While the Treaty does provide some relief from the double taxation which results on the death of a non-resident owning U.S. situs property, it may not provide full relief. In general, the estate planning for non-resident aliens owning U.S. situs property focuses on one of the following three methods:
- reducing the assets owned at death which have a U.S. situs;
- decreasing the worldwide gross estate; and
- increasing the available deductions.
2. Sole Purpose Corporation
As noted above, one planning opportunity is to remove assets from the category of U.S. situs property. One of the most popular planning tools used to accomplish this in the past involved placing U.S. situs assets, particularly a U.S. vacation property, in a Canadian or other foreign (e.g., Cayman Islands, British Virgin Islands) corporation. Shares of a Canadian corporation (or shares of any foreign corporation) are not considered U.S. situs property and are not subject to U.S. estate tax.
(b) Canadian Position
Technically, a shareholder who uses corporate owned property (e.g., a U.S. vacation property) will be deemed to have received taxable income in the form of a shareholder benefit under section 15(1) of the Act. However, Revenue Canada (now Canada Revenue Agency ("CRA")) in response to Question 20 at the Revenue Canada Round Table of the 1980 Canadian Tax Foundation Conference provided administrative relief in certain circumstances. Where certain conditions were met, a Canadian shareholder of a sole purpose corporation would not be deemed in receipt of a shareholder benefit. This assumes a fair market rental fee is not paid to the corporation. However, the CRA, which has replaced Revenue Canada, revoked the prior administrative position in June, 2004, subject to certain transitional rules rendering shareholders of new sole purpose corporations vulnerable to Canadian (as well as U.S.) income tax on their use of the sole corporation's premises.
(c) U.S. Position
Whether the sole purpose corporation ever was an effective planning tool from a U.S. estate tax perspective is far from certain. The main argument upon which the IRS could rely to challenge this type of planning is that the deceased individual rather than the sole purpose corporation really owned the U.S. vacation property. The IRS has stated that it may in certain circumstances pierce the corporate veil and treat U.S. property legally owned by a corporation as an asset of the shareholder. In fact, compliance with the former Revenue Canada requirements for a sole purpose corporation provides support to the IRS when it attempts to attack the corporation as a sham. For instance, the facts that (i) the corporation has no business purpose, (ii) the corporation does not generate income, and (iii) the shareholder pays all the expenses lends strong support to a challenge by the IRS that the individual, not the corporation, owns the real estate. It would appear that the IRS would have a strong case to challenge existing sole purpose corporations and there is evidence that the IRS has done so in Florida and forced estates to concede U.S. estate tax liability or at least settle on less favourable terms. It is still possible to hold U.S. real estate in a foreign (non-U.S.) jurisdiction (e.g., Cayman Islands, British Virgin Islands) which imposes no corporate income tax, and many U.S. real estate properties are still held in foreign corporations, but the risk of challenge by the IRS that the individual rather than the corporation owns the real estate remains a hurdle. Although the IRS rarely attacks foreign corporations holding U.S. real estate (except as noted below), they may easily change their policy, and the lines of attack would be simple.
Does the foreign corporation really "own" the U.S. real estate, or does the ultimate individual shareholder enjoy all the benefits of the real estate without adhering to corporate formalities? Formalities include:
- maintaining corporate minutes;
- conducting all business (e.g. bank accounts) through the corporation;
- registering the corporate (rather than individual) ownership everywhere (e.g. in condominium associations or clubs); and paying rent for use of the corporate property by the individual shareholder.
To avoid a challenge by the IRS, the shareholder should respect the separate existence of the corporation by maintaining annual and special meeting minutes, issuing stock, paying bills with corporate funds and titling and insuring property in the corporate name. In addition, the corporation should comply with the requirements of the jurisdiction in which the U.S. vacation property is located. For instance, most jurisdictions require that if a corporation owns real property in the jurisdiction, the corporation must have a registered office and a registered agent in the jurisdiction. Finally, the Snowbird should use a foreign corporation (e.g. Cayman Islands, British Virgin Islands) rather than a Canadian corporation. In a recent court case the United States Tax Court concluded that the rent free use of corporate owned premises by members of the ultimate corporate owner's family constituted a constructive dividend by the Florida corporation whose premises were used on a rent free basis to the ultimate shareholder, an individual in Peru. It should be noted, however, that significant income tax disadvantages arise from the use of the sole purpose corporation or any other foreign corporation. Specifically, much higher tax rates are imposed on the sale of property by a corporation than by an individual, particularly in Florida, and there may be substantial double taxation if the shareholders (or their heirs) decide to sell the U.S. vacation property. A corporation (foreign or domestic) pays full U.S. tax on the sale of real estate at tax rates generally higher than if the property were held by the individuals directly. Then Canada (or any other ultimate jurisdiction in which the individuals reside) may impose tax on the distribution of the net proceeds from the corporation to the shareholders. Finally, Canadian shareholders may not credit the U.S. taxes paid by the corporation on the sale of the property against their Canadian income tax on receipt of the proceeds by the individual shareholders. If the foreign corporation is formed in a tax free jurisdiction (e.g., Cayman Islands or British Virgin Islands), then the second level of tax on the release of the funds from the corporation will be eliminated.
3. Qualified Domestic Trusts
As described above, the TRA of 2010 provided estates of decedents dying after December 31, 2009 but before January 1, 2011, the opportunity to elect out of federal estate taxation. The consequence of making this election was that the basis of the decedent's assets would not be entitled to a step-up to date of death values for capital gains purposes. If an individual died after December 31, 2009 but before January 1, 2011 and the Executor made the election to exempt the estate from federal estate taxation, then the US situs estate is not subject to federal estate and there is no need for a qualified domestic trust (QDOT). This election applies only to 2010 decedents and much analysis is required to determine whether the federal estate tax regime with a step-up in basis or the election out of the federal estate tax regime is more beneficial to the specific estate. For any estate subject to the federal estate tax regime, the use of a QDOT is required to obtain the federal estate tax marital deduction for property passing for the benefit of a non-U.S. Citizen surviving spouse. Property passing outright to a non-U.S. Citizen surviving spouse does not qualify for the federal estate tax marital deduction. Caution should be exercised with respect to jointly owned assets, i.e. real estate, securities or bank accounts titled with rights of survivorship in the names of husband and wife. Property passing outright by title (survivorship or beneficiary designation) or operation of law (tenants by the entireties property) to the surviving spouse does not qualify for the federal estate tax marital deduction. As noted above, using allowable deductions is one planning opportunity to consider. For example, an unlimited marital deduction is allowed for property passing to a QDOT.
To qualify as a QDOT, a spousal trust must meet the following criteria:
- the surviving spouse must be entitled to receive all of the net income of the trust during the spouse's lifetime and such income must be payable at least annually;
- no distributions of trust principal may be made to anyone other than the surviving spouse during the spouse's lifetime;
- the trust instrument must provide that at all times at least one trustee is a citizen of the United States or a U.S. domestic corporation;/p>
- - the trust instrument must provide that no distribution of principal to the surviving spouse may be made unless the U.S. trustee approves and is given the power to withhold from such distribution the estate tax that is due upon such a distribution or upon the death of the surviving spouse; and
- the executor of the non-resident alien's estate must irrevocably elect to treat the trust as a QDOT (electing to do so on the U.S. estate tax return).
Moreover, IRS regulations further provide that QDOTS must meet the following requirements in order to be a QDOT:
- the U.S. trustee must be a U.S. resident;
- if the fair market value of the assets to be held in the QDOT is greater than US$2,000,000 (without any reduction for associated indebtedness), one of the following two additional measures of security must be met:
- a U.S. bank or trust company or a U.S. branch of the foreign bank must be the U.S. trustee; or
- a bond or irrevocable letter of credit equal to 65% of the fair market value of the trust property held by the QDOT must be posted with the IRS; and
- if the value of the assets to be held in the QDOT is less than US$3,500,000, the trust instrument must provide that no more than 35% of the fair market value of the trust assets held by the QDOT may consist, during the term of the QDOT, of real property located outside of the United States. If it does exceed 35%, the bank or bond requirement must be met.
If these requirements are met, the estate tax will be deferred until the earlier of:
- the distribution of principal by the Trustees of the QDOT (except for distributions of income) prior to the death of the surviving spouse other than distributions to relieve hardship; or
- the death of the surviving spouse.
Since distributions of income to the surviving spouse from a QDOT are not subject to the deferred estate tax, one means of maximizing the benefit of the QDOT is to ensure the QDOT is constituted with income-earning assets as opposed to growth assets. With respect to the "hardship" exception, a distribution must be in response to an immediate and heavy financial need relating to the surviving spouse's health, maintenance or support. On the death of the surviving spouse, the estate tax will be imposed on the value of the property remaining in the QDOT. The tax rate applicable is determined by having regard to the marginal estate tax rate of the estate of the first spouse and not the estate of the surviving spouse. When a non-resident alien couple owns U.S. situs property jointly with right of survivorship, the value of the property passing to the surviving spouse does not qualify for the U.S. marital deduction. However, if the value of such property exceeds the exemption available to the non-resident alien, the executors and the surviving spouse may transfer the property to a post-mortem QDOT. In that event, the surviving spouse and the executors of the first spouse to die elect to qualify the trust as a QDOT on the estate tax return. Given the introduction of the marital credit in the Treaty, it will be important for executors to have the flexibility to determine whether the use of a QDOT is the most tax efficient vehicle for the estate. The marital credit provided by the Treaty is not available for assets which are transferred to a QDOT. Accordingly, the estate of the first spouse to die must decide between using the new marital credit provided under the Treaty and the marital deduction provided under the Code for assets passing to a QDOT.
While insurance is not a planning tool directed at lowering estate tax payable, it is an important tool in ensuring that the non-resident alien's estate has the liquidity to satisfy any liability for estate tax. Life insurance proceeds payable on the death of a non-resident alien by a U.S. insurer are not U.S. situs property and so do not form part of the U.S. gross estate. Such proceeds are, however, part of the worldwide gross estate if they are payable to the insured's estate or are available to satisfy any claims against the insured or the insured's estate, including to pay estate or other taxes payable by reason of the insured's death; or the decedent retained any incidents of ownership in the policy within three years of death as determined by U.S. domestic law.
Incidents of ownership are not limited to actual ownership of the policy but include any of the following: the right to change the beneficiary; the right to surrender or cancel the policy; the right to assign or transfer the policy; and the right to pledge the policy as security for a loan.' If the non-resident alien can somehow effect the beneficial enjoyment of the property, he or she will have an incident of ownership. If insurance forms part of the worldwide gross estate, it will impact the deduction and credits permitted to the non-resident alien's estate. To avoid inclusion in the worldwide gross estate, the insured cannot retain any incidents of ownership. Accordingly, another person must be the owner of the policy. Anyone with an insurable interest may be the owner of an insurance policy. A spouse is not an effective choice because the proceeds would be included in the spouse's worldwide gross estate on the death. Children may not necessarily be the best choice either. In the United States, a planning tool known as the irrevocable life insurance trust has developed as a means of avoiding the retention of any incidents of ownership. Given the importance of who owns the policy, the use of life insurance to fund the estate tax liability should be addressed at the time the policy is acquired. If a non-resident alien already has a life insurance policy purchased in his or her name, he or she can either make an absolute assignment of the policy to another person or transfer the policy to an irrevocable life insurance trust.
5. Use of Spousal Trust
Some Canadians choose to use Canadian (Ontario) spousal trusts to hold their U.S. vacation properties. In the typical example, the husband forms an irrevocable spousal trust in Ontario and settles it with funds sufficient to purchase the target real estate. The husband names his wife and children as the beneficiaries. The trust purchases the vacation home and holds it for the benefit of the wife and children. The spousal trust must be drafted to avoid the provisions of section 2036 of the Code which enables the IRS to return the property to the estate of the husband if he has sufficient powers (e.g. acting as a trustee, being a beneficiary, having the right to change the terms of the trust). However, a carefully drafted trust should avoid this problem. On the death of the husband, he has no U.S. estate as he holds no U.S. situs property. When the wife dies, she also dies holding no U.S. situs property as she was a simple beneficiary. This assumes that she has no general power to appoint the property. In this way, the property passes down to the children with no U.S. estate tax. Obviously, the husband must be confident of his marriage as he will have no right to the property or to visit the property and must come as a guest of his wife. In addition, a trust is considered for tax purposes in Canada to terminate every 21 years generating a taxable gain in Canada on the increase in the value of the trust property, so care must be taken in Canada as to the Canadian tax implication of such a termination.
6. Inter Vivos Dispositions
An inter vivos disposition of U.S. situs property for inadequate consideration by a non-resident alien will result in a transfer that is subject to U.S. gift tax., Double taxation may result because under Canadian tax law, a disposition for inadequate consideration is deemed to take place for fair market value. Accordingly, any accrued capital gains will be taxable.' The U.S. gift tax may not be credited against the Canadian capital gain tax.