Tax strategies you might use with Canadian clients often can’t be used if your client is a U.S. citizen — especially when it comes to estate planning. If the client’s spouse or partner is not a U.S. citizen, planning opportunities may be limited further.

U.S. citizens pay taxes on their worldwide income, even if they are not residing in the U.S. Canadian taxes are based on residency in this country. If your U.S. clients are resident in Canada, they could be subject to both the Canadian and U.S. tax regimes upon death.

Beth Webel, a partner who has national responsibility for the Canada/U.S. estate planning practice at PricewaterhouseCoopers LLP in Toronto, says Canadian income tax rules assume a deemed disposition of capital assets at death for an amount equal to the fair market value. Capital gains taxes may then apply. But U.S. estate taxes will also apply to the fair market value of those assets.

Federal foreign tax credits available under the Canada-U.S. tax treaty provide some relief against double taxation. Provinces generally also provide foreign tax credit relief. But because Canadian capital gains rates are lower than U.S. estate taxes, the client’s estate probably will pay taxes at the U.S. estate tax rate, Webel says.

In 2006, U.S. estate taxes start at 18% and climb to 46% when the value of the estate reaches $2 million. But, Webel explains, U.S. citizens are entitled to a lifetime estate tax exemption of $2 million in 2006.

However, those rates are subject to change. Jim Yager, a partner in international executive services at KPMG LLP in Toronto, points out the exemption will jump to $3.5 million in 2009. But, Yager also notes, the current schedule of estate taxes is supposed to be repealed for the year 2010, then reinstated in 2011 with a $1-million lifetime exemption and a top tax rate of 55%.

While the Bush administration would like to eliminate estate taxes, Yager says, a bill recently put before Congress proposes to phase in new rules, including a $5-million lifetime exemption and a 15% tax rate for estates above that level and up to $25 million; rates would rise for larger estates. It’s not clear what will happen with these proposals.

Ed Northwood, a partner in the tax and estates and trust practice group and the international cross-border practice group at Hodgson Russ LLP in Toronto and Buffalo, says probably the most helpful principle to explain to clients is the fact U.S. estate taxes are value-based taxes.

Planning strategies should focus on what can be done to start shifting value, he says, so future growth is in some vehicle — such as an irrevocable trust for the benefit of children — that will not be part of the U.S. citizen’s estate. If the spouse is not a U.S. citizen, for instance, try to accumulate value in the hands of that spouse; if she or he dies first, everything should be left in trust to the U.S. citizen spouse. When he or she dies, U.S. estate taxes will not apply, Northwood advises.

DEFERRING TAXES

For a U.S. citizen living in Canada, Webel notes, assets can be transferred to a Canadian resident spouse on a rollover basis at the time of death, allowing the payment of Canadian income taxes to be deferred until the death of the second spouse. But for U.S. estate tax purposes, she points out, a rollover is allowed only if the surviving spouse is also a U.S. citizen. In the U.S., this is called the “marital deduction,” she adds. If both spouses are U.S. citizens, a rollover effectively provides a double lifetime estate tax exemption amounting to $4 million at 2006 rates, with estate taxes payable on the death of the second spouse.

However, Webel also notes, if the spouse is not a U.S. citizen, the marital deduction is not available unless the bequest is made to a special form of trust known as a “qualified domestic trust.” This generally would be used for very large estates, but usually is not worth it for estates of less than $2 million, she adds.

Yager says there are special requirements with such trusts. For example, they must have a U.S. trustee; and if the value of the trust is more than $2 million, the trust must have a U.S. financial institution as a trustee. There are other complications with such trusts that may require additional planning to minimize taxes, he adds.

@page_break@Webel warns that some of the “biggest misses” in wills and estate planning when one spouse is not a U.S. citizen centre around the marital deduction. For example, tax planning for couples in Canada often involves putting assets in the joint names of both spouses. When one spouse dies, everything is automatically rolled over to the other spouse without going through the will and being subject to probate fees and is without tax consequences.

But if an advisor rushes to do this with clients for which one spouse is a U.S. citizen and the other is not, assets in the hands of the U.S. citizen will be subject to U.S. estate taxes when that person dies, undermining attempts to minimize estate tax liability for the U.S. citizen client.

It’s also worth noting that, unlike in Canada, under U.S. tax laws, the proceeds of life insurance form part of the deceased’s estate and so are subject to estate taxes, Webel says. In this situation, she adds, an insurance policy should not be owned by the U.S. citizen spouse or by any corporation that the U.S. citizen owns or controls. Northwood suggests an irrevocable trust own the policy for the benefit of the family.

You may also want to remind U.S. citizen clients that they can’t avoid U.S. estate taxes by giving away their assets during their lifetime because the U.S. also imposes gift taxes on lifetime transfers. Webel notes gift taxes are imposed at the same rate as estate taxes and apply to all types of property, regardless of where the property is located. As a U.S. citizen, she notes, your client will be entitled to a lifetime gift tax exemption of $1 million.

Webel also notes that where the gift tax exemption is used, the estate tax exemption will be reduced by a corresponding amount. Nevertheless, says Northwood, wealthy clients should definitely take advantage of these provisions: “One million dollars given away today may be worth $5 million by the time of the client’s death.”

Gifts to a U.S. citizen spouse are not subject to gift taxes. But if the spouse is not a U.S. citizen, your U.S. citizen client will be subject to gift taxes if assets given to the spouse exceed the annual exclusion threshold — $120,000 for 2006. IE