Canadians who are also U.S. citizens — as well as those who own property in the U.S. — will potentially be liable for U.S. estate tax yet again when the tax returns after a one-year repeal.

The U.S. estate tax can apply to Canadians if, at the time of their death, the value of their U.S. property, including real estate and shares in U.S. corporations, is greater than US$60,000 and if the value of their worldwide estate is more than a set exemption amount.

But while your clients’ worldwide assets are used to calculate the exemption level, the U.S. estate tax applies only to a Canadian’s U.S. assets. Nevertheless, many Canadians who own U.S. property remain unaware of this potential U.S. tax liability.

“The estate tax exposure is commonly overlooked,” says Ryan Carey, a cross-border tax advisor and lawyer in Toronto. “But it’s the biggest tax issue facing foreigners who own U.S. assets.”

The U.S. government normally levies estate taxes on the transfer of a U.S. citizen’s or resident’s taxable estate. A taxable estate is defined generally as the part of the estate that is valued above the exemption amount — in 2009, that exemption level was US$3.5 million. Anything in excess of the exemption amount is subject to estate taxes. In 2009, the top estate tax rate was 45%.

In 2010, the U.S. estate tax was repealed as part of a larger tax reform bill that was passed in 2001. That law was aimed at greatly reducing the estate tax: the legislation gradually raised the exemption amount and lowered the tax rate applied to the rest of an estate, with the tax being finally repealed in 2010. The law was passed in some haste, however, and most tax experts had expected that it would be fixed to prevent an outright repeal of the tax. But while a bill extending the 2009 rate went to the Senate earlier this year, it was never passed. As a result, there is no estate tax in the U.S. in 2010, for the first time since 1916. When the 2001 legislation expires at the end of this year, the pre-existing law will automatically kick back into force for 2011; that law sets the exemption at a much lower level: US$1 million. The top rate of tax on the rest also will rise sharply, to 55%.

That much lower US$1-million exemption figure will subject greater numbers of estates to taxation. “Once you add up the value of a home, investments, insurance proceeds, etc., it’s not that difficult to reach US$1 million,” says Terry Ritchie, a registered financial planner and partner with Transition Financial Advisors Inc. , based in Phoenix and Calgary. “The reinstatement of the estate tax at that exemption amount may force people who haven’t ever done any traditional estate planning to spend money to do that.”

It’s unlikely the U.S. government can impose an estate tax for 2010, retroactive to Jan. 1, tax experts say. A handful of American billionaires died in 2010 without having to face the estate tax; and their heirs have the resources and motivation to challenge any potential retroactive legislation in the courts.

“We really are in a very bizarre situation right now,” says Jamie Golombek, managing director of tax and estate planning with Canadian Imperial Bank of Commerce’s private wealth-management division in Toronto. “No one anticipated [a repeal], and no one thought it was possible.”

There has been much debate in the U.S. about the future of the U.S. estate tax, but, to date, no consensus has been established among U.S. legislators and, thus, no change was made to the rules. Earlier this year, two U.S. senators spearheaded a plan that would have seen the estate tax exemption level rise to US$5 million with a top tax rate of 35% over a period of 10 years, but that plan did not receive enough support to pass into law.

Another possible option is that the estate tax will be reinstated at 2009 levels: a US$3.5-million exemption and a top tax rate of 45%. Many wealthy Americans have already done a great deal of tax and estate planning based on those figures, so a reversion to 2009 numbers would at least have the benefit of aligning with existing planning. Says Ritchie: “It makes sense.”

What most tax-planning experts don’t think will happen is a complete repeal of the estate tax — even if the Republicans take control of the U.S. Congress after the mid-term elections next month.

“If they scrapped the estate tax, they’d have to find that money elsewhere, and it’s hard to see where they’d get it,” says Tannis Dawson, senior specialist in the tax and estate planning department at Investors Group Inc. in Winnipeg. “I don’t think repeal is likely.”

So, in one form or another, the U.S. estate tax appears set to return — and both U.S. citizens and those foreigners who own U.S. property will have to account for it in their tax and estate planning.@page_break@U.S. citizens and holders of green cards receive an exemption on the estate tax, known as a “unified credit,” which in effect equals the exemption level for that year. If the deceased person was married, he or she can transfer his or her entire estate to the surviving spouse without any estate tax at the first death. However, electing to make that transfer may not be tax-effective in some cases, because the decedent would not be able to use his or her own exemption upon the first death. Tax-planning experts recommend the effective use of a will in Canada in cases for which one or both of the spouses is a U.S. citizen, so that each spouse is able to use his or her respective exemption upon death.

Foreigners who own property located in the U.S. that has a total value of more than US$60,000 must file a Form 706-NA, a U.S. estate tax return for non-residents. The definition of “property” includes: real estate in the U.S.; tangible personal property, such as a vehicle or jewelry located in the U.S.; shares in a U.S. corporation, even if they’re included in an RRSP or RRIF; and cash in a safety deposit box in the U.S.; among other things. One major item not included in the definition is any cash in U.S. bank accounts.

Foreigners normally get just a US$60,000 exemption from the U.S. estate tax. However, under the tax treaty between Canada and the U.S., Canadians get an exemption from a portion of the U.S. estate tax, much like U.S. citizens do, but it’s calculated on a pro-rated basis.

To determine a Canadian’s estate tax exemption, you take the value of the U.S. property, divide it by the total value of the Canadian’s worldwide estate and then multiply by the exclusion amount for that year. The effect of this calculation, in most cases, is to give the Canadian the same exemption a U.S. citizen would have — in 2011, that will be US$1 million if the legislators do nothing.

Estate tax is due on the value of the U.S. property that is in excess of the exemption amount. Under the tax treaty, Canadians get to avail themselves of a doubling-up of the exemption for married couples if the surviving spouse is the beneficiary of the U.S. assets.

Tax-planning experts say that with all the uncertainty surrounding the U.S. estate tax, it’s challenging to design tax and estate plans for clients.

That’s because the usual first step is to determine what a client’s potential U.S. estate tax liability could be. Given the shifting landscape, most tax planners are running numbers for clients using US$1 million, US$3.5 million and US$5 million exemption amounts. Dawson, for one, says she has been projecting a client’s potential U.S. estate tax hit using the US$1-million exemption as a starting point: “The US$1-million exemption represents the worst-case scenario. Of all the proposals that have been put in front of the U.S. Congress to reform the estate tax, none features an exemption of less than US$1 million.”

If a client doesn’t have a projected U.S. estate tax liability at the US$1-million exemption level, Dawson says, then there’s probably no need for further action relating to the U.S. estate tax, as long as the client’s financial circumstances don’t change drastically.

Even if there is a potential estate tax liability, it may be preferable for the estate simply to accept that liability, if it’s a modest one, rather than pursue other pre-emptive planning options, which can be complicated and costly to set up.

If the potential estate tax liability is large, then a number of planning options are available, including gifting or divesting clients’ U.S. assets during their lifetimes to avoid U.S. estate taxes; buying insurance to cover the estate tax liability; or financing the purchase of a home in the U.S. using a non-recourse mortgage, which allows the buyer to deduct the value of the mortgage from the estate. Each strategy, used by itself or in combination, has its benefits and drawbacks, so clients need to consult with tax experts.

In fact, it’s recommended that clients consider U.S. estate-planning issues before they make the decision to buy property in the U.S. — particularly a home — tax-planning experts say. There are strategies involving the title of the home, for example, that can potentially reduce the estate tax liability greatly, but they must be completed before the home is purchased. Changes to a home’s title afterward may, in certain circumstances, trigger the U.S. gift tax.

IE