What is a Canadian tax practitioner to do for their clients (or family) who intend to own real property outside of Canada and the US1 (“Foreign Real Property”) until death do they part?
Such holdings, while often a source of joy during a Canadian resident’s lifetime, can create some serious tax problems for their estate and their heirs.
In the discussion that follows, we’ll try and illustrate this issue and a possible solution using a fictional client named Lola and a number of hypothetical scenarios.
Facts: Lola’s Tel Aviv Property
Imagine that Lola acquired an apartment in Tel Aviv (“Tel Aviv Property”) 25 years ago for $500,000. Today, the Tel Aviv Property is worth $1,500,000.2
Scenario 1: Sale of Tel Aviv Property
If Lola were to sell the Tel Aviv Property, both Israel and Canada would have an opportunity to tax the capital gain of $1,000,000 that will be realized on the sale.3 However, pursuant to Article 13(1) of the Canada-Israel Tax Treaty,4 the first right to tax capital gains realized on certain immovable property, including real property, is provided to the country where the immovable is located.5 Accordingly, since the Tel Aviv Property is located in Israel, Israel would have the first right to tax the capital gains realized on the sale of the Tel Aviv Property.
We understand that the capital gains tax in Israel would be $250,000, being 25% of the $1,000,000 capital gain, leaving Lola with $1,250,000 to spend.6
Although Lola will also be taxable in Canada on the Tel Aviv Property capital gain, to minimize incidents of “double taxation,” Canada’s income tax system has been designed so that, with respect to certain foreign income and gains, such as gains on dispositions of Foreign Real Property, Canada will provide a Canadian taxpayer with a foreign tax credit to offset taxes paid to a foreign government.7 The result of the Canadian foreign tax credit system is that a Canadian taxpayer should only be required to pay tax on income or gains that qualify for a foreign tax credit at the higher of the tax rates of Canada and the foreign jurisdiction.
For convenience, let’s assume that the combined effective Canadian federal and provincial tax rate applicable to capital gains realized by Lola in respect of the Tel Aviv Property is 25%. Because the combined Canadian capital gains taxes will be equal to the Israeli capital gains taxes paid (see calculation above), Lola should be eligible to claim a foreign tax credit for the full amount of Israeli tax paid by her, with the result that no Canadian tax should be payable by her on the Canadian capital gain.
Scenario 2: Death of Lola Followed by Sale of the Tel Aviv Property
If instead of selling the Tel Aviv Property while she was alive, Lola’s estate was to sell the Tel Aviv Property when she died. Very different tax results would have arisen than those set out in Scenario 1.
These different tax results will arise due to the fact that, while Canada deems:
There are no similar deemed disposition rules that apply on the death of an individual in Israel.
As a result, even though the Canadian capital gains tax was already paid, on a subsequent sale, Israeli capital gains tax will be payable by Lola’s estate or her heirs, as the case may be, since the original cost base of the Tel Aviv Property for Israeli capital gains tax purposes will not be increased on the death of Lola.
Furthermore, recall that under both the Canada-Israel Tax Treaty and general international principles,9 Israel has the first right to tax Israeli real property, such as the Tel Aviv Property. Therefore, if there is to be a solution to this double tax problem, it would be necessary for Lola’s estate or her heirs, as the case may be, to look to the Canadian tax authorities for tax relief. Unfortunately, the Act currently contains no provisions to grant foreign tax credits or any other relief to Lola, her estate or her heirs for tax paid in Israel on a subsequent disposition of the Tel Aviv Property.
Having now explained how taxation would apply in this scenario, let’s illustrate these principles with Lola’s facts in mind, but assume that both at the time of death and at the time of the actual sale of the Tel Aviv Property, its FMV is $1,500,000.
Based on the prior example:
As mentioned above, in this scenario, the Act provides no ability for Lola, her estate or her heirs, as the case may be, to claim a foreign tax credit or any other relief in Canada against Israeli taxes paid on this subsequent sale. As a result, nearly double the tax is payable in respect of the Tel Aviv Property in this scenario than in Scenario 1. In particular, following the payment of total taxes of $500,000, Lola’s heirs will only be left with $1,000,000 compared to the $1,250,000 they would have inherited if Lola had died after selling the Tel Aviv Property in Scenario 1.
Lola’s situation, as described in this scenario, is likely to become a much more common one in the future. This is because many jurisdictions worldwide that have capital gains tax regimes do not tax unrealized capital gains on death, and more and more Canadians are inheriting or acquiring and dying with Foreign Real Property.
To our knowledge, there is no justification for such an inequitable tax result.
In fact, Parliament acknowledged the inequity in similar situations impacting both emigrating Canadians owning Foreign Real Property and beneficiaries of Canadian resident trusts that receive distributions of Foreign Real Property. As such, it statutorily fixed these inequities by enacting subsections 126(2.21) and 126(2.22), respectively.10 In a nutshell, these two subsections allow a foreign tax credit deductible against tax payable on an individual’s departure year Canadian tax return that is equal to the foreign taxes on a post-departure gain from a disposition of property, including Foreign Real Property, to the extent of the portion of the property gain that accrued while the individual was a Canadian resident.
The historical explanatory notes in respect of these provisions state, in part, that:
Subsections 126(2.21) and (2.22) will apply, in most cases, only for taxes paid to countries with which Canada has a tax treaty. Exceptions are provided for taxes imposed by a foreign country on gains on real property situated in that country. In keeping with the general international principle that the country in which real property is located has the first right to tax gains on that real property, Canada will always provide credit for such taxes. Similarly, credit for those taxes will be available regardless whether Canada has a tax treaty with the particular country. (Emphasis added.)
In order to enable subsections 126(2.21) and 126(2.22) to operate outside of ordinary statutory limitation periods, consequential amendments were also made to subsection 152(6).
Scenario 3: Emigration of Lola Followed by Sale of the Tel Aviv Property
If Lola emigrated from Canada owning the Tel Aviv Property, she would have been deemed to have disposed of the Tel Aviv Property at its $1,500,000 FMV pursuant to paragraph 128.1(4)(c), giving rise to Canadian deemed capital gains taxes of $250,000.11
Assume that some years following emigration, Lola sold the Tel Aviv Property for $1,500,000. As was the case in Scenario 1 and Scenario 2, Israel would still collect $250,000 in capital gains taxes. However, provided that Lola amends her emigration year personal Canadian tax return as permitted pursuant to the interaction of subsections 126(2.21) and 152(6), she would be able to claim a tax credit and generate a refund of the $250,000 of taxes paid to her upon her emigration, thereby eliminating the otherwise inappropriate double taxation.12
Subsections 126(2.21) and (2.22) Roadmap for a Fix?
It is worth repeating the highlighted portion of the explanatory notes to subsections 126(2.21) and (2.22) above:
In keeping with the general international principle that the country in which real property is located has the first right to tax gains on that real property, Canada will always provide credit for such taxes. (Even more emphasis added.)
As illustrated by the example involving a sale of the Tel Aviv Property in Scenario 2, this general international principle is currently inapplicable in the event of the death of a Canadian taxpayer such as Lola. Consequently, the Department of Finance’s statement above (the “Statement of Principle”) is untrue in a situation involving the death of a Canadian taxpayer.
If the Department of Finance can be convinced to find a way to apply the Statement of Principle in post-mortem situations, it shouldn’t be difficult to use the roadmap in subsections 126(2.21) and (2.22) to create a similar exception to allow foreign tax credits to be applied against a decedent’s terminal year tax return. However, because this new exception needs to apply to property vendors who are an estate or heirs of a decedent, it needs to be designed so that the triggering event for the foreign tax credit is based on the sale by a taxpayer other than the decedent.
Since the Act already contains subsection 164(6), a provision to allow tax pools realized by an estate to be retroactively applied against income reported in a decedent’s terminal year tax return, one would think that it should be possible to create a similar rule to allow the foreign tax credits to be retroactively applied against taxes paid or payable by a decedent in accordance with the decedent’s terminal year tax return.13
As is the case with subsections 126(2.21) and (2.22), consequential amendments should be made to subsection 152(6) to eliminate any time limit on the claim of foreign tax credits against the terminal year deemed disposition tax.14
It is our sincere desire that the Department of Finance will address these inequities by taking steps to amend the Act. Hopefully, the roadmap set out in this article can provide the Department of Finance with a pathway to do so. However, until the Act is amended to resolve this inequity, practitioners should advise their clients who hold property that is subject to foreign taxation, such as Foreign Real Property, of this potential cross-border post-mortem tax-planning pitfall.
Reproduced with permission. Published by and copyright Wolters Kluwer Canada Limited.
Special thanks to Daniel Paserman, Adv (C.P.A) TEP Head of Tax, Gornitzky & Co, for guidance in connection with Israeli tax matters.
1 The issues described in this article will generally not be a concern in respect of US real property owned by Canadians on death because of unique features of Article XXIX-B in the Fifth Protocol to the Convention Between Canada and the United States of America with Respect to Taxes on Income and on Capital, which coordinate US estate tax and Canadian death taxes with one another and thereby can avoid double taxation issues and allow for US cost base adjustments to match those in Canada, provided the taxpayer in question is an individual and the election under Article XIII(7) is properly filed. Several treaties have similar provisions that coordinate a step-up in tax basis, but they only apply where an individual has ceased residency in a particular country—it is our understanding that none (or almost none) of Canada’s other tax treaties contain step-up provisions for deemed disposition on death.
2 It is assumed that, for purposes of Canadian taxation, Lola is considered to have an adjusted cost base (“ACB”) determined in accordance with the Income Tax Act (Canada) (“Act”) of $500,000 and that for Israeli tax purposes, Lola is considered to have a tax cost base of $500,000 as well (tax cost in Israel includes an indexing concept that, for simplicity, has been ignored in this article).
3 Both Canada and Israel have capital gains tax regimes. For simplicity, we have assumed both Canadian and Israeli capital gains will be calculated by netting the current $1,500,000 fair market value (“FMV”) of the Tel Aviv Property against its $500,000 ACB (the Israeli tax regime underwent significant changes, including changes impacting the taxation of residential properties in 2014). Our choice of Israel to illustrate a non-US international jurisdiction in this article is for illustration purposes only. All Israeli tax and legal matters should be reviewed with professionals qualified to practice in those disciplines in Israel.
4 Convention between the Government of Canada and the Government of the State of Israel for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, E102286 - CTS 2016 No. 10 (“Canada-Israel Tax Treaty”).
5 Terms similar to Article 13 of the Canada-Israel Tax Treaty are common in Canada’s treaty network for tax treaties that include capital gains tax provisions.
6 Dollar amounts ignore any potential Israeli tax exemptions, costs of sale, VAT taxes in Israel (if relevant), etc.
7 Pursuant to subsection 126(1). The foreign tax credit will not be limited to 15% of the foreign income amount because subsection 20(11) and paragraph (b) of the definition of “non-business-income tax” in subsection 126(7) do not apply to a capital gain. Please note that, based on general international principles Canadian residents will usually be able to claim a subsection 126(1) foreign tax credit with respect to capital gains tax paid in connection with dispositions of Foreign Real Property regardless of whether the Foreign Real Property is situated in a treaty or a non-treaty jurisdiction (see, for example the views of the Canada Revenue Agency as set out in paragraph 1.62 of Income Tax Folio S5-F2-C1).
8 Pursuant to subsection 70(5).
9 Supra, footnote .
10 Bill C-22; S.C. 2001, C. 17, S. 117, applicable to the 1996 and subsequent taxation years.
11 Subject to Lola deferring this tax by posting security acceptable to the Minister of Finance and otherwise satisfying the provisions in subsection 220(4.5).
12 As no interest will be refunded to Lola, the time value of money will still negatively impact Lola’s financial situation.
13 See subsection 164(6), which allows losses realized by an estate to be carried back and applied against income of a decedent in the terminal year tax return of a decedent.
14 A limitation on time to claim the foreign tax credit would be contrary to the Statement of Principle. Although it is recognized that the ability to claim a subsection 164(6) is currently time limited to the first taxation year of an estate, this time limitation has been the subject of much criticism by writers and legal scholars. Perhaps this is a good time to review the one year time limitation in subsection 164(6) as well.
About the Authors
Michael A. Goldberg works with clients and their advisors to assist them with their corporate, estate, personal, and international tax planning needs.
Michael is a lifelong learner. He has a business degree and chose tax as his legal specialty as it appealed to his practical and creative mind. As part of his ongoing objective to better understand the complexities and challenges facing his clients and to provide the most strategic and meaningful advice possible, Michael recently pursued and received the Family Enterprise Advisor designation. Michael ensures his clients always know where they stand and gets them the solutions they need when they need them.
Michael's experiences outside of law have provided him with a unique understanding of how businesses run, and the importance of any tax savings had. As a prolific writer and speaker, Michael frequently publishes in a number of Wolters Kluwer tax publications and speaks to associations and industry groups on succession planning and current tax issues. He also presents a quarterly session, Tax Talk with Michael Goldberg, about current, relevant, and real-life tax situations for professional advisors who serve high net-worth clients.
Kenneth Keung is the Director at the Calgary office of Moodys Tax/Moodys Private Client Law LLP. He has been providing his expertise in tax planning to high net-worth families, private businesses, and multinational enterprises for over 20 years. His wide-ranging practice includes individual, trust, and corporate tax planning, cross-border investments, mergers, acquisitions and divestitures, and estate and succession planning.
Kenneth is a frequent tax blogger and an award-winning author of a number of published papers. He is currently a governor of the Canadian Tax Foundation, a director of the Society of Trust and Estate Practitioner (STEP) and chair of its Calgary branch, and deputy chair of STEP’s national Tax Technical Committee. Kenneth has also facilitated and developed teaching material for CPA Canada’s In-Depth Tax Program since 2009. He has previously assisted The Joint Committee on Taxation in working with Finance Canada and the CRA on the development and enforcement of several tax legislation. Kenneth was also previously a member of Financial Planning Standards Board’s (FP Canada) Technical Knowledge Development Committee.