Canada Focus

The Fifth Protocol to the Canada/US Treaty

  • Author : Beth Webel
  • Author : Nadja Ibrahim
  • Date : September 2008
Beth Webel TEP is a partner in the Private Company Services tax group in Pricewaterhouse-Coopers in Hamilton and Nadja Ibrahim TEP is a partner in the Private Company Services tax group in Pricewaterhouse-Coopers in Calgary

In September 2007, after nearly ten years of negotiation, Canada and the United States jointly released the Fifth Protocol to the Canada-US Income Tax Convention. The impact of the Protocol on the area of cross-border estate planning has received little discussion or fanfare.

The Protocol includes important changes relating to charitable deductions, taxes imposed by reason of death on registered retirement savings plans (RRSP), registered retirement income funds (RRIF) and US stock options.

Charitable donations

Canadians can be subject to US estate tax if they own certain US assets on death. Such assets include shares in a US company, US real estate, and US stock options.

The Protocol includes important changes relating to charitable deductions, taxes imposed by reason of death on RRSP, RRIF and US stock options

A common estate-planning technique used by Canadians to allow them to minimise or eliminate their US estate tax exposure on US assets is to provide that such assets be donated to a Canadian charity on death. This donation is usually provided for directly in the individual’s will. Currently, the US provides an estate tax deduction equal to the value of the donation if a Canadian resident donates US property on death to a US or Canadian charity. If the individual donates all of his or her US property to a US or Canadian charity there will be no US estate tax payable on death.

In addition, any donations to a Canadian charity would provide the estate with a charitable donation credit to be used to offset Canadian tax payable on the individual’s death.

Changes

Under the Protocol, this tax relief will no longer be available with respect to donations made by will to Canadian charities. As a result, a Canadian decedent who donates US assets on death can avoid US estate tax only if the US property is donated to a US charity. This restriction does not apply if the Canadian resident is also a US citizen.

The Protocol also provides that if a Canadian resident donates US property to a US charity, then for Canadian tax purposes the estate can elect that the property is deemed to be disposed for an amount between cost and fair market value. The effect of this election is to eliminate Canadian tax payable arising on US assets that are donated to US charities.

Even though a Canadian may still eliminate their US estate tax exposure through the donation of US property on death to a US charity, the Canadian may have little or no connection to any US charity and therefore may have no wish to make a donation to a US charity.

RRSPs and RRIFs

The Protocol also provided clarification on existing Treaty provisions. In particular, the Protocol confirms that foreign tax credit relief is available when Canadian and US taxes are imposed at death on RRSPs and RRIFs. Prior to this clarification a submission to Competent Authority was often required in order to be entitled to foreign tax credit relief.

Canadian residents: Canadian residents who die owning US securities in an RRSP or RRIF may be subject to both US estate tax and Canadian income tax. The Protocol clarifies that a Canadian-resident decedent can claim a foreign tax credit on the Canadian terminal income tax return for US estate tax paid on the US investments in their RRSPs or RRIFs. The foreign tax credit is limited to the amount of Canadian federal income tax paid on the RRSP or RRIF on death. The Provinces do not allow such a foreign tax credit as they are not parties to the Treaty.

To claim the foreign tax credit for US estate tax paid, the Canadian income tax must be triggered at the decedent’s death. Therefore, no foreign tax credit relief is available if the RRSP or RRIF is transferred to a surviving spouse on death since such transfers occur on a tax free basis. There is no ability to claim a foreign tax credit for US estate tax paid on the first spouse’s death against Canadian tax arising on the second spouse’s death.

US citizens/residents: A decedent who is a US citizen or resident may be subject to both US estate tax and Canadian income tax if he or she dies owning an RRSP or RRIF. The Protocol confirms that US decedents are able to claim a foreign tax credit on their US estate tax returns for Canadian federal income tax paid as a result of the deemed disposition of the RRSP or RRIF.

Prior to the Protocol and unlike the Canada Revenue Agency, the IRS had recently conceded to allow such a foreign tax credit after a Competent Authority resolution was reached in an unpublished case. As a result of the resolution the IRS was changing their instructions to all of their agents and examiners to allow a foreign tax credit. However, the clarification of this point in the Protocol provides taxpayers with comfort regarding their foreign tax credit claim.

US stock options

It is not uncommon for Canadian-resident employees to be granted options to acquire shares of a US public company. Upon death, the Canadian resident may be subject to US estate tax on the value of the US options if the value of the US stock exceeds the exercise price. In addition, the decedent may be subject to Canadian income tax as a result of the deemed disposition of the option on death.

The Protocol confirms relief from double taxation when a Canadian resident owns US stock options at death. Canadian federal tax arising on the deemed disposition of the options at death will be reduced by the amount of US estate tax paid on the US options.

Final thoughts

While the Protocol has resolved the double tax issues on death relating to RRSPs, RRIFs and options in the cross-border context, it has taken away a useful planning strategy for Canadians wishing to minimise their US estate tax exposure by donating US property to a Canadian charity. US estate tax planning steps put in place in the past likely will have to be revisited in light of the proposed changes in the Protocol.

The Protocol confirms relief from double taxation when a Canadian resident owns US stock options at death

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