A Closer Look at the U.S.- Canada Tax Treaty Article Governing the U.S. Estate Tax

By Anthony Diosdi

The United States imposes estate and gift taxes on certain transfers of U.S. situs property by “nonresident citizens of the United States.” In other words, individual foreign investors may be subject to the U.S. estate and gift tax on their investments in the United States. The U.S. estate and gift tax is assessed at a rate of 18 to 40 percent of the value of an estate or donative transfer. An individual foreign investor’s U.S. taxable estate or donative transfer is subject to the same estate tax rates and gift tax rates applicable to U.S. citizens or residents, but with a substantially lower unified credit. The current unified credit for individual foreign investors or nonresident aliens is equivalent to a $60,000 exemption, unless an applicable treaty allows a greater credit. U.S. citizens and resident individuals are provided with a far more generous unified credit from the estate and gift tax. U.S. citizens and resident individuals are permitted a unified credit of $12,920,000 or $25,840,000 for a married couple (for the 2023 calendar year).

Article XXIX(B) of the U.S.-Canada tax treaty provides relief from the U.S. estate tax. Under the treaty, a Canadian real estate investor is entitled to relief from the U.S. estate tax, but the treaty does not provide any relief from the U.S. gift tax. A Canadian investor can claim a pro rata portion of the U.S. unified credit and marital credit for estate tax purposes. The pro rata portion is based on the percentage of the individual’s gross U.S. estate and gross worldwide estate.

Claiming a Treaty Position to Reduce or Eliminate the U.S. Estate Tax

The taxation of non-U.S. domiciliaries can be harsher than that of U.S. domiciliaries. Non-U.S. domiciliaries are subject to estate tax on their U.S. situs assets and are not allowed an exemption of only $60,000. Article XXIX(B) of the U.S.- Canada income tax treaty provides a pro rata unified credit to the estate of an individual domiciled in Canada (who is not a U.S. citizen) for purposes of computing the U.S. estate tax. The pro rata portion is based upon the ratio that the Canadian resident’s gross estate situated in the United States at the time of his death bears to his or her worldwide gross estate. Below, please see Illustration 1, Illustration 2, and Illustration 3 which discusses how pro rata unified credit is computed. For purposes of these illustrations, Canadian residents are not subject to U.S. estate tax unless their gross worldwide estate exceeds $10 million (for 2018 calendar year). All amounts contained in the illustrations discussed below are in U.S. dollars.

Illustration 1.

Justin Lieber owns a vacation home in Florida with a value of $5,000,000, unencumbered by a mortgage. His other worldwide assets amount to $5,000,000. There will be no U.S. estate tax whether or not Justin Lieber is survived by his spouse.

A Canadian citizen who passes away owning U.S. assets is entitled to a credit against his U.S. estate tax liability in an amount equal to that proportion of the U.S. unified credit as his U.S. situated estate bears to his worldwide estate. 

Illustration 2.

Bryan Bosling, a Canadian resident, owns two vacation homes in California and Hawaii, each of which is unencumbered by a mortgage and has a value of $5,450,000. Bryan also owns Canadian property with a total value of $10,900,000. When Bryan dies in 2018, his estate, for U.S. estate tax purposes, would be entitled to a prorated unified credit of $2,208,900 (i.e., $4,417,800 × ($10,900,000 / $21,800,000)). When applied against his computed gross U.S. estate tax of $4,305,800, this prorated unified credit results in a net U.S. estate tax liability of $2,096,900 (i.e., $4,305,800 – $2,208,900). If Bryan Bosling has a Canadian spouse and leaves property to her outside of a qualified domestic trust (“QDOT”), the U.S. will allow an election to be made for an additional nonrefundable marital credit up to the amount of the proportionate credit.

The estates of individuals not domiciled in the United States are generally not entitled to a marital deduction for U.S. estate tax purposes. Marital deductions refers to exceptions to gift and estate taxes for transfers made to spouses. Almost all property qualifies for this deduction and there is no limit. The deduction does not avoid transfer taxes completely, but rather, the spouse receiving the property must pay the eventual estate taxes. The marital deduction for non-U.S. citizens is limited to an annual exclusion of $175,000 for the 2023 calendar year.

Below, please find Illustration 3, which demonstrates how the marital deduction is applied under Article XXIX(B) of the U.S.-Canada income tax treaty. 

Illustration 3.

The facts are the same as in Illustration 2, except that Bryan Bosling leaves one of his two vacation homes in the U.S. to his Canadian spouse. The additional marital deduction “credit” allowed under the U.S.-Canada treaty equals the excess of the computed gross U.S. estate tax over the estate tax computed without including the U.S. property passing to the Canadian spouse. The marital deduction credit is capped at the estate’s prorated unified credit. Here, the U.S. estate tax on the vacation home not passing to Bryan’s spouse is $2,125,800. Thus, the marital deduction credit equals $2,180,000 (i.e., $4,305,800 – $2,125,800). After taking into account both the prorated unified credit and the marital deduction credit, the net U.S. estate tax liability owed by Bryan’s estate is reduced to zero (i.e., $4,305,800 – $2,208,900 – $2,180,000). Any excess marital deduction credit does not result in a refund.

Treaty Charitable Deduction 

U.S.- Canada income tax treaty Article XXIX(B)(1) states that a Contracting State shall accord the same death tax treatment to a bequest by an individual resident in one of the Contracting States to a qualifying exempt organization resident in the other Contracting State as it would have accorded if the organization had been a resident of the first Contracting State. The exempt organizations that qualify for this provision are referred to in paragraph 1 of Article XXI (Exempt Organizations). A gift or bequest by a U.S. domiciliary to a U.S. exempt organization is typically deductible for U.S. estate tax purposes. See IRC Section 2055. This deduction is typically only available to bequests made to U.S. based exempt organizations. Although a deduction for estate tax purposes is typically limited to domestic charities, the U.S.- Canada income tax treaty broadens this deduction to Canadian residents subject to the U.S. estate tax. Under Article XXIX(B)(1), in certain cases, a Canadian resident subject to U.S. estate tax will be permitted a U.S. estate tax deduction for a charitable bequest made to a Canadian-registered charity.

Filing Requirements

If an individual nondomiciliary or decedent that was not domiciled in the U.S. would like to take a treaty position, this treaty position must be disclosed on Form 8833 which must be attached to either a U.S. estate or gift tax return.

Conclusion

This article is intended to acquaint readers with some of the principal U.S. estate considerations that can come into play when Canadian investors invest in a business or real estate in the United States. This area is relatively complex and is constantly evolving with Congress entertaining new tax laws, the IRS issuing new regulations and interpretations and courts rendering new rulings in this area. As a result, it is crucial that Canadian investors consult with a qualified international tax attorney when planning to invest in a U.S. business or real estate. This is to ensure that the proposed investment is appropriate given the investor’s tax circumstances and that no developments have arisen in the area that can impact the investment’s tax objectives. With careful, individualized planning, Canadian investors may be able to substantially reduce the U.S. estate and gift tax consequences of their U.S. investments that affect not only themselves but their heirs and beneficiaries as well.

We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in cross-border tax planning and compliance. We have also  provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.