The U.S. Tax Cuts and Jobs Act sets new tax rules for U.S. citizens doing business abroad. Over the long run, the Act promises to lower the taxes of people earning money in other countries. Short term, though, your clients with U.S. citizenship might face a one-time levy on their Canadian earnings. This levy is called a transition tax.
How the Transition Tax Works
The transition tax is a corollary to the Act’s participation exemption system. This new system allows U.S. citizens who earn income abroad to repatriate the money without it being subject to taxes. The citizen still must file tax returns but receives a credit that effectively zeroes out the U.S. tax liability.
The corollary to the new system is a one-time levy of 15.5% on foreign earnings.
Suppose you have a client who is a U.S. citizen but a resident of Toronto. The client runs a small business in the social media marketing industry. This year, the client has $1 million in accumulated earnings from its company. Thanks to the transition tax, the client would owe $155,000 in U.S. taxes this year. These taxes are on top of Canadian taxes owed for the same year, which as a resident of Canada, the client must pay.
Are Your Clients Affected by the Transition Tax?
The transition tax does not apply to every U.S. citizen doing business in Canada. But it applies to enough that you want to be vigilant if you have clients with U.S. citizenship (including those with dual citizenship).
The tax applies to U.S. citizens and corporations with at least 10% ownership or 10% of the vote in a foreign corporation. This includes nearly all small business owners as well as practitioners such as doctors, solicitors, and chiropractors.
Helping Your Clients Address the Transition Tax
If you have clients with U.S. citizenship, it’s a good idea to sit down with them and make sure they understand how the transition tax affects them. Expecting a million dollars this year and then learning that $155,000 of it has the U.S. government’s name on it might come as a shock, particularly if the client hasn’t been keeping tabs on recent tax changes. You can soften the blow by working with the client to take advantage of the long-term provisions of U.S. tax reform.
Section 965 of the Act lays out the specifics of the transition tax. The tax covers not only active business owners and executives but also passive shareholders if their holdings exceed 10%. This means your clients might have employees or investors affected. A good question to ask is, "Do any U.S. citizens have a stake in your company?" If yes, you can review the financials and determine if the tax applies.
The Tax Cuts and Jobs Act makes sweeping changes to U.S. tax law. One of those changes is the transition tax. It also impacts Canadians if they or someone at their business has U.S. or dual citizenship. By knowing the facts of the law, you can help your clients be prepared for it.