Estate tax relief and planning under the U.S.-Canada Income Tax Treaty.

Normally, income tax treaties are not part of an estate planner's toolkit. The U.S.-Canada Income Tax Treaty of 1980, as amended in 1995 (Treaty), is an important exception (see Protocol Amending the Convention Between the United States of America and Canada With Respect to Taxes on Income and on Capital Signed at Washington on September 26, 1980, as amended by the Protocols Signed on June 14, 1983, March 28, 1984, and March 17, 1995). It is the first tax treaty to address estate tax inequities that arise between the U.S. and a country without estate or inheritance taxes.

Treaty provisions apply to the estates of citizens and residents of the U.S. or Canada, as follows:

* U.S. citizens who reside in Canada, regardless of where their assets are located.

* U.S. citizens who do not reside in Canada, but have assets there.

* U.S. residents with Canadian assets.

* Canadian residents with U.S. assets.

Background

The U.S. imposes an estate tax on the value of assets transferred at death. Canada imposes an income tax on 50% of the unrealized gains on capital property deemed sold at death.

To further complicate matters, the Federal estate tax applies to both U.S. citizens and residents, while Canada's income tax is based only on residence. A U.S. citizen decedent who was a resident of Canada at death is subject to tax in both countries on all assets. In addition, each country taxes nonresidents on transfers of certain assets considered located within that country (e.g., real estate). This means that a Canadian resident is subject to both Canadian income tax and U.S. estate tax on the at-death transfer of appreciated real estate located in the U.S.

Because estate and income taxes are different, neither country's tax code allows a credit for the taxes imposed at death by the other country. As is discussed below, the Treaty mitigates the resulting inequities with provisions that address the following:

1. Double taxation.

2. Spousal bequests.

3. Unified credit for nonresidents.

4. Small estates.

5. Charitable donations.

The Treaty does not provide gift tax relief.

Double Taxation

To address the double-tax burden, the Treaty provides a foreign tax credit for the Canadian income tax on some or all of the U.S. estate tax paid on U.S.-situs assets (i.e., assets that would have been subject to U.S. income tax); see Treaty Article XXIX B.6. For U.S. estate tax purposes, it also provides a foreign death tax credit for the Canadian income tax assessed on the deemed sale at death of assets located in Canada; see Treaty Article XXIX B.7.

Spousal Bequests

The Treaty includes provisions to equalize the treatment of spousal bequests. In 1988, the U.S. estate tax law was changed to provide that the estate tax deduction for property passing to a surviving spouse is allowed only if the spouse is a U.S. citizen or the property passes to a qualified domestic trust (QDOT). An outright bequest to a noncitizen spouse is a taxable transfer for U.S. estate tax purposes.

Similarly, in Canada, a spousal rollover allows a deferral of the income tax assessed at death if the property passes to a surviving spouse and both the decedent and the surviving spouse are Canadian residents. Spousal trusts also qualify for rollover under Canadian law if the trust is resident in Canada, created by the will of a Canadian resident decedent and required to distribute its income to the spouse. A trust is resident in Canada if a majority of the trustees are Canadian residents.

Canadian provisions: The Treaty provides that for Canadian income tax, a U.S. resident decedent and spouse (regardless of residency) will be treated as Canadian residents and will be allowed the spousal rollover; see Treaty Article XXIX B.5. A spousal trust created under the will of a U.S. resident decedent may qualify for rollover treatment if it is resident in Canada or treated as such based on the determination of the Canadian Competent Authority. Canadian resident decedents are not eligible for this Treaty relief.

U.S. provisions: On the U.S. side, the Treaty provides a marital estate tax credit if the decedent is a U.S. citizen or a resident of either the U.S. or Canada; the surviving spouse is a U.S. or Canadian resident; if both the decedent and spouse are U.S. residents, at least one of them is a U.S. citizen; and the executor makes an irrevocable election to waive any marital deduction allowed by the Code; see Treaty Article XXIX B.3.

The amount of the credit can be significant. It is the lesser of the estate tax attributable to the spousal transfer computed without the marital credit, or an amount equal to the allowable unified credit; see Treaty Article XXIX B.4.

For a U.S. citizen decedent, this could be the equivalent of having a second unified credit. For decedents who die in 2006-2008, the Sec. 2010 unified credit (now referred to as the "applicable credit") is $780,800 (i.e., the tax on an estate of $2 million). A doubled credit would exempt from tax an estate of $3,697,345.

Example 1: J, a resident of Canada and U.S. citizen, dies in 2006. K, his spouse, is a Canadian resident. His will leaves his entire estate, worth $5 million, to K. Because K is not a U.S. citizen, J's estate tax without the marital credit is $1,380,000 (total estate tax of $2,160,800-$780,800 unified credit). Because the tax without the marital credit is more than $780,800, the marital credit is limited to $780,800; the net Federal tax after both credits is $555,800. Because. J and K are both Canadian residents, the spousal rollover defers the Canadian income tax on the at-death transfer to K, so there would be no foreign death tax credit on J's Federal estate tax return.

Unified Credit for Nonresidents

Yet another Treaty benefit is the enhanced U.S. estate tax unified credit for nonresidents. Sec. 2102(b) provides nonresidents a $13,000 credit from the Federal estate tax (i.e., the tax on a transfer of $60,000). The credit is of limited benefit for nonresidents with significant U.S. assets.

The Treaty provides for an alternative credit--a prorated U.S. unified credit (applicable credit). It is prorated based on the ratio of U.S. assets to the decedent's worldwide assets. The credit is limited to the lesser of the prorated credit or the tax, computed without the benefit of the unified credit; see Treaty Article XXIX B.2. Whether this credit is more beneficial than the $13,000 credit provided by the Code depends on the percentage of U.S. assets in the decedent's worldwide estate.

Example 2: A is a resident and citizen of Canada. At the time of her death in 2006, her worldwide gross estate was $3 million, which included $400,000 of real estate located in the U.S. The beneficiary of her estate is her son. A's Federal estate tax would be $121,800 before credits. The prorated credit is $104,107 (($400,000/$3,000,000) x $780,800). This amount is less than the total tax of $121,800, but significantly more than the $13,000 credit available under the Code, so the allowed credit is $104,107; the net tax is $17,693. A's estate saves $91,107 ($121,800-$13,000-$17,693) by taking advantage of this Treaty provision. If the U.S. real estate was worth only $40,000, however, the prorated credit would be only $10,411, less than the $13,000 U.S. statutory credit. For Canadian income tax purposes, a foreign tax credit for the U.S. estate tax may be available if there is Canadian tax on the deemed sale of the U.S. real estate. If A's beneficiary was her Canadian citizen spouse, the marital credit would be limited to $17,693 (the remaining tax after the prorated unified credit), and the estate would have no Federal estate tax.

Exclusion for Small Estates of Certain Canadian Residents

The Treaty provides an exclusion from some or all U.S. estate tax for certain small estates. This exclusion applies only to a non-U.S.-citizen, Canadian resident whose worldwide gross estate is $1.2 million or less. The exclusion does not apply to the extent that the U.S. assets are appreciated U.S. real property interests, stock of a U.S. real property holding company or business property of a business operated before the Canadian's death that would have been subject to U.S. income tax; see Treaty Article XXIX B.8. Basically, the first requirement is that the worldwide gross estate be no greater than $1.2 million (in U.S. dollars). Then, U.S. assets are evaluated to determine which can be excluded. The marital and prorated unified credits discussed above may also be used to minimize or eliminate the U.S. estate tax on assets that do not qualify for the exclusion.

Charitable Deductions

For Federal estate tax purposes, under Sec. 2106(a)(2), the charitable deduction for nonresident decedents is allowed only for contributions made to U.S. tax-exempt organizations. Under the Treaty, however, contributions to qualifying organizations in the U.S. or Canada are considered to be contributions to a qualifying organization in the taxing country; see Treaty Article XXIX B.1. This means that contributions to qualifying Canadian charities may be considered in the computation of a Canadian's U.S. estate tax.

Additional Relief

For instances of double taxation or other inequities that are not adequately addressed by Treaty provisions, competent authorities in either country may provide relief (i.e., the IRS and the Canada Revenue Agency).

Conclusion

Obviously, Treaty provisions can provide significant relief to estates subject to tax in the U.S. and Canada.

More importantly, the Treaty provides Opportunities for proactive estate planning--for example, converting foreign investments to assets exempt from tax under the Treaty or Code (e.g., bank accounts), or selling assets that would be taxed unfavorably at death. It also provides an opportunity to have a less complicated estate plan, by possibly eliminating the need for a QDOT for a non-U.S.-citizen spouse.

FROM KRISTI M. MATHISEN, CPA, J.D., BADER MARTIN PS, SEATTLE, WA