November 16, 2011

U.S. Estate Tax Exposure for Canadians

Death and taxes are two certain things in life.  But did you know that even if you are a Canadian citizen and a resident of Canada, you may be subject to U.S. estate taxes when you die?  If you own U.S. situs assets and have over US$5 million in total worldwide assets, or are a married couple with over US$10 million in total assets you need to be aware of the current and future U.S. estate tax implications. Most people would expect that U.S. situs assets would include U.S. real estate, but other examples from an investment perspective of U.S. situs assets that aren’t so obvious include:

• U.S. publically traded securities held in Canadian brokerage accounts, Registered Retirement Savings Plans (RRSP), Life Income Funds (LIF), Tax Free Savings Accounts (TFSA) or Registered Education Savings Plans (RESP).  (Note that American Depository Receipts for international companies like Sony or Nestle are not considered U.S. situs assets)
• U.S. mutual funds including money market funds (Note that U.S. cash holdings are not considered U.S. situs assets for estate tax purposes.  Also, Canadian mutual funds holding shares of U.S. corporations are also not classified as U.S. situs property)

The Tax Relief, Unemployment Insurance Authorization and Job Creation Act of 2010 that was enacted on December 17, 2010 changed the U.S. Estate tax rules for deaths in 2011 and 2012.  Essentially, the Act reinstated the estate tax at a maximum rate of 35% for 2011 and 2012, and changed the individual credit amount to an exemption equivalent to US$5 million in total worldwide assets.   For 2013 and beyond, unless new legislation is enacted, the exemption will drop to US$1 million in total worldwide assets. Unfortunately, the lack of certainty around the 2013 period requires caution when individuals or families are addressing estate planning issues.  The table below shows the history of the exemption and top estate tax rates over the past 5 years.

It is also important to note that unlike the Canadian tax system, U.S. estate tax applies to the fair market value of U.S. situs assets and does not take into account whether a capital gain has been made on the asset or not.  This means that an investment that lost 50% of its value may still be subject to U.S. estate taxes on the remaining fair market value! Conversely, if a significant capital gain is realized at your death on a U.S. situs asset, there would be a deemed disposition for Canadian tax purposes triggering capital gains taxes, in addition to potential U.S. estate taxes.  In some cases, depending on the individual’s circumstances, the combination of Canadian and U.S. taxes could amount to a substantial portion of the total value of the asset.

The tables below provide some hypothetical examples of how much U.S. estate tax one could expect to incur using various assumptions.  Also to clarify, technically there is no “exemption” of US$5 million.  The law actually states that there is a “unified tax credit” of US$1,730,800, which has the effect of offsetting the U.S. estate taxes applicable to the first US$5 million of taxable estate.  Due to the Canada/U.S. Tax Treaty, a Canadian citizen that resides in Canada would be entitled to a portion of this tax credit in proportion to the ratio of their U.S. situs assets to their total worldwide assets.  The first table lays out potential U.S. estate tax exposure for the 2011 and 2012 period and the second table outlines the theoretical tax exposures from 2013 and beyond.

What does this mean to the average Canadian investor?  Holding U.S. situs assets could be very costly when you pass away.  Given that none of us know our expiration date, some potential estate planning tools that are available to address this issue include:

• Holding U.S. publically traded companies inside a corporation.
• Owning Canadian based mutual funds to get U.S. asset exposure.
• Discussing your individual positioning with your tax accountant, as everyone’s tax situation is different and any tools available should be used after consulting a qualified tax advisor.

The article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided in this report is compiled from our own research and is based on assumptions that we believe to be reasonable and accurate at the time the report was written, but is subject to change without notice.