Canada has not had estate and gift taxes since their repeal in 1972.[i] It will be a surprise for many Canadians that they could still be subject estate and gift taxes under US tax law. Canadian residents who are not US citizens can be subject to tax on assets owned in the United States including US real property and stocks.
Overview of US tax attributes
The US Internal Revenue Code (IRC) imposes tax liability depending on a taxpayer’s classification as: (1) a US citizen; (2) a US resident alien; or (3) Non-resident aliens. US Persons (citizens and residents) are taxed on their worldwide income, no matter their residence. Income tax law residency is determined different than for transfer tax law (gift, estate and generation-skipping transfer taxes[i]).
Individuals who are US citizens or residents are taxed on worldwide income.[i] Non-resident alien individuals are subject to US federal income tax on: (1) net income that is effectively connected with the conduct of business within the US[ii] at the same rates applicable to US citizens and residents;[iii] and (2) US-source income that is fixed or determinable annually or periodically.
Residency is determined under two tests: the substantial presence test[iv] and the green card test.[v] A person who is not a US citizen and also fails both the substantial presence test and the green card test is considered a US non-resident alien for income tax purposes.
Unlike income tax law, US transfer tax law is based on domicile. Domicile is determined in a different manner from residency. An individual can acquire a domicile by living at a location while having no definitive or present intention of moving. An individual can have exactly one domicile and once established the individual must demonstrate intent to leave that domicile in favour of a new one. There are many factors that help determine the domicile of a person for US transfer taxes, none of which are individually determinative. [vi]
For transfer tax purposes, a non-resident alien is an individual that is not domiciled in the US and is not a citizen or resident. Further, since non-resident aliens are not US persons for transfer tax purposes, they will not attract the same gift and estate tax exemptions available to US residents and citizens. Non-resident aliens are not subject to transfer tax on worldwide assets, only US-situs or deemed US-situs assets.[vii]
For US persons, the retained interest rules mean that estate tax is not limited to the assets the decedent[viii] owned at death. Despite attempts by an individual to make lifetime transfers, some previously transferred property may be deemed to remain with the decedent’s estate at death. These include, but are not limited to: certain gifts made within three years of death; transfers with a retained life estate; certain annuities; interests owned jointly; and revocable transfers among others.
Retained interest rules also apply to the estate of a non-resident alien; however the application is limited by the same situs rules that limit estate tax applicability.
US gift and transfer taxes are applied at a graduating rate. For US citizens and residents, the graduated rates are applied to the fair market value of the individual’s taxable estate. For non-resident aliens, only the fair market value of US situs or connected assets are included in the taxable estate. The maximum federal estate tax rate for estates over $1mm is 40%, with an exemption amount of $5mm, indexed annually since 2013 for inflation. For 2015 the exemption for US citizens and residents is $5.43mm; this exemption is not available to non-resident aliens.
For US citizens and residents, the transfer exemption is unified across transfer and gift taxes. There is an annual gift exemption that exists ($14,000 in 2015); however, any exempt gifts provided during the individual’s lifetime will reduce the $5mm estate exemption amount.
US estate tax limits non-resident aliens to a $60,000 estate tax exemption and a $0 annual gift tax exemption.
US citizens and residents receive a credit against the estate tax that will exempt the first $5.43mm of the gross estate for 2015.
Administrative expenses, debts, taxes and losses
There may be available to reduce the gross estate for US citizens or residents, but are limited for most non-resident aliens. [ix]
US citizens and residents can receive a deduction for the entire value of any property donated to a qualifying charitable organization, located anywhere in the world upon death. For non-resident aliens the deduction is available, however it is only applied to non-resident’s gross estate (US situs or connected assets) and the property may only pass to US-based charities.
Marital deductions – US citizen spouse
US citizens, residents and non-resident aliens receive an unlimited marital deduction for bequests to US citizen spouses.
Marital Deductions – non-US citizen spouse
There is no marital deduction for a transfer to a non-US citizen spouse. There is an estate planning option which allows deferral of tax at the death of the first spouse. This is called a qualified domestic trust. The deferred tax is paid at the marginal rate of the decedent’s estate, but at current asset fair market value.
In Part II of my series on US estate planning considerations we will discuss expatriation tax, trusts and life insurance among other issues.
[i] At a maximum federal rate of 39.6 percent plus a 3.8 percent “Medicare Tax” on certain investment income. Long-term capital gains and certain qualified dividends are taxed at a maximum federal rate of 20 percent + Medicare Tax. State and local taxes may also apply.
[ii] “Effectively connected income” – note: gains from the disposition of US situs assets are treated as effectively connected income.
[iii] Medicare tax does not apply.
[iv] Substantial presence test determines residency based on the number of days an individual spends in the US over a three-year period. An individual is a US resident for income tax purposes is they are in the US for 183 or more days in the current year, or for 183 days or more during a three year period using a weighted average formula. Any day or portion of a day, counts as a day of presence in the US. There are exemptions for individuals who are in the US for school, medical reasons, commuters from Canada or Mexico, professional athletes and foreign government officials.
[v] The green card test is based on the person’s immigration status and treats a person as a resident for US tax purposes if the individual obtains lawful permanent resident status.
[vi] These include statements of intention (wills, visa applications, trust agreements and deeds) time spent in the US versus other jurisdictions, location and size of the person’s residences, and business, family, social and religious attachments.
[vii] “Situs” means the place of taxation, or the country that has jurisdiction to levy a particular tax on persons, property or business.
[viii] The person who has died.
[ix] Nonresident aliens determine the deductibility of these expenses as a fraction – [total US situs property]/[estate determined as if decedent were a US citizen/resident]. Deductible expenses are multiplied by this fraction.
[i] The generation-skipping transfer tax is designed to prevent property transfers to heirs more than one generation removed. There is also an inflation indexed $5mm exemption for generation-skipping transfer tax.
[i] While there are no Canadian estate and gift taxes, there is a deemed disposition of all capital property owned by the individual at the time of death that is deemed to occur at the death of a taxpayer. The disposition is deemed to occur at the fair market value of the property immediately before death. It may result it in a capital gain or loss to be included in the computation of income for the year of death. The beneficiary or the estate will be deemed to acquire the property at cost equal to the deemed disposition. There are certain circumstances where relief from these taxes is available; however, this is beyond the scope of this discussion.