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U.S. estate taxes can bedevil cross-border families

'Enormous number of people' need to do international tax and estate planning in Canada, experts say

Of the many freedoms that come with having significant personal net worth – the ability to own multiple residences at home or abroad, to spend on luxury items or support philanthropic causes – come a plethora of legal and financial complexities. Nowhere is that more apparent than on the international estate-planning front.

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“If you look at almost any family of means in Canada, 99 per cent of the time there will be a family member or a foreign asset outside of Canada, often in the U.S.,” says Darren Coleman, senior vice-president at Coleman Wealth, a division of Raymond James Ltd. in Toronto.

“International tax and estate planning impacts an enormous number of people.”

That’s especially true in Canada, a country of immigrants with deep ties to their countries of origin, many of whom will eventually leave at least part of their estate to loved ones back home.

Even more high-net-worth families have close family or property connections to the U.S. (think Florida condos) that could render them subject to our southern neighbour’s complex tax system – one that can easily ensnare resident and non-resident foreign nationals alike.

Worse, many wealthy families don’t fully comprehend the scope of their compliance responsibilities and the potential estate-planning pitfalls, especially when it comes to taxation.

Moving to a new country

Ultra-wealthy families tend to possess a complicated web of international assets, from property to equities, across jurisdictions that must be accounted for in their wills. While they often implement trusts and other effective wealth-transfer mechanisms to manage their post-mortem affairs, even the best-laid plans can be uprooted if a family member relocates from Canada to a country such as the U.S. (or elsewhere) and suddenly finds him or herself subject to that country’s tax laws.

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Overlooking estate compliance obligations can result in dramatically increased tax liabilities, penalties and potentially even legal trouble. Coleman says the estate planning questions become even more convoluted when assets outside of North America enter the equation.

“If my family has property in Portugal, the United Kingdom or Croatia, for example, is there a tax treaty with Canada, and if not, what are their inheritance rules?

“Then you introduce complexities around language. Does a power of attorney in Canada work in Croatia? What language should it be in?” Coleman asks. “People need to think about the complexity and not leave this to chance.”

One of the challenges is that if you seek out a lawyer they’ll focus on the legal issues, the accountant will focus on the tax issues, the financial person on the money issues. Someone needs to quarterback it.

Darren Coleman, Coleman Wealth

When it comes to the U.S., high-net-worth Canadians often overlook the estate risk bundled into their (typically sizable) investment portfolios, according to Margaret O’Sullivan, the managing partner at O’Sullivan Estate Lawyers LLP in Toronto, which regularly assists Canadian clients with cross-border estate planning issues.

“A sleeper issue for Canadians who are invested in U.S. securities directly as opposed to through a holding company is they may not be aware that under U.S. tax law, those securities are considered U.S.-situs property subject to U.S. estate tax of approximately 40 per cent,” she says.

Minimizing U.S. estate tax

While the U.S. and Canada maintain a tax treaty that generally prevents double taxation, cross-border inheritances are treated differently. An oft-overlooked point is that the U.S is one of the only countries in the world that taxes by citizenship rather than country of residence. No matter where U.S. citizens reside, they have U.S. tax reporting obligations.

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That’s why O’Sullivan points to the need for careful planning to minimize U.S. estate tax, which is particularly important for Canadian citizens married to (or who might bequeath assets to) U.S. or dual Canada-U.S. citizens who could be subject to U.S. tax laws.

David Kuenzi, director of international wealth management at Thun Financial Advisors in Madison, Wis., notes that if an American citizen receives an inheritance from a Canadian grantor who is not a U.S. taxpayer, there is no U.S. tax to pay because the U.S. has an estate tax – the exemption for which is currently USD$11.58 million for 2020 – but doesn’t tax the inheritor. In contrast, Canada taxes the unrealized capital gains on an estate, but does not have an inheritance or estate tax.

If the inheritance was heading north of the border to a Canadian-citizen beneficiary, on the other hand, the tax liabilities are entirely on the U.S. side. Once the estate is settled and U.S. estate taxes are paid (if applicable), the Canadian beneficiary would receive the assets with no U.S. tax obligations.

When trusts are involved, however, cross-border estate planning can get complicated.

Kuenzi explains that in the case of utilizing a Canadian trust that is not a pass-through (a legal mechanism to help resolve the estate), and which is distributed to a U.S. beneficiary over time, what would otherwise be a tax-free inheritance for the U.S. citizen could now be a taxable income stream. As a legal entity, the Canadian trust would also need to file an annual U.S. tax return and remit any applicable taxes.

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“In many cases these trusts exist, but they go unnoticed over time,” Kuenzi says. “Years go by with the beneficiary and trust not reporting, and now you have a massive U.S. tax problem on your hands.” He often advises clients to avoid trusts altogether when dealing with U.S. beneficiaries of a Canadian estate.

Special estate structures

Michael Cirone, a Toronto-based cross-border tax, trust and estate planning lawyer with TaxChambers LLP, notes that the U.S. tax system is effectively divided into two parts: income tax and the transfer taxes that cover estates and gifts. An individual may be a U.S. income tax payer but may not be subject to the transfer tax system, or vice versa (U.S. citizens would be subject to both systems).

For Canadians with U.S. beneficiaries designated in their wills, he sometimes recommends structures such as bypass trusts and testamentary dynasty trusts, the latter being a mechanism that designates a U.S.-based trustee (such as a bank) as an entity to receive the cross-border inheritance. The drawback is that while beneficiaries would still be able to access their inheritance, they would be subject to specific withdrawal rules, among other complications. The upside is that it protects the inheritance from U.S. estate tax.

But Cirone stresses that trust structuring is complex, which is why advisors need to take everything from a client’s personal financial circumstances and country of residence – as well as their beneficiaries’ circumstances – into account before developing a comprehensive estate planning strategy.

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That could also include the drafting of wills in multiple jurisdictions if necessary – even at the state level in the U.S. – or at the very least inserting clauses in Canadian wills that account for foreign estate and tax laws, as necessary.

Coleman’s advice to wealthy families is simple: Estate planning is highly nuanced. That’s why it’s necessary to build an experienced team of advisors with the right expertise (and potentially access to a global advisor network) to help navigate the myriad challenges of international estate planning.

That often includes seeking legal help in the country where an estate beneficiary resides. Either way, the various experts involved in the process need to co-ordinate their strategies.

“One of the challenges is that if you seek out a lawyer they’ll focus on the legal issues, the accountant will focus on the tax issues, the financial person on the money issues. Someone needs to quarterback it and take a top-down view and make sure everything is co-ordinated properly from a high level,” he says.

“Silo-ing the information will lead to major problems.”