Taxation Upon Death
Part 1: U.S. Persons Who Die Owning Canadian Property. While the U.S. estate tax provides a credit against foreign death taxes paid, this credit is limited to death and inheritance taxes and does not include income taxes. Helpfully, the Treaty provides relief from potential double taxation by providing estate tax credits for Canadian gains taxes on death-related property dispositions. The Protocol provides that income tax paid to Canada on the deemed disposition of Taxable Canadian Property upon the death of a U.S. person, whether or not a Canadian resident, is treated as a foreign death tax and, therefore, the United States must give a credit against the U.S. estate taxes imposed on the Canadian property for income tax paid to Canada.
Canadian tax law also provides for a deferral of tax on property that is transferred to a Canadian surviving spouse or a spousal trust at death. In effect, if an individual bequeaths real property to a surviving spouse who is a resident of Canada, that property is treated as being disposed of at its cost basis, with no recognition of gain or loss at the time of the transfer. As a result, the recognition of gain or loss will be deferred until the earlier of the sale or deemed disposition of the property by the surviving spouse. When an individual owning Canadian property is a resident of the United States immediately before death, the Treaty (as amended by the Protocol) extends this deferral benefit by treating the U.S. resident surviving spouse as a resident of Canada.
Part 2: U.S. Citizens Who Die as Canadian Residents. When a U.S. citizen dies resident in Canada owning U.S. property, Canada is obligated under the Treaty to give a tax credit against the Canadian federal income tax imposed on the deemed disposition of the U.S. property for U.S. estate taxes. However, the amount of this credit is limited to the estate taxes that would have been payable to the United States if the individual were not a U.S. citizen. The concept appears to be that, between this Canadian credit for U.S. estate taxes on the U.S. property and the U.S. credit for Canadian tax on the Canadian property discussed in Part 1, double taxation should effectively be avoided. However, most provinces take the position that the Treaty does not apply to them and the credit may not offset their portion of the tax (which can be as high as one-half of the income tax assessment).
Part 3: Canadian Residents Who Are Not U.S. Citizens and Die Owning U.S. Property. The Treaty (as amended by the Protocol) provides significant benefits to non-U.S. citizen Canadian residents who die owning U.S. property. The Treaty provides that Canadian residents are entitled to a unified credit against U.S. federal estate tax equal to the greater of (i) the unified credit available to estates of non-U.S. persons, which is currently $60,000, and (ii) a pro-rated portion of the unified credit available to estates of U.S. persons based on the value that an individual's gross U.S. estate bears to the value of such individual's worldwide estate. This means that a Canadian resident will not be subject to federal estate tax if the value of his worldwide assets is less than the amount of the unified credit, which is currently $2 million.
The Treaty also provides that, instead of using a QDOT to obtain a marital deduction, the estate of a Canadian decedent can take advantage of a marital credit that is available for U.S. property transferred to a surviving non-U.S. citizen spouse who is either a Canadian or U.S. resident (or to a spousal trust for such person). The amount of this additional credit is limited to the smaller of (i) the amount of the unified credit discussed in the previous paragraph allowable to non-U.S. citizen Canadian residents who die owning U.S. property, and (ii) the amount of additional estate tax that would otherwise be imposed on the property left to the spouse, if such property were subject to U.S. estate tax.
When U.S. federal estate tax is imposed on the estate of a Canadian decedent owning U.S. property, the Treaty provides a credit against any Canadian federal income tax for the U.S. estate tax paid on the U.S. property equal to the smaller of the two taxes. This credit will be useful in situations where the value of the U.S. property is significantly greater than its cost basis immediately prior to the death of the Canadian resident. For most Canadian residents in such a situation, however, there may still be some double taxation because the U.S. estate tax may not offset the provincial component of the Canadian gains tax.
Historically, many Canadian residents who owned U.S. property planned to avoid U.S. estate tax by holding the U.S. property through a Canadian holding company. Canadian law, however, imposes a substantial disincentive to such a strategy by imputing income to the shareholder for the use of property owned by the corporation. An exemption from this treatment for so-called "single-purpose corporations" was abolished in 2005 on the theory that the Protocol eliminated the danger that U.S. property owned by Canadian residents would be subject to double death taxes. However, this Canadian Revenue ruling ignored the fact that, even with the benefit under the Protocol of the credit for U.S. estate tax against the Canadian capital gains tax, the estate of a Canadian resident might be paying a net additional U.S. tax of as much as 30 percent of the value of the U.S. property for the privilege of owning property in the United States instead of in Canada. Canada does not have limited liability companies, which are generally untested as barriers to U.S. estate tax on property owned by non-U.S. persons anyway. Alternative strategies that might be considered include the use of non-recourse debt, life insurance and possibly acquiring U.S. property through partnerships.