U.S. estate tax for Canadians

If you have Canadian clients who are married to a citizen of the United States or a dual citizen, you may need to advise them to prepare for U.S. estate tax.

U.S. estate tax is a wealth transfer tax levied at death on the fair market value of property held by an individual. The top rate of tax can reach 45% (2009 rate).

Even those who are not US citizens, but who do have US-based assets (real property or company shares are most common) will be subject to US estate taxes on those assets that are actually situated in the U.S.

These might escape the estate tax net, though, if the amounts are not significant since they can be sheltered by the Canada–U.S. Tax Convention, most commonly known as the Canada-U.S tax treaty.

U.S. residents and citizens are entitled to a credit, up to $1,455,800 in 2009, to offset estate taxes on property or assets that are worth up to $3.5-million. (The credit offsets, dollar for dollar, the amount a person’s estate would otherwise owe.)

Under the treaty, Canadian residents need to pay U.S. estate taxes on any property that’s located there, but also are entitled to a portion of the credit to offset of taxes owing.

For Canadians, this credit is calculated as a fraction: [U.S. based assets/worldwide estate assets]. So, for example, if U.S. based assets make up 10% of a client’s total estate assets worldwide, he or she is entitled to 10% of the estate tax credit. That means if a person’s U.S. real estate holdings (or other assets) are worth $1 million, and his or her worldwide estate is worth $10 million, the client will be entitled to a credit of $145,580.

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If your client’s spouse is a U.S. or dual citizen, however, the picture changes dramatically. The U.S.-citizen spouse will be required to pay U.S. estate taxes on the fair market value of his or her entire estate, worldwide, whether these assets are situated in the U.S. or not.

Worldwide assets include all property owned at death. This may include insurance proceeds, jointly held property (100% inclusion subject to certain limits), trust interests, stock options and registered plans (RRSPs, RRIFs and pensions).

Traditional wills

Using a traditional will, a person may leave all of his or her assets outright to his or her U.S.-citizen spouse. Unfortunately, when the spouse dies, he or she will be subject to U.S. estate taxes of up to 45% of all assets held worldwide, including inherited property, that exceed $3.5 million.

Case study

For example, assume that your client, Mr. Brown, a Canadian citizen and resident, has a U.S.-citizen spouse. Mr. Brown bequeaths the following items to his wife:

	Fair Market Value (US$)
House	$1,500,000
Investment portfolio	$2,000,000
Canadian recreational property	$ 500,000
Insurance proceeds	$1,000,000
Total	$5,000,000

Assuming that Mrs. Brown owned only these assets at her death, the estate tax liability would be $675,000 — a significant proportion of the Brown family’s assets.

So what are your client’s options?

Will planning

Spousal testamentary trusts are often used as part of a Canadian estate plan for the tax-effective transfer of assets on death. However, a traditional Canadian spousal testamentary trust, in which assets are left in trust for the benefit of the surviving spouse, is generally not effective for U.S. estate tax purposes. According to U.S. tax law, the surviving spouse owns the trust assets on account of his or her trustee position and the degree of control he or she has over trust assets. To effectively shelter the assets from U.S. estate tax on the surviving spouse’s death, your client has two options:

• A spousal testamentary trust could be established by will. The surviving spouse must not be a trustee.

• A modified spousal testamentary trust could be established, structured specifically to keep the assets exempt from U.S. estate tax. This would require that the surviving spouse’s ability to participate in decisions to distribute the trust’s capital be restricted.

Spousal testamentary trust options

The first option is simple, but often not practical. In many cases, a surviving spouse wants to be a trustee so that he or she can exercise some control over the trust assets.

Under the second option, the surviving spouse is made a trustee, but his or her powers are limited to an “ascertained standard.” Under this special trust, the surviving spouse is entitled to receive all income derived from the trust assets. However, his or her ability to participate in decisions to use the trust’s capital is limited to situations in which it will cover expenses related to his or her health, education, maintenance or support.

This special testamentary trust should also qualify for the Canadian “spousal rollover” so that no Canadian income tax liability should arise on the death of one spouse, instead deferring the liability until the surviving spouse’s death.

If required, the spousal testamentary trust can also be drafted to meet many other needs for your client. For instance, a migration clause could be added to allow the trust to become a U.S. trust if the surviving spouse decides to move to the U.S.

Conclusion

The U.S. estate tax regime may apply a hefty tax on a U.S.-citizen spouse’s assets upon his or her death, which may include assets inherited from a Canadian spouse. However, with an appropriate tax plan, your clients may be able to minimize or eliminate these adverse tax consequences and protect non-U.S. assets from U.S. estate tax.

Nadja Ibrahim is a partner in the tax services practice of PricewaterhouseCoopers LLP. She specializes in high-net-worth tax planning with a focus on cross-border estate planning and succession planning. nadja.ibrahim@ca.pwc.com

Christopher Gandhu is a senior associate in the tax services practice of PricewaterhouseCoopers LLP. He specializes in high-net-worth tax planning with a focus on cross-border estate planning. christopher.s.gandhu@ca.pwc.com

(04/20/09)