Canadian business owners might have holding companies as part of their corporate structure for several good reasons. These reasons include tax deferral, both on profits from active business income and as part of a tax deferral strategy after selling an operating company, and creditor protection. For Canadians planning on moving to the U.S., however, owning a Canadian holding company can be problematic because it gives rise to significant U.S. tax complications.
The complications arise from the anti-deferral rules in U.S. tax law, which are meant to discourage U.S. taxpayers from earning passive income (dividends, interest, rents, and royalties) through foreign corporations. Prior to the enactment of the anti-deferral rules, U.S. taxpayers could avoid current U.S. taxation on passive income earned through foreign corporations until eventual repatriation to the U.S. through the distribution of dividends.
Depending on their ownership structure, Canadians moving to the U.S. with a holding company could potentially fall victim to either of two U.S. anti-deferral regimes under the Controlled Foreign Corporation (“CFC”) rules or the Passive Foreign Investment Company (“PFIC”) rules.
The CFC rules apply when U.S. shareholders own more than half of the shares (either by value or votes) of a foreign corporation. When a U.S. taxpayer owns 10% or more of the voting stock of a CFC, any passive income generated by that CFC is considered “Subpart F income” to the U.S. person shareholder.
Subpart F income leads to the loss of tax deferral because it is treated as current income to the shareholder regardless of whether the CFC makes a distribution. This can create “phantom income”, where U.S. tax is owed but without any cash distributed from the CFC to pay the tax. Worse, Subpart F income is generally subject to ordinary income treatment at the shareholder’s top marginal U.S. federal income tax rate rather than the preferential tax rate that would otherwise be applicable to qualified dividends.
Even where the CFC rules don’t apply, a departing Canadian’s ownership interest in a holding company could still lead to negative U.S. tax consequences under the harsh PFIC rules. A PFIC is any non-U.S. corporation that derives 75% or more of its gross income from passive investments or that has at least 50% of its assets producing passive income. As the default PFIC taxation rules are highly punitive, if a departing Canadian’s holding company interest is considered a PFIC under U.S. rules, this can produce even worse tax results than if that interest is considered a CFC.
Canadians planning to depart Canada for tax purposes also need to be aware that any unrealized capital gains on investments held within their holding companies will become taxable at exit because of Canadian departure tax.
Because of the punitive U.S. anti-deferral rules, Canadian departure tax considerations, and other issues, pre-exit planning is important for Canadians with holding companies who are considering a move to the U.S. Pre-exit planning can help Canadians who own holding companies avoid undesirable U.S. tax complications and ensure that they take advantage of pre-exit opportunities that may be available. To learn more, please request a consultation.
MCA Cross Border Advisors, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.