Originally published in Canadian Tax Highlights, Volume 23, Number 2, February 2015. Reprinted with permission.
President Obama’s State of the Union address, delivered on January 20, 2015, proposed three significant changes to US federal tax law: (1) an increase from the current 20 percent rate to 28 percent for the top federal capital gains and dividend tax rates applicable to high-income taxpayers (spouses with combined income exceeding about $500,000); (2) a closing of what President Obama called in a January 17, 2015 fact sheet “the trust fund loophole,” by which an estate beneficiary enjoys a tax-free basis step-up in inherited property to its FMV at death; and (3) the imposition of a 7-basis-point fee on the liabilities of a large US financial institution whose assets exceed $50 billion (the same benchmark for enhanced supervision of those institutions that was imposed under the 2010 Dodd-Frank Act). It is not clear whether the higher capital gain and dividend rates include the special 3.8 percent net investment income tax already paid by high earners.
The tax-free basis step-up at death was widely seen as a counterbalance to the estate tax on a decedent’s assets. However, the US estate and gift tax exemption (currently about $5.3 million for a US citizen and domiciliary and $10.6 million for US-citizen and/or US-domiciliary spouses) reduces or eliminates the estate tax outlay, and to that extent the basis step-up for income tax purposes may be seen as a windfall. (No income tax is ever payable on the appreciation.) President Obama’s proposal treats transfers at death (except to charitable organizations) as realization events or deemed sales that give rise to tax on the property’s appreciation, similar to the Canadian death tax. But the proposal does not modify US estate tax to reflect this change.
Several carve-outs and exceptions are proposed to the new “deemed sale at death” rule, including a carve-out for the transfer of certain tangible personal property and exceptions for a spousal transfer (tax is deferred until the surviving spouse’s death), for lower levels of capital gains, and for a personal residence ($500,000 per spouse).
The current tax-free stepped-up basis at death is available to a beneficiary of a non-US-citizen Canadian-resident decedent, even though the decedent’s estate is not subject to US estate tax on non-US-situs property that passes to the US beneficiary (subject to narrow exceptions—for example, for PFIC shares). A Canadian resident who owns passive assets in a Canadian entity that will pass to a US beneficiary at death is encouraged to use a ULC holdco—not a Canco holdco—so that the step-up applies not only to the entity’s shares but also to its underlying assets.
If the US capital gain rate for an individual increases to 28 percent, a Canadian who invests in US property is more motivated to structure the investment to exempt its sale from US tax. The most common structure exempts from capital gain tax the sale of shares of a USco (unless it is a US real property holding corporation under FIRPTA). It is not completely clear whether the gain from the sale of an LLC or an LP interest qualifies for exemption. Revenue ruling 91-32 (1991-1 CB 107) says that the gain should be taxable to the extent that the LLC’s or LP’s assets are part of a US trade or business, but practitioners have expressed doubt about the ruling’s reasoning. President Obama proposes to codify the ruling’s principles in the Code, which suggests that the administration also has doubts about the ruling’s support in current law.
The proposals are unlikely to be enacted without significant modification. Moreover, since the Republicans took control of both the Senate and the House after the 2014 elections, increased calls have been heard for a sweeping overhaul of the Code; such an overhaul would dwarf the three Obama proposals. The criticisms focus especially on rules that affect businesses’ ability to compete in the world marketplace, such as the rule that treats a dividend from a foreign subsidiary to a US parent as a taxable distribution, which has encouraged US multinationals to accumulate offshore billions of dollars of unrepatriated profits and has impelled the current wave of inversion transactions. It is hoped that any serious tax reform that occurs will remedy the inequities that face US citizens resident in Canada. For example, foreign tax credits are denied to US-citizen Canadian residents for the new 3.8 percent net investment income tax. Another example is the overly broad classification rules that determine when a Canco is a PFIC; those rules trap many active Canadian companies, especially those engaged in rental real estate operations.