons who may become an object
of a power of appointment. . . .
[T]he last aspect of the resident beneficiary definition is that there must be a “connected contributor.” This is generally someone who contributed property to the trust
either during Canadian residency, within 60 months before coming to Canada, or
within 60 months after leaving Canada. In the case of a testamentary trust, the
60-month period after leaving Canada is shortened to 18 months.
When determining if an estate created on someone’s death has a connected contributor, the relevant consideration is whether the deceased was a resident of Canada
immediately before death or within 18 months of death. If so, there will be a connected
contributor.21
Consider an individual who was a Canadian resident immediately before death
and, through her will, appointed a majority of non-residents as executors to exercise
the management and control of the assets of the estate. The estate will be treated as
a non-resident trust for specific purposes of the Act. If this estate has at least one
resident beneficiary, it will be subject to the application of the deemed-residenttrust rules pursuant to section 94. None of the exceptions that limit the application
of subsection 94(3) will prevent the deemed-resident-trust rules from applying to a
non-resident estate that has a resident beneficiary.
ita subsection 104(7.01) limits the ability of a deemed resident trust to make
deductions from income under subsection 104(6). The rules are meant to ensure
that a subsection 94(3) trust is not used to distribute Canadian-source income to
non-residents free of tax.22 Subsection 104(7.01) therefore ensures that any Canadiansource income distributed to a non-resident beneficiary is subject to taxation under
part i of the Act.
In the earlier example, Mr. Candad specified through his will that the value of
Investco was be distributed to his children following the windup of the corporation.
As a result of the deemed-resident-trust rules, the deemed dividend on windup
would be subject to part i tax within the estate.23 This result is not optimal considering that, under different circumstances, a dividend paid to a non-resident could be
subject to reduced part xiii tax of 15 percent.
If Mr. Candad’s estate were determined to be a Canadian resident, on the windup, the entire deemed dividend paid to the estate and allocated to a non-resident
21 Ibid.
22 See ITA subsection 104(7.01).
23 Ibid.
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beneficiary could be deducted from the estate’s income. The deemed dividend allocated to a non-resident beneficiary would generally be subject to a 25 percent
withholding tax under part xiii;24 however, for a us-resident beneficiary, the rate
would be reduced to 15 percent under article x(b) of the Canada-us tax treaty.25
The deemed-resident-trust rules limit the possibilities of implementing an estate
plan that would create an optimal tax result. In our example, to avoid the disadvantages that may arise from naming a majority of us-resident executors, Mr. Candad
can limit the exposure to section 94 by appointing a majority of Canadian-resident
executors. Doing so makes the estate a Canadian resident not subject to the deemedresident-trust rules under section 94.
Residence of an Estate Under US Ta x L aw
Foreign Estates
For us tax purposes, any estate that is not a “foreign estate” is treated as a us estate.26
The irc defines a “foreign estate” as an estate in which the income earned is from
foreign sources not effectively connected with a us trade or business and thus not
includible in gross income for us tax purposes.27
us tax law determines residence by examining all the facts involved. The Internal
Revenue Service (irs) provides an example of the determination of residence in Rev.
rul. 57-245.28 The decedent was not a citizen of the United States and, at the time
of death, was domiciled in a foreign country. His will was admitted to original probate in the United States because over 90 percent of his property was physically
located in the United States at the time of death and the decedent owned few, if any,
assets in the foreign country. The executor was resident in the United States. The
irs concluded that the estate would be considered a foreign estate irrespective of
the fact that the non-resident’s will was probated in the United States and over
90 percent of the property held in the estate was located in the United States. The
irs also concluded that the residence of the executor is not controlling in determining the estate’s residence for us tax purposes.29
24 ITA paragraph 212(2)(a).
25 The Convention Between Canada and the United States of America with Respect to Taxes on
Income and on Capital, signed at Washington, DC on September 26, 1980, as amended by the
protocols signed on June 14, 1983, March 28, 1984, March 17, 1995, July 29, 1997, and
September 21, 2007 (herein referred to as “the Canada-US treaty”).
26 IRC section 7701(a)(30)(D). See Research Institute of America, RIA’s Complete Analysis of the
Small Business, Health Insurance and Welfare Reform Acts of 1996 (New York: RIA, 1996), at
section 1507, “Estates and Trusts Subject to Objective Testing To Determine Residency.”
27 IRC section 7701(a)(31)(A).
28 1957-1 CB 286.
29 Rev. rul. 57-245 was modified by Rev. rul. 62-154, 1962-2 CB 148, to remove any implication
that the residence status of the estate of a non-resident alien decedent depends on the location
of the domiciliary administration of that estate.
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In a similar interpretation, the irs has concluded in a private letter ruling that
the taxable income of an estate is computed in the same manner as in the case of an
individual. . . . Thus, a nonresident alien estate is taxable on its income from sources
within the United States in the same manner as a nonresident alien individual. . . .
Under section 861(a)(1)(a) of the Code, interest earned on amounts deposited by a
nonresident alien individual with a person carrying on the banking business, and not
effectively connected with the conduct of a trade or business within the United States,
is not United States source income.
Whether the administration of the estate of a nonresident alien decedent in the
United States creates a resident estate subject to United States income tax pursuant to
Subchapter j of the Internal Revenue Code depends on the facts, including the extent
of the role played by a resident ancillary administrator. . . . In determining the residence
of an estate, one of the most significant factors to be weighed is the residence of the decedent. . . .
(“The estate is merely the representative of the decedent after death and, in the ordinary case, the same tax consequences should occur whether the decedent collects the
income before his death or the estate collects it after his death.”)30
On the other hand, the estate of a non-us resident will not necessarily be a foreign estate in all situations. In Rev. rul. 62-154,31 the irs has set forth the principles
to be applied in determining whether an estate will be treated as domestic or foreign
for us income tax purposes. In that ruling, the irs held that residence depends on all
the relevant facts involved. For an understanding of the application of this principle,
Rev. rul. 62-154 refers to the pre-1997 criteria for the determination of a domestic
trust:
irs held in Rev. Rul. 60-181 that a trust was a resident of the u.s. where a u.s. trustee
actively administered the trust through a u.s. office and most of the assets of the trust
were in u.s. corporation securities. An estate would presumably be considered a u.s.
resident (and thus a u.s. estate) where ancillary administration by a u.s. administrator
of a substantial part of the estate takes place in the u.s.32
In respect of the us interpretation of residence, it appears that an estate may be
considered a us person if assets situated in that country are actively administered by
a us resident. This would likely be the case if the majority of the executors are us
residents. Therefore, as stated previously, the will should specify that the majority
of the executors are to be Canadian residents.
In the context of the estate of a Canadian-resident individual, the residence of an
estate for us purposes depends on all relevant facts, particularly the residence of the
deceased. From both Canadian and us perspectives, it is therefore imperative to
30 Private Letter Ruling 8527065, April 10, 1985 (emphasis added).
31 1962-2 CB 148.
32 1960-CB 257 (emphasis added).
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have a clear understanding of the deceased individual’s residence status, the type of
assets held in the estate, and who will be administering the estate’s affairs.
In the United States, the same tax rules apply to foreign estates and non-resident
aliens.33 On any undistributed income from us sources not effectively connected
with a us trade or business, a foreign estate will be subject to us tax at 30 percent
or a lower treaty rate, if applicable.34
Similarly, undistributed income from us sources effectively connected with a us
trade or business will be taxed at the same graduated rates as are applicable to usresident individuals under irc section 1.35
Application of US Anti-Deferral Rules
The us Congress enacted a series of rules to prevent us residents from deferring
taxes through the use of foreign corporations. us persons are taxed on their worldwide income. Absent the anti-deferral rules, us residents would be able to defer taxes
by interposing a foreign corporation until the foreign corporation distributed the
foreign-source income. The us anti-deferral rules seek to tax the us person’s pro
rata share of the income earned in a foreign corporation on a current basis. Any tax
planning for an estate that will have us-resident beneficiaries must take these rules
into account. Indirect ownership of shares in a foreign corporation through a Canadian estate can have significant tax implications.
A us person who is a direct or indirect shareholder of the foreign corporation generally is subject to the anti-deferral rules, particularly those that apply to controlled
foreign corporations (cfcs) and passive foreign investment companies (pfics).
Controlled Foreign Corporations
A cfc is any foreign corporation of which on any day during its taxation year
“United States shareholders” own more than 50 percent of either the total voting
power of all classes of shares with the right to vote or the value of the corporation.36
For this purpose, a “United States shareholder” of a foreign corporation is a us
person who owns, or is considered to own, at least 10 percent of the total votes of
all classes of shares of the Canadian corporation.37
In the example above, upon Mr. Candad’s death, shares of Investco, a Canadian
investment corporation, will be transferred to a Canadian-resident estate, and
therefore will be treated as a foreign estate for us tax purposes. The estate will own
100 percent of the voting rights and 100 percent of the value of Investco. The two
33 IRC section 641(b).
34 IRC section 871(a); Treas. reg. section 1.871-1.
35 IRC sections 641 and 871(b).
36 IRC section 957(a).
37 IRC section 951(b).
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children who are us residents (u and s) will each be entitled to receive one-third of
the beneficial interest of the estate. Does this make Investco a cfc?
The irc has rules that attribute ownership of the shares held by a foreign intermediary (such as a foreign estate) to us persons holding interests in the intermediary.
Shares owned, directly or indirectly, by a foreign corporation, foreign partnership,
or foreign trust or estate are considered to be owned proportionately by the shareholders, partners, or beneficiaries.38 Proportional ownership or proportionate interest
in a foreign corporation, partnership, trust, or estate is based on all the facts and
circumstances.39 Treasury regulations state that a person’s “proportionate interest”
in a foreign corporation for the purposes of the income inclusion in respect of subpart f will generally be determined with reference to that person’s interest in the
income of the corporation.40
In contrast, when determining the extent of voting rights held by a person for
the purposes of meeting the definition of a “United States shareholder” and ultimately the definition of a cfc, that person’s proportionate interest is determined with
reference only to the extent of voting rights held in the foreign corporation.41
The Treasury regulations provide the following example to illustrate the application
of the facts-and-circumstances test to a foreign estate with us-resident beneficiaries:
Among the assets of foreign estate w are Blackacre and a block of stock, consisting of
75 percent of the one class of stock of foreign corporation t. Under the terms of the
will governing estate w, Blackacre is left to g, a nonresident alien, for life, remainder
to h, a nonresident alien, and the block of stock is left to United States person k. By
the application of this section, k is considered to own the 75 percent of the stock of
t Corporation, and g and h are not considered to own any of such stock.42
This example can be applied to Mr. Candad’s situation. u and s are each entitled
to one-third of the assets held in the estate. The estate will own all of the outstanding shares of Investco. Assuming that only one class of shares exists, u and s each
own one-third of the voting rights and one-third of the value of Investco. Each of
u and s has an ownership interest that exceeds the threshold of 10 percent of the
voting rights, and therefore each is a United States shareholder of Investco. Together,
u and s are United States shareholders who own two-thirds of the votes and value
of the shares. This exceeds the 50 percent threshold, making Investco a cfc for us
tax purposes.
In accordance with irc section 951(a)(1), if the foreign corporation is determined to be a cfc for an uninterrupted period of 30 days or more during a taxation
38 IRC section 958(a)(2).
39 Treas. reg. section 1.958-1(c)(2).
40 Ibid.
41 Ibid.
42 Treas. reg. section 1.958-1(d), example 4.
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year, any United States shareholder who owns stock in the foreign corporation on
the last day in that year must include in his or her gross income for the year, his or
her pro rata share of the cfc’s subpart f income.43 There will be a corresponding
increase in the basis of the stock held in the cfc pursuant to irc section 961(a).
In the example, u and s each would be considered to own one-third of the interest
in the income of the corporation, so each would have to include in gross income
one-third of the subpart f income of Investco. As a result, the adjusted basis of the
shares of Investco would be increased.
United States shareholders of a cfc are taxed currently on undistributed passive
income earned by the cfc. Therefore, when the income is finally distributed to the
United States shareholders from the cfc, any amounts previously included in the
shareholder’s gross income under irc section 951(a) will be excluded from gross
income in the year in which the distribution is received.44 This prevents the United
States shareholder from being taxed twice in the United States on the same income.
However, where no foreign tax credit is available, the same income could be subject
to double taxation by being taxed in both Canada and the United States. This issue
is addressed below.
In our example, at such time as the Investco shares are redeemed or the corporation is liquidated, the us beneficiaries will be considered to have recognized a gain on
the sale or exchange of the shares in the cfc.45 The gain realized must be included
in the us beneficiary’s gross income as a dividend, to the extent of the earnings and
profits (e & p) attributable to Investco.46 The dividend is limited to the us beneficiary’s pro rata share of Investco’s e & p for the taxable years during which Investco
was a cfc, less any amounts already included in the beneficiary’s gross income
pursuant to irc section 951.47 Any gain in excess of that dividend amount and any
loss is normally a capital gain or loss as determined under the general irc capital
gains rules.48
Subpart F Income
Subpart f income is generally defined in irc section 952 (and the regulations thereunder) and irc section 954(c), as passive gross income of a cfc to the extent of its
current earnings derived from dividends, interest, royalties, rents, annuities, and
other passive income. However, subpart f income does not include income from
sources within the United States that is effectively connected with the conduct by
the cfc of a trade or business within the United States, unless such income is exempt
43 IRC section 951(a)(1)(A)(i).
44 IRC section 959(a); Treas. reg. section 1.959-1(a).
45 Treas. reg. section 1.1248-1(b).
46 IRC section 1248(a).
47 IRC section 1248(d)(1).
48 IRC section 1001.
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from taxation (or subject to a reduced rate of tax) pursuant to a treaty obligation of
the United States.49
In our example, Investco is a Canadian investment corporation, the majority of
the assets of which are marketable securities and other investment instruments.
This would make the revenue earned by Investco mainly passive income such as
dividends, interest, and rents. The application of the cfc rules will subject the beneficiaries u and s to an income inclusion of their proportionate shares of Investco’s
income under subpart f. us beneficiaries of a foreign estate may face significant tax
liabilities, particularly when the foreign corporation earns substantial passive income.
A simple example illustrates how the cfc rules would apply to Mr. Candad’s
estate and its us beneficiaries. As noted earlier, the estate is to include the shares of
Investco. Mr. Candad’s will divides his estate equally among his three children—u
and s, who are us residents, and c, who is a Canadian resident. There are no other
beneficiaries. Investco’s year-end is December 31. Assume that Mr. Candad dies on
January 31, 2013. The fair market value of the shares of Investco immediately before death is $2.7 million. The after-tax net investment income earned by Investco
from February 1 to December 31, 2013 is $300,000. All shares are redeemed on
January 1, 2014, for a total value of $3 million.
Following Mr. Candad’s death, u and s each will be considered to hold a proportionate interest in Investco in accordance with irc section 958(a)(2). As discussed
above, their combined two-thirds interest in Investco gives them more than 50 percent of the voting control and value, making the corporation a cfc under IRC section
957(a). As indirect shareholders of a cfc on the last day of the year, under irc section 951(a)(1) u and s must each include their respective pro rata shares of Investco’s
subpart f income in gross income for 2013. Investco’s total subpart f income for the
year (its investment income before taxes) is $374,547.50 u and s must each include
$124,849 ($374,547/3) in gross income. If both are in the top us tax bracket, each
will incur a tax liability of $49,440 (39.6% × $124,849) on subpart f income.
When the shares are redeemed on January 1, 2014, proceeds receivable by the
us-resident beneficiaries will be subject to part xiii withholding taxes under ita
subsection 212(2). The 25 percent statutory withholding rate will be reduced to
15 percent pursuant to article xxii(2) of the Canada-us treaty. u and s will each be
entitled to receive $1 million as their share of the proceeds ($3,000,000/3). They
will each incur a Canadian tax liability of $150,000 (15% × $1,000,000) as a result
of the distribution of their share of the redemption proceeds.
For us tax purposes, the redemption is treated as an exchange for stock; as a result, the us indirect shareholder recognizes a gain under irc section 1248. However,
because for both u and s the basis for Investco’s shares has been stepped up by
49 IRC section 952(b).
50 Investco’s gross income earned from February 1 to December 31, 2013 is $374,547. This amount
is based on a combined federal-provincial tax rate of 46.57 percent applicable to investment
income earned by a Canadian-controlled private corporation in Quebec, less 26 2 ⁄ 3 percent,
which is the refundable portion of part I tax: $300,000/(100% − 19.90%) = $374,547.
international tax planning  n  209
amounts previously included in gross income under irc section 951 (subpart f income), their new basis is $1 million, and neither recognizes a gain. The taxes paid
in Canada cannot be recovered because no us taxes are payable in the year on the
foreign income earned. This result is not optimal for the us beneficiaries.
Table 1 illustrates the combined Canadian and us tax burden applicable to the
distribution made to each us-resident beneficiary where Investco’s income is treated
as subpart f income. The inability of the us-resident beneficiary to claim a foreign
tax credit with respect to the Canadian taxes paid results in a worldwide tax burden
of approximately 72 percent on the portion of income of Investco that is treated as
subpart f income for us tax purposes. Tax-planning strategies to reduce the us tax
on investment income earned by Investco are discussed in part 2 of this article.
Passive Foreign Investment Companies
Like the cfc rules, the rules relating to pfics were implemented to prevent the
deferral of us income taxation through the use of foreign corporations. A foreign
corporation will be considered a pfic if either
n
n
75 percent or more of its gross income in the taxable year is attributed to passive income;51 or
an average of at least 50 percent of the value or adjusted basis of the assets52
held by the corporation in the taxable year produces or is held to produce
passive income.53
Unlike the qualifying conditions of the cfc rules, the conditions for the application
of the pfic rules do not take into consideration the ownership of voting shares of
the foreign corporation.
A foreign corporation qualifying as a pfic under the above conditions will not be
treated as such in respect of a United States shareholder of a cfc.54 As discussed
51 IRC section 1297(b) defines “passive income” as any income of a kind that would be foreign
personal holding company income as defined in section 954(c). That definition reads as follows:
“foreign personal holding company income” means the portion of the gross income
which consists of:
(A) Dividends, interest, royalties, rents, and annuities.
(B) The excess of gains over losses from the sale or exchange of property.
52 Under IRC section 1297(e), for publicly traded corporations, the 50 percent test is based on
the fair market value of the corporation’s assets; for CFCs that are not publicly traded, the test
is based on the adjusted tax basis of the corporation’s assets; and for all other corporations, the
test is based on the fair market value of the corporation’s assets, unless the corporation elects to
apply the test on the alternative basis (that is, the adjusted tax basis of its assets).
53 IRC section 1297(a).
54 IRC section 1297(d). Note that this rule is effective for tax years of United States shareholders
beginning after December 31, 1997. Shares of a corporation held prior to December 31, 1997
that would be considered both a CFC and a PFIC with respect to a United States shareholder
could be subject to both the CFC and the PFIC regimes.
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Table 1 Example: Canadian and US Tax Consequences to a
US-Resident Beneficiary Where Investco Is a CFC
Subpart F
income
Value on
death
Canada
Investco’s value at time of shareholder’s death . . . . . . . . . . . . 3,000,000
Investment income earned by Investco . . . . . . . . . . . . . . . . . 374,547
Taxes paid by Investco after dividend refund (19.90%) . . . . . 74,547
Amount available for distribution . . . . . . . . . . . . . . . . . . . . . 300,000 3,000,000
Distribution to each US-resident beneficiary (1⁄ 3) . . . . . . . . . 100,000 1,000,000
Withholding taxes (15%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 150,000
United States
Subpart F income reported by US-resident beneficiary . . . . 124,849
US income taxes paid on subpart F income (39.6%) . . . . . . . 49,440
Foreign tax credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . nil
Worldwide tax burden . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89,289
% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72%
150,000
15%
above, a United States shareholder (as defined in irc section 951(b)) of a foreign
corporation will be subject to the cfc rules if all of the United States shareholders
own more than 50 percent of the votes or value of the foreign corporation. Both
rules accomplish the same objectives, and the shareholder is subject to only one
regime. If a foreign corporation qualifies as both a cfc and a pfic, a United States
shareholder will be subject to the cfc regime and the corporation will not be
treated as a pfic in relation to that shareholder.55 On the other hand, shareholders
not subject to the cfc rules, such as us persons owning less than 10 percent of the
voting power in all classes of shares of a cfc or us persons who are shareholders of
foreign corporations not controlled by United States shareholders, will be subject
to the pfic rules.56
As with the application of the cfc provisions, for pfic purposes shares of a
foreign corporation owned directly or indirectly by a partnership, estate, or trust
are considered to be owned proportionately by their partners or beneficiaries.57 The
proportionate interest will be determined using the facts-and-circumstances analysis considered under the application regulations for subpart f.58
For estate planning, the application of the pfic rules must be considered if the estate
will have us beneficiaries, even when the us beneficiaries do not control the foreign
corporation. In our example, irc section 1297(d) specifically precludes the application of the pfic rules to the us beneficiaries of Mr. Candad’s estate because Investco
qualifies as a cfc.
55 IRC section 1297(d).
56 HR rep. no. 105-220, 105th Cong., 1st sess. (1997), 623-28.
57 IRC section 1298(a)(3). Treas. reg. section 1.1291-1(b)(8)(iii)(C).
58 Technical Advice Memorandum 200733024, August 17, 2007.
international tax planning  n  211
If the proportion of Canadian-resident beneficiaries to us-resident beneficiaries
in the original example were reversed, Investco would no longer qualify as a cfc.
Investco would not be controlled by United States shareholders, since two-thirds
of the voting power and two-thirds of the value of Investco would be in the hands of
others. However, the us-resident beneficiary would nonetheless be subject to the
pfic rules because Investco’s income is mainly passive. This scenario is discussed in
more detail later in this article.
In contrast to the anti-deferral rules related to cfcs, us shareholders of pfics are
taxed on the distributions received. Distributions received from a pfic are categorized
as either “excess distributions” or “non-excess distributions.” An excess distribution
is the portion received from a pfic during the taxable year that exceeds 125 percent
of the average distributions received in respect of the share within the preceding
three years. If the shareholder’s actual holding period59 is less than three years, the
excess distribution is determined using the actual holding period preceding the taxable year in question. In the first year of owning the pfic share, the excess distribution
amount is zero.60 The excess distribution amount is calculated share by share, in
relation to the total number of pfic shares held by the us resident.61
A non-excess distribution is simply the portion that is not an excess distribution.
It is taxable to a shareholder in accordance with the general rules of us corporate
income taxation. The non-excess distribution amount is treated as a dividend to the
extent of current or accumulated e & p.62 Non-excess distributions on pfic shares
are not eligible for the net capital gains tax rate63 available in respect of “qualified
dividend income” because a pfic does not meet the definition of a “qualified foreign
corporation.”64
The excess distribution is taxed differently. First, it is allocated pro rata to each
day throughout the period during which the shareholder held the shares. That period
has three distinct segments: (1) pre-pfic years65 before the corporation became a
59 Treas. reg. section 1.1291-1(h)(4)(i) provides that a shareholder’s holding period of stock of a
PFIC owned indirectly begins on the first day that a shareholder is considered to own stock of
the PFIC under Treas. reg. section 1.1291-1(b)(8).
60 IRC section 1291(b)(2).
61 Prop. Treas. reg. section 1.1291-2(c)(1). The proposed regulations are found in INTL-941-86,
INTL-656-87, and INTL-704-87, 1992-1 CB 1124.
62 Prop. Treas. reg. section 1.1291-2(e)(1).
63 The applicable rates are set out in IRC section 1(h)(1), as follows: 0 percent on long-term
capital gains income of $36,250 or less; 15 percent on long-term capital gains income between
$36,251 and $400,000; and 20 percent on long-term capital gains income of $400,001 and over
(amounts based on a single filer).
64 IRC section 1(h)(11)(c).
65 Treas. reg. section 1.1291-1(b)(3) defines a pre-PFIC year as a taxable year (or portion thereof )
of the shareholder that is included in the shareholder’s holding period of the stock of a
corporation during which the corporation was not a PFIC within the meaning of Treas. reg.
section 1.1291-1(b)(i).
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(2014) 62:1
pfic; (2) prior-pfic years66 when, before the current year, the corporation qualified
as a pfic; and (3) the current taxable year.
The portions of excess distributions allocated to pre-pfic years and the current
taxable year are included in the shareholder’s gross income as ordinary income for
the current taxable year. This income will not be treated as a qualified dividend for
federal income tax purposes.67 Any portion of the distribution allocated to priorpfic years is not included in gross income but instead is treated as a deferred-tax
amount.68 The deferred-tax amount is defined as the “sum of the aggregate increases
in taxes . . . and the aggregate amount of interest . . . determined with respect to the
aggregate increases in taxes.”69 The deferred-tax amount is the product of the excess
distribution allocated to each prior-pfic year and the top marginal tax rate for each
year in question.70 Interest is added and is based on the increased amount of tax for
each prior-pfic period. The interest is deemed to accrue starting on the due date
for the prior-pfic year and ending on the due date for the taxable year in which the
distribution occurs.71
66 Treas. reg. section 1.1291-1(b)(4) defines a prior-PFIC year as a taxable year (or portion
thereof ) of a shareholder, other than the current shareholder year, that is included in the
shareholder’s holding period of stock of a corporation during which the corporation was a
section 1291 fund. According to prop. Treas. reg. section 1.1291-1(b)(2)(v), a PFIC is a section
1291 fund if (1) the shareholder did not elect to treat the PFIC as a “qualified electing fund”
(QEF) or make a mark-to-market election with respect to the PFIC (discussed below under
“US Tax Reduction Strategies”); or (2) the PFIC is an “unpedigreed” QEF (as defined in Treas.
reg. section 1.1291-9( j)(2)(iii)).
67 IRC section 1(h)(11)(C)(iii).
68 Prop. Treas. reg. section 1.1291-2(e)(2).
69 Prop. Treas. reg. section 1.1291-4(a).
70 Prop. Treas. reg. section 1.1291-4(c)(1).
71 IRC section 1291(c)(3). An example provided in Treas. reg. section 1.1291-4(e) illustrates how
the deferred tax is calculated:
Example 1.
(i) Facts. X is a domestic corporation that is a calendar year taxpayer. The due date
(without regard to extensions) for its federal income tax return is March 15. X acquired
a share of stock of FC, a corporation, on December 31, 1986, for $500. FC has been a
section 1291 fund with respect to X since FC’s taxable year that began January 1, 1987.
On December 31, 1990, X sold the FC stock for $1000. X did not incur any foreign tax
on the disposition of the FC stock. X’s gain on the sale, $500, is taxed as an excess
distribution. The excess distribution is allocated pro rata over X’s four-year holding
period. Accordingly, $125 is allocated to each year in X’s holding period. The $125
allocated to 1990, the current shareholder year, is included in X’s ordinary income for
that year. The allocations to 1987, 1988 and 1989, the prior PFIC years, are subject to
the deferred tax amount under §1.1291-4.
(ii) Calculation of the 1987 increase in tax. The increase in tax for the $125 allocated
to 1987 is determined in the manner described in section 15(e) by using a weighted
average rate. The weighted average rate is 40%:
international tax planning  n  213
The tax implications for a us beneficiary of Mr. Candad’s estate may be quite
significant if shares of Investco, which are indirectly held by the us beneficiary, are
considered pfic shares and the us beneficiary receives or is treated as having received a distribution, such as a dividend, from Investco.72 The amount received will
be taxed in part as a non-excess distribution and the remaining portion as an excess
distribution, as previously summarized. Any distribution made to the US beneficiary
as a result of the liquidation of Investco or a redemption73 of its shares will constitute a disposition for the purposes of the pfic rules.74 Any gain realized by the us
beneficiary from the indirect disposition75 of the pfic shares will be treated entirely
as an excess distribution.
To determine the gain, irc section 1291(e) specifies a reduction in the basis of
any pfic shares acquired from a decedent. This generally would eliminate any
46% rate: 181/365 × 46% =22.81%
34% rate: 184/365 × 34% = 17.14%
39.95%.
The increase in tax for 1987 is $49.94 ($125 × 39.95%).
(iii) Calculation of the other increases in tax. The highest statutory rate of tax
applicable to X that was in effect for both 1988 and 1989 was 34 percent. The increase
in tax for each of 1988 and 1989 is $42.50 ($125 × 34%).
(iv) Aggregate increases in taxes. The aggregate increases in taxes are $134.94
($49.94 + $42.50 + $42.50).
(v) Interest charge. Interest on each of the three increases in tax ($49.94, $42.50, and
$42.50) is computed using the rates and method provided in section 6621 for the
respective interest period. The following are the interest periods:
Year of allocation
Interest period
Increase in tax
Beginning on
Ending on
$49.94
42.50
42.50
March 15, 1988
March 15, 1989
March 15, 1990
March 15, 1991
March 15, 1991
March 15, 1991.
1987
1988
1989
72 Prop. Treas. reg. section 1.1291-2(f ): “an indirect shareholder is taxable on the total
distribution paid by the section 1291 fund with respect to the stock attributed to the indirect
shareholder, as if the indirect shareholder had actually received that amount.”
73 IRC sections 302(a) and 317(b).
74 IRC section 1291(a)(2). Prop. Treas. reg. section 1.1291-3(b)(1).
75 Prop. Treas. reg. section 1.1291-3(e)(2) defines an indirect disposition as follows:
An indirect disposition is—
(i) Any disposition of stock of a section 1291 fund by its actual owner if such stock
is attributed to an indirect shareholder under §1.1291-1(b)(8),
(ii) Any disposition, by an indirect shareholder or any other person, of any interest
in a person, if by virtue of such interest the indirect shareholder was treated as
owning stock of a section 1291 fund under §1.1291-1(b)(8), or
(iii) Any other transaction as a result of which an indirect shareholder’s ownership
of a section 1291 fund is reduced or terminated.
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basis step-up76 as a result of the acquisition of property of a decedent. irc section
1291(e)(2), however, provides an exception for shares received from a decedent who
was a non-resident alien at all times during the holding period of the stock. The
basis for the pfic shares owned indirectly by the us-resident beneficiaries of a Canadian estate would be the fair market value of the shares at the date of death.
The following example illustrates the effect on Mr. Candad’s estate and its beneficiaries if Investco is determined to be a pfic.
In contrast to the original example, two of Mr. Candad’s children are Canadian
residents and the third is a us resident. As before, the three children are the only
beneficiaries of the estate. Mr. Candad dies on January 31, 2013. The shares of
Investco are the only assets of the estate. Investco’s fiscal year-end is December 31.
The fair market value of the shares of Investco immediately before Mr. Candad’s
death is $2.7 million. As part of the liquidation process of the estate, the shares of
Investco will be redeemed on January 1, 2014 for a total redemption value of $3 million. Under Mr. Candad’s will, his estate is to be divided equally among his three
children. The $300,000 increase in the value of the shares of Investco from Mr.
Candad’s death to December 31, 201377 is attributable to the after-tax net income
earned during this period.
Following Mr. Candad’s death, the us-resident child will be deemed to hold a
proportionate interest in Investco in accordance with irc section 958(a)(2). Because
he holds a one-third proportionate interest and Investco earns only investment income, the corporation is a pfic pursuant to irc section 1297(a)(1).
The redemption of the shares of Investco on January 1, 2014 will give rise to a
deemed dividend pursuant to ita subsection 84(3). The us-resident beneficiary will
be entitled to receive $1 million (one-third of the redemption value of Investco).
One-third of the dividend distribution will be paid to the us-resident beneficiary
and will be subject to part xiii withholding tax under ita subsection 212(2). The
statutory withholding tax rate of 25 percent will be reduced to 15 percent pursuant
to article xxii(2) of the Canada-us treaty. The distribution to the us-resident beneficiary will be subject to withholding tax in Canada of $150,000 (15% × $1,000,000).
Under the pfic rules discussed above, the redemption of the shares of Investco
will constitute a disposition of the shares78 deemed to be held by the us-resident
beneficiary. On disposition, the us-resident beneficiary will realize a gain.79 His cost
basis will be the fair market value of the shares immediately before the death of
Mr. Candad (that is, $900,000), as stated under irc section 1291(e)(2). The gain
realized by the us-resident beneficiary on the disposition of Investco’s shares on
January 1, 2014 is therefore $100,000.80
76 IRC section 1014(a).
77 See supra note 50.
78 See supra note 74.
79 See supra note 75.
80 1⁄ 3 × ($3,000,000 − $2,700,000).
international tax planning  n  215
As noted earlier, the pfic rules will apply only during a person’s holding period.
In this example, the us-resident beneficiary’s holding period is 335 days from the
day immediately following the death of Mr. Candad to the day on which the shares
are disposed of.
In accordance with irc section 1291(a)(2), the entire portion of the $100,000
gain attributed to the us-resident beneficiary is considered as an excess distribution.
The us-resident beneficiary’s us tax liability on that excess distribution is calculated
as follows:
1. The excess distribution amount is grossed up by the excess distribution tax.
2.The excess distribution tax, pursuant to irc section 1291(g)(2)(b), is that
portion of withholding tax that is attributable pro rata to the excess distribution. The excess distribution tax is $15,000 in our example.81
3.The excess distribution tax and the total excess distribution, totalling
$115,000,82 are allocated to each year of the us-resident beneficiary’s holding
period, with the allocated amount being based on the number of days in each
taxable year. The excess distribution is allocated to the current taxable year
and the prior-pfic year, because the us-resident beneficiary indirectly held
the shares in Investco from February 1 to December 31, 2013 (334 days in the
prior-pfic year and on one day—January 1, 2014—in the current taxable
year). Therefore, $114,65783 is allocated to the prior-pfic year and $34384 to
the current taxable year.
4. The amount of $114,657 allocated to the prior-pfic year is used to determine the deferred-tax amount.85 The deferred-tax amount is calculated by
multiplying the amount allocated to the prior-pfic year by the highest tax
rate applicable in that year. In 2013, the highest tax rate for individuals was
39.6 percent.86 The deferred-tax amount is therefore $45,404.87 Accrued
interest is added pursuant to irc section 6621. The deferred-tax amount and
the accrued interest will be added to the taxes payable by the us-resident
beneficiary for 2014.
81 Foreign tax paid with respect to the distribution to the US-resident beneficiary multiplied by
(the excess distribution divided by the total distribution): $150,000 × ($100,000/$1,000,000)
= $15,000.
82 Excess distribution taxes plus total excess distribution: $15,000 + $100,000 = $115,000.
83 The allocation for the prior-PFIC year is calculated as the prior-PFIC-year holding period
divided by the total holding period multiplied by (the total excess distribution plus excess
distribution taxes): 334/335 × $115,000 = $114,657.
84 The allocation for the current taxable year is calculated as the current-year holding period
divided by the total holding period multiplied by (the total excess distribution plus excess
distribution taxes): 1/335 × $115,000 = $343.
85 See supra note 68.
86 IRC sections 1(a) through 1(d).
87 $114,657 × 39.6% = $45,404.
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(2014) 62:1
5. The amount of $343 allocated to the current taxable year is added to the
gross income of the us-resident beneficiary and taxed as ordinary income.
6.The us-resident beneficiary may claim as a foreign tax credit, against the
deferred-tax amount, the lesser of (1) the deferred-tax amount for that year
($45,404) and (2) the excess distribution tax applicable to the deferred-tax
amount ($14,955).88 The excess distribution tax will therefore reduce the
deferred-tax amount to $30,449 ($45,404 − $14,955).
7.An irc section 901 foreign tax credit is applicable for the current-year excess
distribution tax allocated to the current year—that is, $45 (1/335 × $15,000).
Table 2 illustrates the combined Canadian and us tax burden on the distribution
made to a us-resident beneficiary where Investco is treated as a pfic. As the table
shows, the inability of the us-resident beneficiary to claim a foreign tax credit with
respect to the corporate taxes paid by Investco results in a worldwide tax burden of
approximately 56 percent on the income of Investco distributed to him. Tax-planning
strategies to reduce the us taxes paid on the amount distributed are explained in
part 2.
Qualified Electing Fund Election
A us shareholder of a pfic may elect to be subject to tax treatment other than the
excess distributions treatment. An election can be made for the pfic shares to have
“qualified electing fund” status.89 This status will apply only to shares held by the
shareholder who makes the election.
Where the shareholder is a us-resident beneficiary of a foreign estate, the election
will be made in regard to all the pfic stock owned directly and indirectly by the estate
and other pfic stock owned by the beneficiary. The election made by the beneficiary applies only to that beneficiary.90 Pursuant to this election, the shareholder must
include his or her pro rata share of the pfic’s ordinary income and net capital gain
in gross income for the year.91 In making this election, the shareholder will be taxed
currently on the pfic’s up-to-date e & p.92
88 334/335 × $15,000 = $14,955.
89 IRC section 1295(b).
90 Treas. reg. section 1.1295-1(d)(2)(iii)(B)(1).
91 IRC section 1293(a).
92 A QEF election, if made with respect to the first taxable year in which the corporation is a
PFIC for that shareholder, is referred to as a “pedigreed” election (see Treas. reg. section
1.1291-9( j)(ii)). If the QEF election is not a pedigreed election, it is referred to as an
“unpedigreed” election (see Treas. reg. section 1.1291-9( j)(2)(iii)) and the PFIC may continue
to be subject to the excess distribution regime on undistributed earnings. A taxpayer may
generally make a deemed dividend election to tax E & P currently to cause an unpedigreed
election to be treated as a pedigreed election.
international tax planning  n  217
Table 2 Example: Canadian and US Tax Consequences to a
US-Resident Beneficiary Where Investco Is a PFIC
Investco’s
Value on
income
death
Canada
Investco’s value at time of shareholder’s death . . . . . . . . . . . . 3,000,000
Investment income earned by Investco . . . . . . . . . . . . . . . . . 374,547
Taxes paid by Investco after dividend refund (19.90%) . . . . . 74,547
Amount available for distribution . . . . . . . . . . . . . . . . . . . . . 300,000 3,000,000
Distribution to each US-resident beneficiary (1⁄ 3) . . . . . . . . . 100,000 1,000,000
Withholding taxes (15%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 150,000
United States
Current-year income allocation . . . . . . . . . . . . . . . . . . . . . . . 343
US income taxes paid on current-year allocation (39.6%) . . 136
Deferred-tax amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,404
Foreign tax credit on deferred-tax amount . . . . . . . . . . . . . . (14,955)
Foreign tax credit on current-year income allocation . . . . . . (45)
Worldwide tax burden . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,389
% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56%
150,000
15%
Mark-to-Market Election
A second alternative to the excess distribution regime is the mark-to-market tax
treatment. This election can be made if the shares of the pfic are “marketable,”93
making it generally available to pfics that are public companies. Subject to this
election, the shareholder will include in gross income on an annual basis the
amount in excess of the fair market value of the pfic shares owned over the adjusted
basis of the shares for each year in which the election applies.94 This alternative
would not apply in the context of a Canadian private corporation such as Investco
because the company’s shares are not traded on a stock exchange.
93 Under IRC section 1296(e)(1), the term “marketable stock” means:
(A) any stock which is regularly traded on—
(i) a national securities exchange which is registered with the Securities and
Exchange Commission or the national market system established pursuant to
section 11A of the Securities and Exchange Act of 1934, or
(ii) any exchange or other market that the Secretary determines has rules
adequate to carry out the purposes of this part,
(B) to the extent provided in regulations, stock in any foreign corporation which is
comparable to a regulated investment company and which offers for sale or has
outstanding any stock of which it is the issuer and which is redeemable at its net asset
value, and
(C) to the extent provided in regulations, any option on stock described in
subparagraph (A) or (B).
94 IRC section 1296(a).
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Foreign Tax Credit
An additional element to consider in assessing the tax implications of the cfc and
pfic rules is their effect on a foreign tax credit claim. The foreign tax credit mechanism loses part of its effectiveness as a result of the application of the cfc and pfic
regimes.
us residents are subject to tax on their worldwide income, so foreign-source
income that they earn is subject to double taxation. To provide relief against the
taxation of the same income in two countries, us taxpayers may elect to take a deduction or a credit against their us income tax liability for any foreign income taxes
paid.95 Claiming a foreign tax credit is generally more favourable than deducting
foreign taxes paid from income.
The foreign tax credit mechanism allows us persons to credit foreign income
taxes directly paid or incurred against their us tax obligation. Referred to as a direct
foreign tax credit, this relief is also available to a beneficiary of an estate for his or
her proportionate share of the foreign taxes paid by the estate to the same extent as
if the beneficiary had paid his or her share of taxes directly.96
However, the foreign tax credit mechanism is not always effective in providing
relief in instances where a us-resident beneficiary who is subject to the cfc rules is
required to include in income his or her pro rata share of subpart f income in a year
in which an actual distribution is not received. The us-resident beneficiary will be
subject to double taxation because he or she will be subject to us tax in the year the
income is earned, pursuant to subpart f, and will also be subject to Canadian withholding tax on the same income when an actual distribution of earnings is made to
that beneficiary. No foreign tax credit will be available to reduce the us tax obligation of the beneficiary when these two events do not occur in the same taxation year.
us beneficiaries who receive, or are deemed to receive, distributions resulting
from the liquidation or redemption of shares of a foreign investment corporation
considered to be a cfc or a pfic are subject to special rules for determining the
foreign tax credit allowable in respect of the foreign taxes paid on the distribution.
In respect of a distribution from a pfic to a us-resident beneficiary, the amount
of the distribution will be grossed up by the amount of foreign taxes paid.97 A portion of the foreign taxes paid is considered to be attributable, pro rata, to the excess
distribution portion of the distribution.98 This portion of the foreign taxes paid is
referred to as “excess distribution tax.” The remaining portion is allocated against
taxes paid on the non-excess distribution.99 The portion of the excess distribution
95 IRC section 901(a).
96 IRC section 901(b)(5).
97 IRC section 1291(g)(1)(A).
98 IRC section 1291(g)(2)(B).
99 Prop. Treas. reg. section 1.1291-5(b)(1)(i).
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tax allocated to the current shareholder year and pre-pfic years is taken into account in the current shareholder year under the general foreign tax credit rule, as
are the foreign taxes allocated to the non-excess distribution.100 Any part of the
excess distribution tax allocated to the prior-pfic years will reduce the deferred-tax
amount for the year.
For the purposes of determining the foreign tax credit available to the us-resident
beneficiary of an amount received from a cfc as a result of a liquidation or redemption of shares, the portion of the gain that is recharacterized as a dividend is treated
as a distribution under irc section 1291.101 The foreign tax credit on the dividend
would thus be determined in the same manner as for a distribution received from a
pfic.
On the basis of the particular rules governing the determination of the foreign
tax credit applicable to distributions received from cfcs and pfics, this mechanism
may at best be effective to reduce the amount of us tax payable by the amount of
withholding tax on distributions from the estate. However, the cfc and pfic rules
do not allow a claim for a foreign tax credit in respect of the taxes paid by Investco
in our example, in effect resulting in double taxation.
Conclusion
The us anti-deferral rules have significant tax implications for us persons who find
themselves deemed, under us tax law, to be indirect owners of shares in a foreign investment corporation such as Investco. The application of either the cfc or the pfic
rules is complex, and the tax liabilities that result are penalizing. In part 2 of the
article, we will review certain planning techniques for minimizing the impact of the
CFC and PFIC rules.
100 Prop. Treas. reg. section 1.1291-5(b)(1)(vi).
101 Prop. Treas. reg. section 1.1291-5(e).