LIVE IN L.A. Your all access pass to complete Wealth Management U.S. TAX ISSUES for business owners and complex cases Will Todd, Davis LLP Taxation / Wills, Estates & Trusts Sean Rheubottom, Regional Vice-President, Wealth Planning, United Financial, a division of CI Private Counsel LP Tax and estate planning strategies

Meet the Jones family What else do we need to ask when creating a family tree? 2 Jim (60) Sue (59) Bart (29) (M) Caley (27) (S) 24 Abby (35) (M)

Your first question, every time Is anyone involved a U.S. citizen, U.S. resident or U.S. “green card” holder? “Ignorant Americans” and “Zombie Green Cards” present risk that clients may be unaware of the status of some family members, or themselves

Facts and assumptions Jim and Sue – Jim’s 1st marriage, Sue’s 2 nd marriage –Abby (35) – daughter of Sue, married, teacher –Bart (29) – son of Jim and Sue, married, studying accounting –Caley (27) - daughter of Jim and Sue, single, graduate student Jim and Sue own Jones Mfg Ltd. (“JML”), and Building Co. which owns the building JML operates out of. –They have each owned 50% of voting shares of both corporations since incorporation –They implemented an estate freeze and family trust 5 years ago –Business is getting more profitable –Jim and Sue are fairly confident someone will buy the business some day and they would like to retire in 5 to 7 years

Jones Manufacturing Ltd. (“JML”) 5 Jim and Sue think they would get about $5M for the operations if sold now. They hope to grow it to at least $12M before retiring Jim and Sue have not used their Capital Gains Exemptions (CGEs) The freeze structure has not been maintained – too much cash in JML JML p/s JS Building Co. 50% c/s Building used in the business $500,000 Cash and investments $2,000,000 Beneficiaries: Jim, Sue, children, future grandchildren FT 100% common shares

JML needs to be purified 6 Need to purify JML for the usual reasons: –Ensure the shares will qualify for CGE –Ensure capital gains splitting / multiplication of the CGE can be achieved –Protect cash and investments from potential future creditors –Ensure dividend income splitting can be achieved free of corporate attribution JML p/s JS Building Co. 50% c/s Cash and investments $2,000,000 Beneficiaries: Jim, Sue, children, future grandchildren FT 100% common shares

Wait a minute…Sue is a U.S. citizen Sue was born in the U.S. –Canadian resident - landed immigrant –U.S. resident from birth until she moved to Canada at age 24 –Has not taken any steps to lose her U.S. citizenship –Recently became “vaguely aware” of possible U.S. citizen planning concerns Jim is a Canadian resident; has never been a U.S. citizen or resident Sue believes she has not made any transfers to Jim or anyone else in excess of the applicable gift tax exclusion in a particular year Sue wishes to remain a U.S. citizen

Status of the children: Sue’s daughter Abby was also born in the U.S. –Recently became “vaguely aware” of possible U.S. citizen planning concerns Sue and Jim’s children Bart and Caley: –Have never considered that they might be U.S. citizens –Have never lived in the U.S., have never made any U.S. tax filings Where do we start?

Better to have addressed U.S. issues before implementing the plan… Sue and Abby are U.S. citizens on account of birth in U.S. –Confirm no action that would have resulted in renunciation Bart and Caley are dual citizens, as they are children of a U.S. citizen parent who had grown up in the U.S. prior to their birth –Only one parent required –No “activation” required

Have Sue and Abby kept current on U.S. filings? No doubt, Bart and Caley will need to catch up –Currently, 2 common paths to compliance: Streamlined procedures –for taxpayers with little or no U.S. tax owing –3 years of tax returns; 6 years of Foreign Bank Account Reports (FBARs) –must pay tax owing, but often no penalties Offshore Voluntary Disclosure Program –open to all, unless the IRS is already investigating –8 years of tax returns and 8 years of FBARs –Penalty unavoidable - range: »5% of max value of Cdn account balances »27.5% of max value of non-U.S. investment assets Compliance status?

LIVE IN L.A. Your all access pass to complete Wealth Management U.S. Tax Issues with the “Canadian Tax-Planned” Structure “... The main issue is that it doesn’t actually work.” Sorry about that.

Problem 1: U.S. citizen as shareholder of Canadian private corporations JML JS Building Co. 50% –$10,000 annual penalty for failure to file –Anti-deferral taxation if either Controlled Foreign Corporation (CFC) or Passive Foreign Investment Company (PFIC) –No CGE from U.S. capital gains tax Filing and other problems Sue’s shares require her to file information reporting her interest in JML and Building Co.

Anti-deferral provisions Controlled Foreign Corporations –If U.S. taxpayers hold more than 50% of a non-U.S. corporation, the CFC anti-deferral regime of Subpart F applies JML JS Building Co. PFIC Building Co. PFIC 50% Passive Foreign Investment Companies –75% of income is not from active business or –50% of assets produce passive income Problem 1: U.S. citizen as shareholder of Canadian private corporations

IRS does not accept typical Canadian valuation analysis of a freeze –Sue, as a U.S. citizen implementing a freeze in favour of her children and spouse, is seen by the IRS: to have made a taxable gift to be a contributor to a trust with a retained interest Some Canadian tax-free transactions (e.g. s.85 & s.86 exchanges) may be subject to U.S. taxation if implemented by U.S. citizens S FT Beneficiaries: Jim, Sue, children JML U.S. GIFT Freezor Problem 2: U.S. person doing a Canadian-style freeze

Beneficiaries are required to file annual information returns –$10,000 annual penalty for failure to file Any distributions made (or deemed made) subject to anti-deferral taxation and interest –Particularly problematic if there is a pattern of making distributions that began before U.S. issues were considered FT Beneficiaries: US persons JML Often the limitations can overwhelm the intended benefit of the Trust –No participation in appreciating capital assets and no CGE Problem 3: U.S. persons as beneficiaries of a non- U.S. trust

Anti-Deferral Provisions: Distributions from current year taxed on same basis as if earned directly FT Beneficiaries: US persons JML Distributions from the trust of income or gain “earned” by the trust in prior years are taxed as if they were ordinary income received in the year “earned,” plus interest at the IRS rate for late paid tax Problem 3: U.S. persons as beneficiaries of a non-U.S. trust

Anti-Deferral Example: Trust distribution of long-term capital gain A Canadian trust sells a property it acquired 3 years prior for a gain of US$300,000 and distributes to beneficiary who is a U.S. taxpayer: Gain is allocated $100,000 to each of the 3 years: –$100,000 is taxed as ordinary income (up to 40%) and subject to interest for two years –$100,000 is also taxed as ordinary income (up to 40%) and subject to interest for one year –$100,000 is taxed as capital gain (10-20%) for the current year Often these calculations result in an amount of tax plus interest exceeding the amount distributed, in which event the amount of tax plus interest is reduced to the distributed amount Problem 3: U.S. persons as beneficiaries of a non-U.S. trust

Trust: Minimize distributions to U.S. beneficiaries Only current year income and capital distributions are made to U.S. beneficiaries (all past income and appreciation must be first paid to Canadian beneficiaries); loss of tax deferral for all beneficiaries JML p/s JS Building Co. c/s Beneficiaries: Jim, Sue, children, future grandchildren FT c/s Problem 4: Solutions? More like “damage control”

PFIC: Sue transfers her shares of Building Co. to Jim Canadian attribution rules will apply to continue to have Sue report the dividends and gains on the transferred stock for Canadian tax p/s c/s JML p/s JS Building Co PFIC Building Co PFIC c/s Beneficiaries: Jim, Sue, children, future grandchildren FT c/s p/s Sue gifts shares to Jim 100% JML p/s JS Building Co. PFIC Building Co. PFIC Beneficiaries: Jim, Sue, children, future grandchildren FT c/s Problem 4: Solutions? More like “damage control”

LIVE IN L.A. Your all access pass to complete Wealth Management Planning around the U.S. citizen issues “...We’re gonna need a time machine.”

Time machine If we had known Sue, Abby, Bart and Caley were Americans…

Objectives: –Limited CGEs available for this family –Deferring taxation on appreciation only possible with U.S. trust –Income splitting, the key employee is the U.S. person, may also be restricted by tough U.S. attribution rules Participants: –Sue would not be able to own shares prior to freeze transaction –Sue and children should not be beneficiaries of a Canadian trust intended to do more than income splitting –Perhaps some of the children will renounce U.S. citizenship and can be added to the trust later A freeze without a trust may be preferred What transaction and who is involved?

Step 1: Objective - Focus on maximizing CGEs Prior to freeze, Sue gifts her common shares of JML to Jim 1. Non-taxable in Canada as a spousal transfer 2. U.S. gift tax exemption used (if value is greater than $143,000), but no U.S. capital gains 3. Gain on sale of shares attributed to Sue for Cdn tax JML No shares of JML JS Building Co.

Sue gifts her shares in Building Co to Jim 1.Non-taxable in Canada as a spousal transfer 2.U.S. gift tax exemption used (if value is greater than $143,000), but no U.S. capital gains 3.Dividends attributed to Sue for Cdn tax, but not U.S. Step 1: Objective - Avoiding PFIC JML No shares of JML JS Building Co. No shares of Building Co

Timing is critical When should Sue join the discussion? If the first discussion arises in the context of Sue giving valuable assets away as a step of a complicated plan, there is grave risk of suspicion and distrust Much better to involve Sue early in a discussion focused on addressing the difficulties for her U.S. reporting and compliance

Step 2: Objective – purify JML Jim implements typical “related persons butterfly” to purify JML, using Building Co. to receive the passive assets –use ITA s.85 (rollover of assets with gains) and ITA s.112 (deductible intercorporate dividends) –without triggering gains or taxable dividends to achieve tax- deferred butterfly JML J Building Co. 100% Cash and investments $2,000,000

Freeze and U.S. family/dynasty trust: a)Jim exchanges his common/participating shares of JML for fixed- value preferred shares (Jim keeps Building Co.) b)U.S. domestic trust subscribes for common/participating shares of JML c)U.S. domestic trust must watch income source re: FTC exposure d)Consider NOT using a family trust Step 3: Objective - focus on deferred appreciation JML p/s JS Building Co. p/s Beneficiaries: Jim, Sue, children, future grandchildren FT common shares No shares

U.S. Domestic Trust U.S. taxpayer for all income, so not subject to U.S. anti- deferral regime (so suitable to hold appreciating assets) Requirements Trustees must be U.S. citizens or U.S. institutions Subject to review by U.S. court May still be Canadian resident: Canadian resident, U.S. citizen trustees Concerns for assets and double taxation – FTC issues

Time machine and time manipulation Playing with the facts: What if just Sue is American, not the children? What if only Sue and Sue’s daughter Abby are American?

a)Jim exchanges his common/participating shares of JML (and possibly Building Co.) for fixed-value preferred shares b)Family trust subscribes (or does not, if facts don’t allow it) for common/participating shares of JML (and possibly Building Co.) Freeze and family trust JML J Building Co. p/s FT common shares Beneficiaries: Jim, children, future grandchildren

Transfer of assets from the U.S. spouse to the Canadian spouse using U.S. gift exemption: –Reduced U.S. estate exemption (treaty multiplier) Best used for asset that is appreciating or gets special tax advantage to be held by non-U.S. taxpayer –Critical gifted value does not “come back” to U.S. estate if U.S. spouse is survivor of couple Will of Canadian spouse must have U.S. bypass spousal trust Estate Planning

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