|January 16, 2013|
Previously published on January 11, 2013
The U.S. Congress rang in 2013 with a bang by passing The American Taxpayer Relief Act of 2012 (the “2012 Act”) on New Year’s Day. The 2012 Act has at long last ended the state of flux that has epitomized the U.S. estate tax system since 2001 by making the rules surrounding U.S. estate, gift and generation-skipping taxes more clear and permanent, allowing advisors greater certainty in planning. The changes also eliminate U.S. estate and gift taxes for the majority of U.S. taxpayers. However, U.S. estate and gift taxes will still be payable for high net worth individuals with a worldwide estate in excess of the $5 million estate exemption amount, which is indexed for inflation.
Under the U.S. Internal Revenue Code, tax is generally imposed on a gratuitous transfer during one’s lifetime (resulting in gift tax), at death (resulting in estate tax) or transfers that skip a generation, i.e., from grandparent to grandchild (resulting in generation-skipping transfer tax). A high-level summary of the changes to the estate/gift/generation-skipping tax regime under the 2012 Act, is set out below:
- The individual estate, gift and generation-skipping tax exemptions are now set at $5 million and indexed for inflation. For the 2013 taxation year the exemption amount, adjusted for inflation, is expected to be $5.25 million.1
- The $5 million exemption for the estate, gift, and generation-skipping transfer taxes is a unified tax credit. This means that the exclusion can be used during an individual’s lifetime with the unused amount available for use upon his or her death. For example, if an individual made a $3 million gift during his or her lifetime, it would be non-taxable for U.S. gift tax purposes, with the individual’s remaining estate tax exemption available reduced to $2 million.
- The maximum estate and gift tax rates on gifts made by individuals has increased from 35% to 40%. Accordingly, transfers above the $5 million exemption will now be taxed at the highest marginal rate of 40%.
- Estate tax exemption “portability” has become a permanent change. This means that the $5 million exemption amount of a pre-deceased spouse can generally be utilized by the surviving spouse where certain elections are made. The result is the doubling of the exemption for a surviving spouse whose deceased spouse used none of his or her lifetime exemption.
The 2012 Act creates a number of planning opportunities for U.S. citizens, including taking advantage of their previously unused lifetime exemption, or ‘topping up’ gifts to the indexed amount.
Impact on Canadians Owning U.S. - Situs Assets
How do these changes affect Canadians owning property in the U.S.? Changes to the exemption amount and U.S. estate tax rates affect the relief from U.S. estate tax provided under the Canada-U.S. Income Tax Convention (the “Treaty”) to Canadians who die owning U.S.-situs assets. Generally speaking, U.S.-situs assets include, while the transferor is alive, real and tangible personal property located in the U.S. and, in addition, also include, on death, stock in a U.S. corporation, certain debt obligations of U.S. persons and property transferred on a revocable basis which is made within three years of death.
Technically speaking, the relief from U.S. estate tax provided to Canadians under the Treaty is the greater of the US$13,000 unified credit allowed to non-residents under the U.S. Internal Revenue Code, and a prorated amount of the US$5 million exemption (adjusted for inflation) which is based upon a fraction, the numerator of which is the individual’s U.S.-situs assets, and the denominator of which is the individual’s worldwide assets. Accordingly, Canadians with U.S.-situs assets indirectly benefit from the passage of the 2012 Act, and continue to enjoy a complete exemption from U.S. estate tax only if the value of such Canadian’s worldwide estate is less than US$5 million (adjusted for inflation). Otherwise, Canadians with U.S.-situs assets face exposure to U.S. estate and gift taxes.
There are planning opportunities to reduce or eliminate U.S. estate tax for Canadians owning U.S.-situs property and having a worldwide estate in excess of US$5 million. Some of these opportunities may include the gifting of intangibles (i.e., stocks, bonds and notes), the use of qualified domestic trusts, the special marital tax credit, irrevocable life insurance trusts and spousal trusts, among others.
1 The 2012 adjusted amount was $5.12 million. The 2013 exemption amount indexed for inflation has not at the time of writing been confirmed by the U.S. Internal Revenue Service (“IRS”).