Thursday, 8 November 2018

US Shareholder of a Canco After 2017 Tax Reform*

Public Law no. 115-97 (2017 tax act)—the Tax Cuts and Jobs Act, signed December 22, 2017—significantly changed the Code and negatively affects a US person in Canada holding shares in a closely held corporation. The changes were intended to target a large corporation, such as Apple, that has large non-US retained earnings, an oversight no doubt attributable to hasty legislative drafting.

A US CFC shareholder is deemed to be a US shareholder if 10 percent of the CFC's votes or value is held by a US individual or US corporation. A CFC is a non-US corporation in which more than 50 percent of the votes or value is owned by US shareholders. Before the 2017 tax act, a US shareholder was a US person who held at least 10 percent of the votes of the non-US corporation.

The 2017 tax act eliminated Code section 958(b)(4), which prevented the attribution of shares owned by a non-US person to a US person. Thus an individual US investor in the accompanying chart is deemed to be a US shareholder of Foreign Subsidiary. The chart is from the AICPA's letter (dated March 13, 2018) to the IRS and the Department of Treasury.

IRS Notice 2018-13 (2018-6 IRB 341) stated an intent to amend IRS form 5471 to except category 5 filing for a US person deemed to be a US shareholder via the new attribution rules.

A US CFC shareholder is subject to the section 965 transition tax regime (also referred to as the "toll tax," or "repatriation tax"). That tax is levied on all earnings and profits (similar to retained earnings) accumulated post-1986 to the higher of earnings and profits on November 2, 2017 or December 31, 2017, and it is payable on the pro rata share of earnings held by a US shareholder. If the US shareholder is a corporation, the cash repatriated is subject to tax at a flat rate of 15.5 percent; other assets are subject to an 8 percent flat rate. A US individual shareholder does not benefit from the flat rates, but if his or her income level is taxed at the highest rate, he or she is subject in 2017 to a toll tax rate of 17.5 percent (or about 27.3 percent in 2018) for cash and 9 percent (or about 14.1 percent in 2018) for non-cash. (See Amanda Athanasiou, "Toll Charge Is Taking Individuals by Surprise," Tax Notes International, February 19, 2018.) The 2018 rate applies to an individual whose tax liability is less than US$1 million and who seeks to use the eight-year payment plan in section 965(h)(1).

Income accumulated in a non-US corporation that was not subject to the toll tax (because it was earned after the tax was introduced) may be subject to the tax under section 951A's global intangible low-tax income (GILTI). GILTI is taxed in the US individual shareholder's hands at his or her highest tax rate: a US corporate shareholder is taxed at 10.5 percent (there is a 50 percent deduction under section 250).

The favourable tax treatment for a US corporate shareholder has many practitioners considering the section 962 election, which allows to an individual US shareholder the corporate tax rates in section 11 on section 951(a) inclusions. This annual election also entitles the individual to claim an otherwise unavailable deemed-paid foreign tax credit under section 960. Sections 965 and 951A are both part of subpart F; arguably, a section 962 election is available to a US individual shareholder faced with the transition tax and with GILTI thereafter. On September 18, 2018 the US Tax Court released Barry M. Smith and Rochelle Smith (151 TC no. 5), which considers the election in a regular subpart F context, not in the context of section 965 or 951A. The court provided a sound overview of the election and explained that it does "not create hypothetical corporations or change real-world facts. [It] simply provide[s] a mechanism that enables an individual U.S. taxpayer to elect what he or she may deem more desirable tax treatment."

In Smith, the CFCs in question were based in Hong Kong and in Cyprus. There was no US-Hong Kong tax treaty and the US-Cyprus tax treaty did not apply (the treaty's LOB clause was not met). The taxpayers elected to treat the Hong Kong CFC and Cyprus CFC as corporations under section 962, and the issue was whether current distributions from each CFC—a domestic corporation under the election—received qualified dividend treatment under section 1(h)(11)(B)(i)(I) or ordinary dividend income treatment at a higher tax rate. This case confirms that a distribution of a qualified foreign corporation that has made a section 962 election will be accorded qualified dividend treatment under section 1(h)(11)(B)(i)(I). A US shareholder of a Canco would meet the section 1(h)(11)(B)(i)(I) test, which accords qualified dividend treatment to dividends "from—domestic corporations, and qualified foreign corporations." Section 1(h)(11)(C) defines a "qualified foreign corporation" as a corporation incorporated in the United States or eligible for benefits under a comprehensive US income tax treaty. Notice 2006-101 provides that Canada meets those requirements; the election is therefore worth considering for US persons in Canada who are deemed US shareholders. Note that the election forfeits the benefits of section 959(a), which holds that a deemed distribution taxed in a CFC is not taxed again in the shareholder's hands upon distribution. Section 962(d) states that, upon actual distribution, the shareholder must include in income that portion of the distribution that exceeds the transition tax paid on the election, which could result in a larger tax liability to the individual taxpayer if an election was not made and if the dividend was issued by a corporation in a non-qualified country. Given the qualified status of Canada, the current higher tax rates on dividends in Canada, and the low tax rates accorded to qualified dividends in the United States, a US shareholder of a Canadian corporation is better off if it makes the section 961(d) election today. However, if Canada lowers its general tax rates and dividend rates, a section 961 election may not be such a good thing.

It is the author's view that a section 961 election does not apply to the GILTI deduction under section 250.

The unintended consequences described above are likely to be corrected by the IRS Treasury, but a question remains about the timing of that correction and what it will entail.

Sunita Doobay
TaxChambers LLP, Toronto

*First published in the October edition of the Canadian Tax Highlights Volume 26, Number 10 ©2018, Canadian Tax Foundation.

Tuesday, 11 September 2018

Guidance on Withholding on US Partnership Interest's Sale*

The Treasury department and the IRS issued Notice 2018-29 on April 2, 2018 (following closely the publication of "US Partnership Interest Sale Triggers 10 Percent Withholding," Canadian Tax Highlights, February 2018). The notice makes three exceptions to the withholding requirement. 

The recent Tax Cuts and Jobs Act (US tax reform) added Code sections 864(c)(8) and 1446(f). The former deems the gain or loss from the exchange or disposition of a private US partnership interest to be effectively connected with a US trade or business if the sale of all partnership assets at FMV would be deemed effectively connected income (ECI); the latter imposes a 10 percent withholding on the amount realized on the gain of a private partnership interest if such gain is deemed ECI under section 864(c)(8). Withholding is not required if the transferor is not a non-US person under section 1446(f)(2). If a transferee fails to withhold as section 1446(f) requires, the partnership must deduct and withhold that amount as tax (plus interest) from distributions to the transferee. 

Before the publication of notice 2018-29, it was not entirely clear whether sections 864(c)(8) and 1446(f) were intended to override existing US tax treaties if ECI income was not taxable in the United States because it was not derived from a US PE. Section 6.05 appears to indicate that those provisions were not intended to override treaties: section 6.05 refers to regulation section 1.1445-2(d)(2) and says that a transferor and a transferee may rely thereon to exempt them from withholding. That regulation provides that a transferee is not required to withhold if there is no gain or loss pursuant to a US treaty. In reading regulation 1.1445-2(d)(2), section 6.05 instructs the reader to substitute section 1445(a) for section 1446(f) and also to substitute "partnership interest" for "US real property interest." Section 6.05 further provides that the treaty statement received from the transferor is not to be mailed into the IRS offices. 

The notice includes two other exceptions to withholding, which are relevant in the event the transferee chooses to not rely on a treaty exception. These two exceptions are set out clearly, unlike the language that sets out the treaty exception. The first of these exceptions clarifies that section 1446(f) applies only if there is a gain on disposition: section 6 says that under planned regulations a transferee may generally rely on a certification received by it and issued by the transferor—signed under penalties of perjury and including a US ITIN—that says that the transfer of its partnership interest does not result in realized gain. However, the transferee is not relieved from withholding if it has knowledge that the certification is false. 

Section 6.03 provides further withholding relief if in three prior taxable years the transferor had less than 25 percent ECI attributable to the partnership interest being transferred. Treasury and the IRS confirm their intention to issue regulations providing that section 1446(f)(1) does not require withholding on a partnership interest's transfer if the transferee receives a certification issued by the transferor—signed under penalties of perjury and including a US ITIN—no earlier than 30 days before the transfer, to the effect that the transferor was a partner in the partnership throughout each of its immediately prior taxable year and its two preceding taxable years, and that its allocable share of effectively connected taxable income for each such taxable year was less than 25 percent of the transferor's total distributive share of partnership income for that year. According to the notice, the transferor's immediately prior taxable year is its most recent taxable year that includes or ends with the partnership's taxable year-end and for which forms 8805 ("Foreign Partner's Information Statement of Section 1446 Withholding Tax") and 1065 ("U.S. Return of Partnership Income," schedule K-1) were due (including extensions) or filed by the time of the transfer. The notice cautions that a transferee may not rely on a certification that was provided before the transferor receives those forms, nor can it rely on a certification—and is not relieved from withholding—if it has actual knowledge that the certification is false. 

Withholding is also not required (notice section 6.04) if the transferee receives—no earlier than 30 days before the transfer—from the partnership a certification to the effect that if the partnership had sold all its assets at FMV, the gain effectively connected with the conduct of a trade or business within the United States would be less than 25 percent of the total gain on the deemed sale of all its assets. For a Canadian transferee, this option is more viable than that of section 6.03, because a US partnership with a December year-end usually seeks extensions to file returns until September: it is difficult for the Canadian transferee to access before mid-June forms 8805 and 1065 for the partnership's most recent taxable year. 

Sunita Doobay
TaxChambers LLP, Toronto

*First published in the May edition of the Canadian Tax Highlights, a Canadian Tax Foundation newsletter.

Thursday, 12 July 2018

No US Deduction for Related-Party Interest or Royalty Paid Abroad*

Section 267A, added December 2017, denies a deduction to a US-situated payer of interest or a royalty to a related non-US hybrid party or as part of a hybrid transaction. This hybrid mismatch provision was likely influenced by Action 2 – OECD Base Erosion and Profit Shifting Report, which was finalized in 2015.

Section 267A originated in the US Senate Committee on Finance International Tax Reform Staff Discussion Draft, released November 19, 2013. Proposed section 267A prevented related-party payments in a base erosion arrangement, defined as a transaction, series thereof, or other arrangement that (1) reduces foreign income tax paid or accrued and (2) involves a hybrid transaction or instrument, a hybrid entity, an exemption arrangement, or a conduit financing arrangement. The proposal was clearly influenced by the said OECD report, but Congress did not entirely follow the report: final section 267A addresses only a hybrid transaction and a hybrid entity.

A US payer of interest or a royalty is denied a related-party deduction if the amount is not included in or is deductible from the related party’s income. That latter concern was raised in the 2016 Treasury Green Book, released February 2015 (the year the OECD Action 2- BEPS report was released). Treasury expressed concern that “there has been a proliferation of tax avoidance techniques involving a variety of cross-border hybrid arrangements, such as hybrid entities, hybrid instruments, and hybrid transfers” such as sale-repurchase transaction:
"In one such hybrid arrangement, a U.S. person holds an interest in a reverse hybrid, which is an entity that is a corporation for U.S. purposes but is a fiscally transparent entity (such as a partnership) or a branch under the laws of a foreign jurisdiction. Because the United States treats the reverse hybrid as a corporation, income earned by the reverse hybrid generally will not be subject to current U.S. tax. Moreover, even if the reverse hybrid is treated as a CFC, interest and royalty income earned by the reverse hybrid from certain foreign related persons (which otherwise would qualify as subpart F income) may nonetheless not be subject to U.S. taxation as a result of either section 954(c)(3) or section 954(c)(6). Payments to the reverse hybrid, however, generally are also not subject to tax in the foreign jurisdiction in which it is established or organized, because the foreign jurisdiction views reverse hybrid as a fiscally transparent entity and therefore treats that entity’s income as derived by its owners, including its U.S. owners. As a result of this hybrid treatment, income earned by the reverse hybrid generally would not be subject to tax currently in the United States or the foreign jurisdiction".
The 2017 Green Book expresses the ongoing Treasury concern with hybrid entities and transactions.

Section 267A refers to section 954(d)(3) for guidance on the meaning of “related party”: a related person that
Is an individual, corporation, partnership, trust, or estate which controls, or is controlled by the person making the payment from the United States or
Is a corporation, partnership, trust or estate which is controlled by the same person or persons which control the payor.

Section 954(d)(3) defines “control” as the ownership, directly or indirectly, of (1) corporate stock that has more than 50 percent of the total voting power of all classes of stock entitled to vote, or (2) more than 50 percent (by value) of the beneficial interests in a partnership, trust, or estate. Rules similar to those in section 958 also apply.

A US payer of interest or a royalty must determine whether it is related to a non-resident payee; a US fund must ensure that no single non-resident investor may hold 50 percent of the fund’s value. The US payer must also determine whether the payee is a hybrid and whether the payment is taxed where the hybrid entity resides for tax purposes (section 267A)(d)). A “hybrid transaction” means any transaction, series thereof, agreement, or instrument under which one or more payments are treated as interest or royalties and “are not treated for purposes of the tax law of the foreign country of which the recipient of such payment is resident for tax purposes or is subject to tax.”

Needless to say, a Canadian financing structure that uses a hybrid through a jurisdiction such as the Cayman Islands (which hybrid has checked the box and is thus a flowthrough for US purposes) must review its current structure. Also, a US entity with non-resident investors must take a closer look at the recipient of an interest and royalty payment and determine whether at time of payment a non-resident payee might be deemed related and a hybrid.

Given the sparse definition of “a hybrid” or “a hybrid transaction” under section 267A, practitioners await further guidance from section 267A regulations yet to be released.

Sunita Doobay
TaxChambers LLP, Toronto

*First published in the June edition of the Canadian Tax Highlights, a Canadian Tax Foundation newsletter 

Tuesday, 27 February 2018

US Partnership Interest Sale Triggers 10 Percent Withholding

Recently published in Canadian Tax Highlights - a Canadian Tax Foundation newsletter and republished here with permission:

The 600-plus-page GOP tax bill was signed by President Trump on December 22, 2017, becoming Public Law no. 115-97, commonly known as the Tax Cuts and Jobs Act or US tax reform. This tax reform essentially codifies, inter alia, IRS Rev. rul. 91-32 (1991-1 CB 107), which was briefly overturned by the 2017 decision of Grecian Magnesite Mining, Industrial & Shipping Co., SA (149 TC no. 3). The new rule sources to the United States the gain on an asset sale of a US partnership interest, and a 10 percent withholding is imposed on that gain. In other words, it is on the gross 

amount realized, similar to FIRPTA withholding.

Rev. rul. 91-32 says that the rules in section 865(e)(2) apply to a foreign partner that has a fixed place of business in the United States:

Section 865(e)(2) provides, inter alia, that income from the sale of personal property by a nonresident will be sourced in the United States if the nonresident has a fixed place of business in the United States and if the income is attributable to such fixed place of business. A foreign partner of a partnership that is engaged in a trade or business through a fixed place of business in the United States itself has a fixed place of business in the United States, since the foreign partner is considered to be engaged in such trade or business pursuant to section 875(l). Income from the disposition of a partnership interest by the foreign partner will be attributable to the foreign partner's fixed place of business in the United States.
The IRS cited section 865(e)(3) and Unger (TC Memo 1990-15, 58 TCM 1157, at 1159) to support its position that the proceeds or loss received on a disposition of an interest in a US partnership by a non-resident is sourced to the United States. The IRS thus applied an aggregate approach to a partnership, as the Code does for the sale of a FIRPTA interest. Section 897(g) says that on the sale of a partnership interest, the proceeds received that are attributable to a US real property interest are considered to be amounts received in the United States. In Grecian, the US Tax Court distinguished the aggregate and entity approaches: "The aggregate approach arises from the observation that a partnership is an aggregation of individuals, while the entity approach applies where the Code focuses on the distinct legal rights that a partner has in its interest in the partnership entity, distinct from the assets the partnership itself owns. See William S. McKee, et al., Federal Taxation of Partnerships and Partners. . . . Subchapter K adopts the entity or the aggregate approach depending on the context, and '[t]he entity approach . . . predominates in the treatment of transfers of partnership interests as transfers of interests in a separate entity rather than in the assets of the partnership." 

The court also recognized that "the enactment of section 897(g) actually reinforces our conclusion that the entity theory is the general rule for the sale or exchange of an interest in a partnership. Without such a general rule, there would be no need to carve out an exception to prevent U.S. real property interests from being swept into the indivisible capital asset treatment that section 741 otherwise prescribes." 

Section 741 provides that income realized on the sale of a partnership interest shall be considered a gain or loss from the sale or exchange of a capital asset. The court noted that Congress used the singular of "asset" rather than the plural. The court also cited section 731(a) in support of the entity theory that when an interest in a partnership is sold, "[a]ny gain or loss recognized under this subsection shall be considered as gain or loss from the sale or exchange of the partnership interest of the distributee partner." 

The court emphasized that the sourcing rules in sections 861-863 do not specify the source of a foreign partner's income from the sale or liquidation of its partnership interest. 

The Tax Cuts and Jobs Act added to the sourcing rules in section 864(c), effective November 27, 2017. Section 864(c)(8)(A) deems a gain or loss from the sale or exchange, by a non-resident alien or foreign corporation, of an interest in a partnership engaged in a trade or business in the United States to be effectively connected with the conduct of a trade or business in the United States. The Act has also amended the Code's withholding rules: section 1446(f) is effective for sales, exchanges, and dispositions after 2017. Section 1446(f)(1) provides that if any portion of any gain on a disposition of a partnership interest was treated under section 864(c)(8) as effectively connected with the conduct of a trade or business within the United States, the transferee must deduct and withhold a 10 percent tax on the amount realized on the disposition. Two exceptions to the withholding are provided. Under the first, the seller must provide a non-foreign affidavit (section 1446(f)(2)(B)) that (1) includes the transferor's US taxpayer identification number and (2) attests that the transferor is not a foreign person. Under the second exception, similar to FIRPTA, either the seller or the buyer of the partnership interest can apply to the IRS for authority to withhold a reduced amount. Otherwise, if the buyer does not withhold, section 1446(f)(4) provides that the partnership must withhold from distributions to the transferee. 

The codification of Rev. rul. 91-32 has brought complexity to the world of funds. Private equity is often structured as a limited partnership in the United States: foreign investors, including Canadian pension funds, often participate in a US fund as limited partners. Canadians must now revisit their exit strategy, which typically involved a sale of their US partnership interests. IRS guidance has not yet been provided to determine the portion of a gain from the sale of a US partnership attributable to a US trade or business. Furthermore, it is not clear how to value a partnership interest: must the entire partnership undertake an asset valuation to accommodate the sale by the 0.1 percent partner? Also, the withholding obligations of the partnership when the buyer partner fails to withhold place pressure on the partnership. 

The new rules are burdensome and will ultimately require a US partnership to track all of its interests held by foreign partners if it is to be cognizant of a foreign partner's sale of an interest to another partner. The new provisions of the Code apply FIRPTA treatment to a partnership interest in the United States that is not tied to real estate. This tracking is onerous for the partnership and impedes a non-US partner from selling a US partnership interest that is not tied to US real estate to another non-US partner. One would expect that this new measure will diminish the commercial appeal of investing in a US partnership. 

The Trump government succeeded in codifying Rev. rul. 91-32; the Obama government sought to do so in the government's 2012 Green Book. At the time of writing, the IRS had not provided relief from withholding on the sale of a private partnership interest as it had for certain public partnerships in IRS Notice 2018-08

Sunita Doobay
TaxChambers LLP, Toronto 

Thursday, 16 November 2017

Dual Resident Estate

Recently published in Canadian Tax Highlights - a Canadian Tax Foundation newsletter and republished here with permission:
For Canadian purposes, an estate is now deemed to be a trust under a 2013 amendment to the subsection 248(1) definition of a trust. My article on Hess (see “Trust or Estate?”, Canadian Tax Highlights, April 2012) is no longer relevant. A distribution from a foreign estate must thus be reported on CRA form 1142 – “Information Return in Respect of Distributions from and indebtedness to a Non-Resident Trust” where a testamentary trust arises out of an estate. This deeming provision may create complications in the case of a trust that is deemed to be a Canadian resident under subsection 94(3). An argument can be made pursuant to subsection 233.6(1) that an estate is not subject to T1142 filing as the language of subsection 233.6(1) excludes an estate that arose as a consequence of the death of an individual .

At the 2017 STEP Canada Round Table, the CRA was asked about the filing position for a US estate with a Canadian trustee. Under Canadian law, a US estate that is managed and controlled by a Canadian trustee is deemed to be a Canadian resident according to the factual test set out in Fundy Settlement (2012 SCC 14). The CRA referred to Income Tax Folio S6-F1-C1, paragraph 1.6, in which the CRA says as follows.
1.6 For example, when making a determination as to the jurisdiction in which the central management and control of a trust is exercised, the CRA will consider any relevant factor, which may include:
·         the factual role of a trustee and other persons with respect to the trust property, including any decision-making limitations imposed thereon, either directly or indirectly, by any beneficiary, settlor or other relevant person; and
·         the ability of a trustee and other persons to select and instruct trust advisors with respect to the overall management of the trust.
For this purpose, the CRA will look to any evidentiary support that demonstrates the exercise of decision-making powers and responsibilities over the trust.
   1.7 After an examination of all factors, it may be determined that a trust is resident in Canada even if another country considers the trust to be resident in that other country.

For US tax purposes, an estate is not a trust. Whether a US estate is a trust for US tax purposes will determine the US tax it will bear. Moreover, a US estate is taxed on its worldwide income, but a non-US estate is taxed only on its US source income and its ECI income. Whether an estate is a US estate is determined by looking at the surrounding facts and circumstances. In Rev. Ruling 81-112, 1981-1 CB, the IRS concluded that the estate was a US estate after considering the following factors: the domicile of the decedent at time of death, the location of the estate fiduciaries, the physical location of the primary beneficiaries, and the physical location of the estate’s major assets.

A non-resident trust is generally deemed to be a Canadian trust if it either had a Canadian resident contributor or has a Canadian resident beneficiary and a connected contributor. A connected contributor is defined as a person who contributed to the trust and within the 5 years before or after was a Canadian resident. The 5-year preceding period is amended to 18 months if the trust arose as a consequence of the person’s death.

For a non-subsection 94(3) trust, the competent authorities for Canada and for the United States consider all the facts surrounding the estate to determine whether the estate is a Canadian or US estate. However, for a subsection 94(3) trust, the CRA says that “It is generally the Canadian competent authority’s position that it would not be appropriate to cede Canadian residence of trusts subject to section 94 of the Act in the course of negotiations with the competent authority of the other Contracting State”. The CRA stands by this position as if it were somewhat like a treaty override. Section 4.3 of the Income Tax Conventions Interpretation Act - in force March 5, 2010 - clarifies that under Canadian law, a trust that is deemed to be resident in Canada by subsection 94(3) is a Canadian resident trust for the application of a tax convention. 

The CRA says that
Furthermore, given that section 94 of the Act anticipates full relief for the foreign taxes paid by the trust, if any, we understand the legislation does not contemplate the other country giving up its right to tax the trust’s income from non-Canadian sources. Accordingly, it is the Canadian competent authority’s expectation that the negotiation of these cases with a view to settle the question of dual residence will generally not be possible or advisable, particularly where both competent authorities are known, more broadly, to be at an impasse on the matter.
The combination of the characterization of an estate as a trust and subsection 94(3) can pose issues. Thus a US estate created by a US-resident decedent may be a deemed Canadian trust if the decedent died within 18 months of a move to the United States even if the person was US domiciled because he or she had expressed an intent to live there permanently. Can and should Canada lay a taxation claim to the estate of that former Canadian resident?

Sunita Doobay
TaxChambers LLP, Toronto

Wednesday, 27 September 2017

Tax Proposals - US and Canada

President Trump released his tax proposals today while in Canada the Morneau proposals consultation period will be ending soon on October 2nd, 2017. The Morneau proposals have caused many of us tax practitioners sleepless nights given how far reaching the proposals are. As I have stated in a presentation - the Morneau proposals discourage Canadians from operating their businesses through a corporation. A corporation is a necessary shield for liability purposes Canadians. Americans are often puzzled as to why Canadians operate through a corporation. We do because of the liability shield and  the preferential tax rate on the first $500,000 of active business income earned annually by a Canadian Controlled Private Corporation. The combined Ontario Federal rate for the first $500,000 is 15%. Aside from the tax rate and liability shield - a corporation is a necessity to access the R&D credit regime (SRED) of the Income Tax Act.

The sleepless nights caused by these proposals is that Canada does not have a limited liability company regime. Limited liability company (LLC) provide the same liability shield that a corporation would provide. The LLC is a structure adopted by the Americans from the Mexicans. It is a flow through similar to a partnership but at the same time provides liability coverage similar to that provided by a corporation. A Canadian limited partnership does not provide that level of coverage.

The proposals in essence leave us in a limbo in Canada.

The Trump Tax proposals focus, unlike the Morneau proposals, on economic growth. It allows for businesses who have made investments into capital assets prior to the 27th of September, 2017 to immediately write off the cost of such assets. The US which had the highest corporate tax rates of all OECD members is proposed to have a tax rate of 20%. And the proposals appear to copy Canada's exempt surplus regime making inversions into Canada not desirable anymore. The Code has implemented provisions to discourage inversions into Canada but who can forget the Burger King inversion in 2015.

The proposals also speak to the repatriation of funds held by US businesses outside of the US and to implement a regime making it less attractive for US companies to shelter their non-US profits in jurisdictions such as Ireland.

Last but not least - the Trump proposals speak to the repealing the U.S. estate tax.

Monday, 28 August 2017

Tax Implications of Cryptocurrency

Virtual currency or cryptocurrency has become popular in today’s financial markets and may be here for some time. Investors increasingly turn to virtual currency to fund transactions and provide portfolio diversity. The rising popularity of virtual currency has created some significant tax issues.

On November 30, 2016, the IRS was successful in its petition pursuant to Codesection 7609(f) in obtaining a John Doe summons to be served on Coinbase, Inc. The IRS is seeking information regarding all US persons who conducted virtual currency transactions on Bitcoin during the period January 1, 2013 to December 31, 2015, reminiscent of the 2008 John Doe summons granted to the IRS for information on US persons with accounts at UBS Switzerland. The July 2008 John Doe Summons resulted in the release by UBS to the IRS of about 4,500 names of US persons who held Swiss bank accounts. The issuance of the John Doe Summons against UBS severely compromised the offshore tax world and led to the implementation of FATCA and the CRS. The effect of the John Doe summons issued to Coinbase, Inc. will be watched closely.
Unlike other IRS summonses, a John Doe Summons does not list the name of the taxpayer under investigation because the taxpayer is unknown to the IRS. A John Doe Summons allows the IRS to obtain the names of all taxpayers within a certain group.

Coinbase, Inc. provides bitcoin wallet services and is a virtual currency exchange who assists merchants and consumers to buy, sell, and use bitcoin currency. A consumer converts bitcoin payments to a fiat currency (legal tender backed by the government that issued it) that is then transmitted to the merchant. A virtual currency exchanger resembles a traditional currency exchanger, but it can exchange virtual currency for government-backed currency and vice versa. A virtual currency exchanger is linked to the conventional banking system and money transmitters: it can receive conventional checks, and credit card, debit card, and wire transfer payments in exchange for virtual currency. A virtual currency exchanger is governed by legislation such as FinCen, is deemed to be a money transmitter under the Bank Secrecy Act, and probably falls within the scope of the CRS, which results in the disclosure of information between more than 100 tax authorities. Wallet services allow a user to quickly authorize virtual currency transactions with another user through the use of a traditional money account held at the exchanger.

According to the IRS Notice 2014-21, a virtual currency is not legal tender but it is intangible personal property. The notice gives examples of the tax treatment of various transactions using virtual currency such as:

  • ·       Wages, salaries, and other income paid to an employee with virtual currency must be reported on a form W-2, and is reportable by the employee as ordinary income and subject to employment taxes paid by the employer;

  • ·         Virtual currency received by a self-employed individual in exchange for goods or services is reportable as ordinary income and is subject to self-employment tax.  A payer must issue a form 1099;

  • ·         Virtual currency received in exchange for goods or services by a business is reportable as ordinary income; and

  • ·         A gain on the exchange of virtual currency for other property is generally reportable as a capital gain if the virtual currency was held as a capital asset and as ordinary income if the virtual currency is held for sale to customers in a trade or business.

Reporting is effected in USD: thus whenever virtual currency is used, a barter transaction takes place, and the parties must know the FMV of the virtual currency on that day. A taxpayer must track which virtual currency lot was used for each transaction in order to properly determine the gain or loss for that particular transaction. Given that the valuation of a convertible currency is a peer–to-peer demand, the exact FMV in legal tender of a virtual currency is not always certain.

Shortly before the petition was filed with the US District Court for the Northern District of California to obtain the John Doe summons, on September 21, 2016 a report was issued by the Treasury Inspector General for Tax Administration (TIGTA), entitled “As the use of virtual currencies in taxable transactions become more common, additional actions are needed to ensure taxpayer compliance”.

The TIGTA report highlights that not much was done by the IRS to ensure tax compliance by US persons who use convertible virtual currencies despite the fact that, as of April 21, 2016, one bitcoin was equivalent to about USD$443, and bitcoins had a total FMV of more than USD$6.8 billion. The TIGTA report points out that the reporting requirements set out in IRS Notice 2014-21 are flawed in that the reporting payer and the recipient payee must report the payment and receipt of virtual currency in USD; information forms 1099-MISC, 1099-B, 1099-K, and W-2 do not inform the IRS that the payments were made in virtual currency. As a result, the IRS has one fewer means of tracking a US person with cryptocurrency on hand. Thus even though cryptocurrency is property for US tax purposes, no US mechanism requires a Bitcoin holder to report that holding to the IRS. Because the identity of the parties using virtual currencies is generally anonymous, the inevitable result is tax evasion.

The fear of tax evasion is confirmed by the IRS agent whose affidavit formed the petition for the John Doe summons to Coinbase, Inc. In his affidavit the agent cites two examples - of which he had knowledge - of tax evasion involving convertible virtual currency:
In the first example, Taxpayer I originally worked with a foreign promoter who set up a controlled foreign shell company which diverted his income to a foreign brokerage account, then to a foreign bank account and lastly back to Taxpayer I through the use of an ATM. Once Taxpayer I abandoned the use of his offshore structure in favor of using virtual currency, the steps described above were the same until his income reached his foreign bank account. Once there, instead of repatriating his income from an ATIM in the form of cash, Taxpayer I diverted his income to a bank which works with a virtual currency exchange to convert his income to virtual currency. Once converted to virtual currency, Taxpayer I’s income was placed into a virtual account until Taxpayer I used it to purchase goods and services. Taxpayer I failed to report this income to the IRS.
And in the second example:
Two separate corporate entities with annual revenues of several million dollars traded bitcoins resulting in the under reporting of income. Both taxpayers admitted to disguising the amount they spent purchasing bitcoins as deductions for technology expenses on their tax returns. The bitcoin transactions were discovered after repeated requests for the original documentation necessary to substantiate the technology expense items claimed on the tax returns.  

US persons who reside in Canada and convert virtual currencies on exchanges other than in the United States, should be advised that their FBAR filings should disclose all of their holdings of convertible virtual currencies.

reprinted with permission from the Canadian Tax Highlights, a Canadian Tax Foundation Newsletter.