Tax Reform Becomes Reality: What Does It Really Mean For Canadians?
On December 22, 2017, President Trump signed into law the biggest change in US tax law in over 30 years. This six part series has been focusing on the US tax changes that will impact Canadians. This segment, Part 4 of 6 examining the top 12 things Canadians need to know about US tax reform, will examine who the states themselves will react to federal tax changes, as well as how the personal tax system has changed.
• States May Not Follow These Changes
The one commonly missed item for Canadian corporations that conduct business in the US is overlooking state filing requirements. In the US, there is no concept of harmonization between the federal tax legislation and state tax legislation. As such, states are not obligated to follow the provisions of the IRC, nor do they have to conform to all federal tax changes even if they do adopt the IRC as the starting point for computing state taxable income. Much like a Canadian business could be subject to state level income taxation even if it is exempt from federal taxation, Canadian businesses with US activities may need to compute taxable income for state income tax purposes very differently than it is computed for federal tax purposes. This could create complexities for many US taxpayers.
For example, states typically do not adopt taxpayer favourable capital asset expensing provisions as this would reduce the state’s overall tax revenues. As such, a US taxpayer may have a taxable loss due to the immediate expensing of the assets related to its US expansion, but this expense may be denied for state tax purposes creating state taxable income. Therefore US taxpayers with nexus, and therefore filing obligations, in various states will need to determine each state’s conformity with the new legislation to determine its state taxable income and tax liability. This will add much complexity to a taxpayer’s US reporting requirements. The same will hold true for individuals who file US federal and state personal returns as the states may not adopt all of the federal changes to the personal tax system.
• US Citizens Living in Canada Need to Determine If They Will Owe Tax
Although Trump promised a reduction in the individual tax rate, the top rate only fell 2.9% from 39.6% to 37%, but the thresholds for a taxpayer to pay tax at the highest rate did increase. The changes to individual taxation also include the repeal or limitation of many itemized deductions. The change in deductions includes reduced limitations on the deductions for mortgage interest and state taxes, as well as the repeal of the deductions for foreign property taxes, investment management fees and tax preparation fees.
At first glance, some US citizens living in Canada may not worry about their individual US tax liabilities under these changes since the Canadian tax rate is much higher than the US rate. As such, many US citizens living in Canada are able to claim a full foreign tax credit to offset any US tax payable on their income already subject to Canadian tax. However, there are taxpayers that often rely on deductions to offset their income that is reported differently in Canada and the US, or income from US sources that is subject to taxation in the US.
For example, assume a US citizen has a short-term capital gain from securities and income earned in a TFSA account. The capital gain will be taxed at a higher rate in the US than in Canada, and the TFSA income is not taxable in Canada at all. As such, a taxpayer may not pay enough Canadian tax to fully offset the US tax on this passive income. The taxpayer may have previously relied on a deduction for investment management fees to reduce this income and the corresponding tax on this income. The taxpayer may also have allocated a portion of his/her other deductions against this income, such as the property taxes on his/her Canadian home. Therefore, taxpayers that have similar fact patterns, may end up with tax liabilities under the new regime. US citizens living in Canada may want to review their income tax returns and the potential changes to their returns for 2018 to determine if they will owe tax and consider making estimated tax payments for 2018.
Stay tuned for part 5 of this series which will discuss the changes to the US estate tax and structuring US based investments.