Cross-Border Counselor

For an employee who is a U.S. taxpayer, both the employer and the employee are liable for a portion of Social Security taxes and Medicare taxes (collectively referred to as “FICA” taxes) on the employee’s compensation. Employers are liable for withholding and remitting both the employer and the employee portions of FICA taxes, which typically occurs at the time the compensation is received by the employee, which his known as the “General Timing Rule.” However, when dealing with awards of nonqualified deferred compensation (“NQDC”) to U.S. taxpayers, a Special Timing Rule (outlined in Treas. Reg. §31.3121(v)(2)-1) may apply.  Under the Special Timing Rule, FICA taxes are owed when the employee becomes vested in the NQDC, whether or not the NQDC is actually paid at that time. If a Canadian company is unaware of this Special Timing Rule, it could result in the employer withholding and reporting incorrect FICA amounts as well as the employee overpaying FICA taxes. What is Nonqualified Deferred Compensation? A NQDC arrangement is really any kind of compensation that has been earned by an employee in one tax year, but that the employee will not receive until a later tax year. This could be as simple as a bonus earned in one year and payable in a later year, or as complex as equity-based awards, such as Restricted Stock Units, phantom stock, or a supplemental executive retirement plan (to name a few). However, this Special Timing Rule generally does not apply to stock options. What is the Special Timing Rule for FICA? As mentioned above, under the Special Timing Rule, FICA taxes are due on NQDC on the later of: (1) when the employee provides the related services, or (2) when the compensation is no longer subject to a substantial risk of forfeiture (i.e., when the amounts vest). In other words, FICA taxes could be due before the NQDC is actually paid to the employee. For a typical employer contribution-based cash plan or phantom stock plan, this rule means that FICA taxes will be due in the year when any deferred compensation (and any earnings) vest. This can become complex to track when there is an extended vesting schedule to ensure that the appropriate amount of FICA taxes are paid by the employer and employee when each tranche of the compensation (and earnings) vest. For a plan where employees are deferring salary or bonus, FICA taxes will be due in the year when the employee makes the deferral. To help ease some of the administrative complexity, there is a “rule of administrative convenience.”  The rule allows FICA taxes to be withheld and remitted as late as December 31 of the same tax year, with the amount of wages subject to FICA adjusted to reflect the value on December 31 (or an earlier date if payment is made earlier) after interest or earnings on the benefit are applied. This rule can be helpful if amounts under a plan vest at numerous times during a year. There are additional rules that can be utilized to help manage this complex issue. What are the Consequences of not Complying with the Special Timing Rule? The Special Timing Rule, although a bit administratively complex, is typically advantageous to the recipient of the NQDC. If FICA taxes are paid when the NQDC vests (but is not paid out), then FICA taxes will not be owed when the NQDC is paid (to avoid double taxation). This generally means that any interest or accruals on the amounts that have already been subject to FICA taxes, will not be subject to FICA taxes at all. On the flip side, the Special Timing Rule can occasionally be disadvantageous if NQDC is never paid, as regulations do not allow employees to recover FICA taxes paid on NQDC amounts that are never received. Unfortunately, many employers forget, or are not aware of the requirement, to include NQDC in income for FICA tax purposes at the time of contribution or vesting. If FICA taxes are not paid in accordance with the Special Timing Rule, the issue may be corrected if caught in time to amend withholding returns; otherwise, FICA taxes are due when payments are actually (or constructively) received and become taxable for income tax purposes (likely resulting in more FICA taxes due overall). The correction process is complex, as it involves determining open tax years for which correction is available, amending prior returns and issuing corrected W-2s. Therefore, employers should be careful to understand their nonqualified deferred compensation plans, and how tax withholding works under those plans.

On January 1, 2024, new direct reporting requirements to the Financial Crimes Enforcement Network (“FinCEN”), a bureau of the United States Department of the Treasury, became effective – known as the Corporate Transparency Act (the “CTA”). Who must file? The CTA, and the regulations promulgated thereunder, apply to corporations, limited liability companies, limited partnerships and similar legal entities either formed in the United States (a “Domestic Reporting Company”) or formed outside the United States but registered to do business in the United States (a “Foreign Reporting Company”). Such entities must identify their natural person beneficial owners and “company applicants” (i.e. the person(s) responsible for the formation or registration of the entity), and disclose certain personal information with respect to each of them. Persons and businesses covered under these new compliance obligations will be confronted with potentially difficult initial reporting and subsequent reporting requirements. Beneficial ownership information (“BOI”) will be reported directly to the federal government. Civil and criminal penalties may apply for non-compliance. Required BOI for each beneficial owner will include, amongst other things, full name, residential address, date of birth, and a photo page of a non-expired U.S. government ID (or, in absence, a foreign passport photo page). When will filing obligations start? For non-exempt Domestic Reporting Companies and Foreign Reporting Companies formed on and after January 1, 2024, an initial report must be filed within 90 days following corporate formation or registration. For non-exempt entities formed or registered prior to January 1, 2024, entities must file an initial report by January 1, 2025. After making an initial report, all entities will be required to file amended reports within 30 days after becoming aware that a previous filing was inaccurate or requires updating (for example, in connection with a change in beneficial ownership). Information disclosed to FinCEN will not be publicly available, but may be obtained by federal agencies engaged in national security, intelligence, or law enforcement activity, certain federal regulators, and certain state, local and tribal law enforcement agencies. Further, certain foreign officials, and certain financial institutions and banks subject to customer due diligence requirements, may also be granted access via submission of a request through a U.S. federal government agency. Who is exempt from the new rules? The intent of the CTA is to collect and compile BOI for legal entities whose ownership and management is not otherwise available. While the CTA provides 23 exemptions to the reporting requirements, most of the available exemptions are limited to regulated entities (e.g., banks and healthcare companies) or large companies with a substantial employee, revenue and operating presence in the United States. Note that most Canadian issuers that conduct business in the U.S. typically do so through a structure that utilizes one or more U.S. subsidiaries. Under this structure, the parent itself typically does not conduct business in the United States and is not qualified to do business in the United States. Accordingly, under this most common structure, the parent would not be a Foreign Reporting Person and therefore would not be subject to the CTA directly. However, its U.S. subsidiaries would need to file if they are not themselves exempt. For most Canadian issuers, the three key exemptions most likely to be relevant are (1) “securities reporting issuers,” (2) “large operating company” and (3) “subsidiary of certain exempt entities.” Securities Reporting Issuer A “Securities Reporting Issuer” is an entity that (i) has a class of securities registered under the U.S. Securities Exchange Act of 1934, as amended (the “34 Act”), and (ii) has a current reporting obligation under the 34 Act. All Canadian issuers that file annual reports on forms 40-F, 20-F and 10-K, including all issuers cross-listed on Nasdaq, NYSE or NYSE American, will qualify as Securities Reporting Issuers. Issuers that are traded on the over-the-counter market in the U.S. (i.e. the OTCQX, OTCQB or OTC Pink) and rely upon an exemption from registration under the 34 Act will not qualify as a Securities Reporting Issuer.           Large Operating Company A “Large Operating Company” is an entity that, in simplified form, has more than 20 full-time employees in the U.S., has gross revenues in excess of $5 million in the U.S. and has a physical operating presence in the U.S. In the typical cross-border structure described above, the Canadian parent would not have a physical presence in the U.S., so the top-tier U.S. subsidiary (if there are multiple entities) would likely be the entity for which the analysis would be applicable. Note that each portion of this test, other than revenue (which may be computed on a consolidated basis), is determined on a separate entity-by-entity basis. Accordingly, some U.S. subsidiaries of Canadian parent companies may be exempt under this test, while others may not be. For some companies, we anticipate that a reevaluation of their subsidiary structure might provide an opportunity to qualify for an exemption from the CTA. Subsidiary of Certain Exempt Entities A Subsidiary of Certain Exempt Entities is any entity that is “controlled or wholly owned, directly or indirectly, by one or more entities” that meet one of the other categories of exemptions under the CTA (although not the exemptions for money services businesses and certain pooled investment vehicles). Notable, however, that FinCEN declined to define “control” in determining the applicability of the subsidiary exemption (although appeared to suggest in its Final Rule that control through majority ownership may not be sufficient for this exemption to apply). All Canadian issuers that are cross-listed in the U.S. will  themselves be eligible for an exemption from the CTA reporting requirements. In addition, their direct and indirect wholly-owned subsidiaries will also be exempt. Less than majority-owned subsidiaries may also be exempt, depending on the circumstances. Other issuers with operations in the U.S. may also be eligible for an exemption, though careful analysis will likely be necessary. Please refer to our long-form update on the CTA HERE. Our attorneys are ready to assist with any questions you may have.

Imagine a Canadian company adopts a deferred share unit plan (DSU Plan) for its directors.  At the time the plan is adopted, the company does not have the plan reviewed by U.S. counsel, because none of their directors reside in the U.S.  It is not until several years later that the company learns that one of its directors, despite living in Canada, has dual citizenship with the U.S.  Because the typical form of Canadian DSU Plan will not comply with U.S. tax laws governing deferred compensation, particularly U.S. Internal Revenue Code Section 409A (Section 409A), the company has quite a mess on its hands.  You can read our prior articles on common payment timing issues with DSUs here and common election deferral issues with DSUs here. It is because of scenarios like the above that it is crucial to consider whether any of your employees or non-employee directors are U.S. taxpayers.  Unlike most other countries, U.S. taxpayers are taxed on worldwide income, regardless of where they reside.  U.S. taxpayers include: (i) U.S. citizens regardless of residency; (ii) legal permanent residents (“green card” holders); and (iii) non-citizen, non-green card holders who have a “substantial presence” in the United States under the U.S. income tax laws (but exceptions to this category apply – careful analysis of the facts and applicable tax treaties is required). Section 409A is so broad that it covers most nonqualified deferred compensation arrangements, unless a specific exception applies, and it imposes specific timing, election and distribution requirements on covered arrangements.  If a nonqualified deferred compensation arrangement fails to comply with the requirements of Section 409A, deferrals are includible in income at vesting (even if they are not paid out) and subject to a 20% additional tax.  In some circumstances, an underpayment interest penalty will also apply. Because of the broad definition of Section 409A, it is easy to overlook that employment agreements, change-in-control agreements, and severance agreements with U.S. taxpayers frequently contain provisions that subject them to Section 409A.  Because the failure to comply with Section 409A can result in such onerous tax penalties, if a Canadian company has U.S. taxpayers participating in its equity plans or if the company is entering into any type of compensation arrangement with a U.S. taxpayer where such arrangement promises to pay compensation in a future taxable year, the company should consider having the terms of any such plan or arrangement reviewed by U.S. counsel.

In our blog post dated August 22, 2022, we discussed the one percent (1%) excise tax on certain stock repurchase transactions by certain publicly traded corporations enacted as part of the Inflation Reduction Act of 2022 (the “Excise Tax”). The Excise Tax became effective on January 1, 2023. The Internal Revenue Services (the “IRS”) issued initial guidance describing future Treasury Regulations expected to be promulgated regarding the Excise Tax that, when finalized, are expected to be effective retroactive to the beginning of 2023. That initial guidance is contained in Notice 2023-2. (the “Notice”). Among other changes and clarifications, the Notice substantially expands the scope of Canadian corporations that may be subject to the Excise Tax. Prior to the publication of the Notice, it was anticipated that only Canadian corporations subject to the “anti-inversion” rules of Code Section 7874 or that effected stock repurchase transactions directly through “specified affiliates” (defined for these purposes as includes any U.S. corporation or partnership which is more than 50 percent owned, directly or indirectly, by the Canadian parent corporation and certain non-U.S. partnerships that have a U.S. entity as a direct or indirect partner) would be subject to the Excise Tax on such repurchase transactions. Pursuant to the Notice, if a specified affiliate funds, or is treated as funding, by any means (including through distributions, debt, or capital contributions) a share repurchase transaction of a Canadian corporation by the Canadian corporation or certain other specified affiliates, and if the “funding” is undertaken for a principal purpose of avoiding the Excise Tax, the “funding” specified affiliate will be subject to the Excise Tax with respect to the share repurchase transaction as if it had completed the repurchase transaction directly. For these purposes, the fair market value of stock treated as acquired by the “funding” specified affiliate is limited to the amount funded by the “funding” specified affiliate. And, for these purposes, a specified affiliate will be deemed to have a principal purpose of avoiding the Excise Tax if such specified affiliate funds by any means (other than a distribution) a share repurchase transaction within two years of such funding. The following is an example that illustrates this new “funding” rule. X is a publicly-traded Canadian corporation with one wholly-owned U.S. subsidiary corporation, Y. X is not subject to the anti-inversion rules of Code Section 7874. X redeems directly $20 million worth of its issued and outstanding stock. Within the two years prior to such repurchase: (i) Y paid X $10 million as repayment of principal with respect to certain intercompany debt obligations owed to X; and (ii) Y also paid X a dividend in the amount of $5 million. Y didn’t otherwise pay or distribute any other amounts to X in the two years preceding the share repurchase transaction. Pursuant to the funding rule, Y would be deemed to have had a principal purpose of avoiding the Excise Tax in connection with such share repurchase transaction completed by X insofar as the $10 million paid to X. Y would also be treated as funding an additional $5 million of the share repurchase transaction by X if it were determined that the $5 million dividend was paid with a principal purpose of avoiding the Excise Tax. Assuming that the $5 million dividend was not paid with a principal purpose of avoiding the Excise Tax, Y would be subject to an excise tax of $100,000 (1% of $10 million - the amount of X’s share repurchase transaction deemed to be funded by Y under the “funding” rule) as a result of X’s share repurchase transaction. Many Canadian companies with U.S. subsidiaries or affiliates may be inadvertently subjecting their U.S. subsidiaries or affiliates to the Excise Tax in connection with share repurchase transactions. The scope of transactions deemed to constitute a share repurchase transaction for purposes of the Excise Tax is considerably broad (including, without limitation, certain acquisitions of Canadian corporations, recapitalizations or other exchanges by shareholders of a Canadian corporation for new, different or a different number of shares of such Canadian corporation, changes to a Canadian corporation’s province of incorporation, split-offs and certain other distributions effected by Canadian corporations, and certain liquidations of Canadian corporations). The U.S. Treasury Department is accepting comments in response to the Notice until March 20, 2023. It is expected that Treasury Regulations will be proposed sometime thereafter. Subject to the promulgation of Treasury Regulations, Canadian corporations with U.S. subsidiaries or affiliates or otherwise subject to the anti-inversion rules of Code Section 7874 that directly or indirectly repurchase stock or otherwise engage in various corporate transactions (including, without limitation, those listed above) should seek advice to avoid or limit the potential application of the Excise Tax.

A Canadian company adopting a deferred share unit plan (DSU plan) for its directors must consider U.S. tax implications for U.S. taxpayers.  It is important to remember that U.S. citizens and U.S. residents for tax purposes (including green card holders) are taxed on worldwide income, regardless of where they reside.  As such, participation by a U.S. director, including an expat or holder of dual citizenship, could result in significant adverse tax consequences under Section 409A of the Internal Revenue Code, as a typical Canadian DSU plan often runs afoul of Section 409A.  In a prior article, DSU Plans Require Careful Review to Avoid Adverse U.S. Tax Treatment, common payment timing violations of U.S. tax laws governing deferred compensation were discussed (as well as tips for properly identifying U.S. taxpayers).  While payment timing is one common violation of Section 409A, it is also important to consider the timing of elections to defer compensation. In order to avoid a violation of U.S. deferral election timing rules, a Canadian company should consider both the general deferral election timing rules under Section 409A, as well as the exceptions permitting more lenient timing.  Generally, deferral elections must be made by the end of the taxable year before the year in which the services giving rise to the compensation that will be deferred are performed.  For instance, for any amounts earned in 2023, the election to defer should be made no later than December 31, 2022.  Once a deferral election is made, payment may not be accelerated, unless a specific exception applies, and payment may not be further deferred, unless strict second deferral election rules are obeyed. While compliance with the general deferral election timing rule is always the simplest and least risky approach, there are exceptions to this general rule that provide greater leniency in some situations.  One of the most common exceptions is for initial eligibility.  Section 409A provides that a deferral election may be made within 30 days following the date that a service provider (e.g., a director) is first eligible to participate in the plan, provided that the election may only apply to compensation earned following the date of the election (and provided the service provider does not participate in another deferred compensation plan required to be aggregated with such plan under Code Section 409A).  There are additional exceptions to the general deferral election timing rules for payments conditioned on continued service for a period of at least 12 months as well as for performance-based compensation.  However, compliance with these exceptions can be rather tricky, and the consequences for failing to comply are severe, so these exceptions should be discussed with legal counsel proficient in U.S. tax law. Where a U.S. director fails to make a timely deferral election within the meaning of Section 409A, the value of the DSUs as of December 31st of the year in which the DSUs vest (i.e. the year in which the DSUs are awarded for the majority of DSU plans) will be included in the U.S. director’s income for that year, regardless of whether actual payment of the DSUs is deferred. In addition, a 20% penalty tax will be imposed on the U.S. director. Advanced planning is crucial to ensure compliance with the above-mentioned deferral election timing rules in order to avoid the adverse tax consequences described above.  A Canadian company with U.S. directors should have any such DSU plan reviewed by counsel proficient in U.S. tax law prior to implementation.  However, even where review prior to implementation is not possible, a review after implementation would still be advantageous, as early correction may avoid or minimize certain adverse tax consequences.  We work regularly with Canadian tax counsel to ensure compliance and/or to correct violations.

On August 16, 2022, President Biden signed the Inflation Reduction Act of 2022, HR 5376 (the “Act”), into law. Among other significant changes, the Act includes a new 1% excise tax on stock repurchase transactions by certain publicly traded corporations (the “Excise Tax”). As described below, publicly traded Canadian companies that: are treated as U.S. corporations for U.S. federal income tax purposes under the anti-inversion rules in Code Section 7874(b); became treated as “surrogate foreign corporations” for U.S. federal income tax purposes on or after September 20, 2021 under the anti-inversion rules in Code Section 7874(a)(2)(B); or are not subject to the anti-inversion rules but that effect a stock repurchase through one or more of its U.S. subsidiaries or affiliates, will each likely be subject to the Excise Tax. Under the Excise Tax, subject to certain exceptions discussed below, a “covered corporation” is subject to a 1% excise tax on the fair market value of certain stock “repurchased” during the covered corporation’s taxable year, irrespective of whether any such repurchase is part of an open-market stock buyback program. For these purposes, a “covered corporation,” includes any U.S. corporation, any Canadian or other non-U.S. corporation treated as a U.S. corporation for U.S. federal income tax purposes pursuant to the anti-inversion rules under Code Section 7874(b), and any Canadian or other non-U.S. corporation that became deemed a “surrogate foreign corporation” pursuant to the anti-inversion rules under Code Section 7874(a)(2)(B) on or after September 20, 2021 (and, only for the applicable ten-year period thereafter as contemplated by Code Section 7874(d)(1)), in any case whose stock is traded on an established securities market (e.g., NASDAQ, NYSE, TSX, LSE, etc.) irrespective of the market capitalization of such corporation. The Excise Tax also applies to a covered corporation if its stock is repurchased by a “specified affiliate”, which includes any corporation or partnership which is more than 50 percent owned, directly or indirectly, by the covered corporation. In addition, U.S. corporations and partnerships (which, for these purposes, includes a Canadian or other non-U.S. partnership with a direct or indirect U.S. entity as a partner) that are “specified affiliates” of Canadian parent corporations, including Canadian parent corporations not otherwise subject to the anti-inversion rules, will also be subject to the Excise Tax upon the repurchase of stock of its Canadian parent corporation if: (i) the Canadian parent corporation has stock traded on an established securities market, and (ii) such U.S. domestic corporation or partnership is a “specified affiliate” of the Canadian parent corporation. Further, the reductions to the Excise Tax with respect to stock issuances during the taxable year, as described below, are limited to those made by such specified affiliate to its employees. In computing the Excise Tax, the fair market value of stock repurchased is reduced by the fair market value of any stock issued by the covered corporation during the taxable year, including any stock issued or provided to an employee of such corporation (including upon exercise of an employee stock option), or to an employee of a “specified affiliate” (as defined above) of such corporation. The Excise Tax applies at a fixed rate without regard to whether such covered corporation has taxable income or loss during the taxable year. For these purposes, a “repurchase” includes a redemption of stock within the meaning of Code Section 317(b), as well as any transaction determined by the Secretary to be economically similar to a redemption of stock within the meaning of Code Section 317(b). Code Section 317(b) provides that stock shall be treated as redeemed by a corporation if the corporation acquires its stock from a shareholder in exchange for property, whether or not the stock so acquired is cancelled, retired or held as treasury stock. Accordingly, redemptions subject to the Excise Tax may include an acquisition by a covered corporation: (i) of its own stock for cash, regardless of whether such purchase is made on the open market or in a private transaction, (ii) to effectuate a “bootstrap acquisition” or a leveraged buyout, and (iii) of fractional shares for cash in an acquisition. Subject to further guidance from the IRS and U.S. Treasury Department, because the Excise Tax only applies to a repurchase of “stock”, the repurchase of an unexercised option or warrant not otherwise treated as a stock for U.S. federal income tax purposes is not anticipated to be subject to the Excise Tax. Further guidance from the Secretary will be necessary to determine the precise scope of the Excise Tax. The Act provides that the Excise Tax will not apply to a stock repurchase transaction: to the extent that the repurchase is part of a reorganization (within the meaning of Code Section 368(a)) and no gain or loss is recognized on such repurchase by the shareholder by reason of such reorganization; in any case in which the stock repurchased, or an amount of stock equal to the value of stock repurchased is, contributed to an employer-sponsored retirement plan, employee stock ownership plan, or similar plan; in any case in which the total value of the stock repurchased during the taxable year does not exceed U.S.$1,000,000; under regulations prescribed by the Secretary, in cases in which the repurchase is by a dealer in securities in the ordinary course of business; to repurchases by registered investment companies or real estate investment trusts; or to the extent that the repurchase is treated as a dividend for tax purposes. The new Excise Tax applies to repurchases effected after December 31, 2022. No grandfathering rule currently applies to stock repurchase transactions already authorized or approved. Subject to the promulgation of additional guidance and Treasury Regulations, Canadian corporations described above that directly or indirectly repurchase stock, utilize cross-border equity financing structures or engage in cross-border acquisitions should seek advice to avoid or limit the potential application of the Excise Tax.

More special purpose acquisition vehicles (common known as “SPACs”) completed their initial public offering (“IPO”) in 2021 than in any prior year. In 2021, approximately 613 SPACs completed their IPO within the United States alone. An increasing number of Canadian companies are being approached by U.S. and tax haven SPACs with significant US shareholders. A SPAC is organized with no business operations and minimal direct assets (cash raised from private investors in the IPO is held in a trust account) for the purpose of acquiring a private company, effectively resulting in that company being taken public. Such acquisition is generally referred to as a “qualifying transaction” (or “de-SPAC” transaction). Private companies generally find de-SPAC transactions attractive because they can result in significant cash infusions and access to public markets while avoiding the complications of a direct IPO. Common de-SPAC transaction structures include: (i) re-domiciling the SPAC to Canada prior to the acquisition of the Canadian company; (ii) acquiring the Canadian company utilizing an exchangeable share structure; (iii) structuring the de-SPAC transaction as an acquisition of the SPAC by the Canadian company; or (iv) forming a new Canadian holding company to acquire the SPAC and the Canadian company. The re-domiciling of a SPAC to Canada will generally result in application of the U.S. anti-inversion tax rules unless the SPAC is organized in a non-U.S. jurisdiction. If the anti-inversion rules apply, the SPAC will continue to be classified as a U.S. domestic corporation for U.S. federal income tax purposes notwithstanding the re-domiciliation to Canada. As a result, U.S. SPACs are generally not re-domiciled to Canada. Properly designed exchangeable share structures whereby the SPAC acquires an interest in the Canadian company and shareholders of the Canadian company receive shares exchangeable for SPAC shares can result in the deferral of taxes by shareholders of the Canadian company until they liquidate their holdings. However, the use of exchangeable share structures often adds cost, time and complexity. The acquisition of a SPAC by the Canadian company, or a newly-formed Canadian corporation organized to acquire both the SPAC and the Canadian company, can result in tax-deferral for the shareholders of the Canadian company and the SPAC if certain detailed requirements are met including, with respect to a direct acquisition of the SPAC by the Canadian company, that such Canadian company have been engaged in an active trade or business (as defined for U.S. federal income tax purposes) for the 36 months preceding the acquisition of the SPAC. Ultimately, the de-SPAC transaction structure to be utilized depends on the particular facts applicable to the Canadian company, the SPAC and their respective shareholders. Involving U.S. tax counsel early in the discussion process can make the de-SPAC transaction process more efficient and avoid unforeseen U.S. tax issues.

Many Canadian companies and individuals own U.S. real property interests through a U.S. corporation. The Foreign Investment in Real Property Tax Act (“FIRPTA”) regime imposes a withholding tax (currently at a rate as high as 15%) on the gross proceeds realized by Canadians upon the sale or transfer of a U.S. real property interest. This withholding is imposed without regard to whether the disposition results in a taxable gain.  However, with advance planning, this withholding may be reduced or eliminated. A U.S. real property interest (“USRPI”) generally includes land, buildings, growing crops and timber, and mines, wells and other natural deposits (including oil and gas properties and mineral deposits) located in the United States and equity interests in a “United States real property holding corporation” (“USRPHC”) as well as certain interests in a USRPI-owning partnerships (subject to certain “look-through” rules). A U.S. corporation (or entity classified as a U.S. domestic corporation for U.S. federal income tax purposes) will generally be a USPRHC if, at any time during the prior 5 year period, the fair market value of its USRPIs equals or exceeds 50% of the aggregate fair market value of (a) such corporation’s USRPIs, (b) such corporation’s interests in foreign real property, and (c) such corporation’s other assets that are used or held for use in a trade or business. If shares in a USRPHC are sold or transferred by a Canadian in certain tax-deferred transactions (as determined for U.S. federal income tax purposes), certain certification and filing requirements must be satisfied to avoid FIRPTA withholding. If that sale or transfer is made pursuant to a taxable transaction (as determined for U.S. federal income tax purposes), FIRPTA withholding may be reduced (or eliminated) by filing an IRS Form 8288-B if the actual tax due on the “built-in gain” in the shares of the USRPHC is less than 15% of the gross sale proceeds (or if the shares are in a built-in loss position). To be effective, an IRS Form 8288-B must be completed, signed, and filed with the IRS prior to the effective time of the sale or transfer. In order to be complete, the form must generally contain: (i) the U.S. taxpayer identification number of the transferor and the transferee; (ii) a description of the USRPI being transferred; (iii) the fair market value of the USRPI being transferred and evidence supporting the same (which, in some cases, requires an independent third-party appraisal); and (iv) the transferor’s adjusted tax basis in the USRPI being transferred. If the Canadian transferor does not have a U.S. taxpayer identification number, it will need to obtain one. Completing an IRS Form 8288-B often requires advanced planning. Canadian companies and individuals holding shares in a USRPHC (or USRPIs) may be able to significantly reduce the U.S. withholding taxes to which they are subject by planning ahead and timely filing an IRS Form 8288-B.

On Thursday, November 4, 2021, the Office of the Superintendent of Financial Institutions announced that, subject to approval by the superintendent, Canadian banks and other financial institutions may begin repurchasing their own shares. Share buyback transactions by Canadian companies are not novel. However, the U.S. federal income tax treatment of U.S. shareholders participating in a share buyback transaction with a Canadian corporation can often be surprising. Depending on the U.S. shareholder’s particular circumstances, the tendering of shares of a Canadian corporation for cash pursuant to a share buyback transaction will generally either be treated as a “sale or exchange” of such U.S. shareholder’s shares or as a “distribution” by the Canadian corporation in respect of such U.S. shareholder’s shares. Under Code Section 302, after applying certain constructive ownership and attribution rules, a U.S. shareholder whose shares are sold back to the issuing Canadian corporation for cash will generally be treated as having engaged in a “sale or exchange” of such shares if the transaction: has the effect of a “substantially disproportionate” distribution by the Canadian corporation with respect to such U.S. shareholder; results in a “complete termination” of such U.S. shareholder’s equity interest in the Canadian corporation; or is “not essentially equivalent to a dividend” with respect to such U.S. shareholder. Each of the tests above generally considers the proportion of shares of the Canadian corporation the U.S. shareholder holds immediately prior to, and (if any) immediately after, the share buyback transaction either based upon the aggregate issued and outstanding shares of the Canadian corporation or the shares actually and constructively held by each U.S. shareholder individually. Provided certain holding period and other requirements are satisfied, a U.S. shareholder that is deemed to “sell or exchange” their shares of a Canadian corporation may be eligible for the lower, more favorable, capital gains tax rates. If the U.S. shareholder is deemed to receive a “distribution” with respect to its shares, such U.S. shareholder would generally recognize, as ordinary income, a dividend equal to the amount of any distribution paid on the shares, without reduction for any Canadian taxes withheld from the amount paid, on the date the distribution is received to the extent the distribution is paid out of the Canadian corporation’s current or accumulated “earnings and profits” as determined for U.S. federal income tax purposes. If the distribution exceeds the Canadian corporation’s earnings and profits, the U.S. shareholder’s tax basis in its remaining shares would then be reduced (but not below zero) with any then remaining excess generally treated as capital gains. However, many Canadian corporations do not maintain calculations of their current and accumulated earnings and profits in accordance with U.S. federal income tax principles. In those instances, U.S. shareholders deemed to receive a “distribution” pursuant to a share buyback transaction may be required to treat the entirety of the proceeds received as a taxable dividend subject to ordinary income tax rates. The U.S. federal income tax consequences of share buyback transactions are different for Canadian corporations classified as “passive foreign investment companies” for U.S. federal income tax purposes. In the U.S., recent legislative proposals have included an excise tax, at a rate as high as 2%, on share buyback transactions for public companies in the U.S. It remains uncertain whether any such tax will be adopted and, if adopted, what scope of publicly traded corporations will be subject to that tax.

In transactions in which a Canadian corporation seeks to acquire a U.S. target entity for shares of the Canadian acquiror in a transaction intended to be tax-deferred for U.S. federal income tax purposes, the ability of U.S. shareholders of the U.S. target to qualify for tax-deferral may depend on the activities the Canadian acquiror conducts in Canada (or other non-US jurisdictions). Under the general rule in Code Section 367(a), if a U.S. person transfers stock in a U.S. corporation to a Canadian corporation (as characterized for U.S. federal income tax purposes), such transfer will not be characterized as a tax-deferred exchange for U.S. federal income tax purposes (even if the transaction would otherwise qualify as a tax-deferred exchange). There are a number of exceptions (and exceptions to the exceptions) to the general rule contained in Code Section 367(a). One of the most important exceptions is the “Active Trade or Business Exception”, which applies where the Canadian corporation directly, or through certain qualified subsidiaries: (i) is engaged in an active trade or business in Canada (or other non-US jurisdiction) for the entirety of the 36-month period immediately prior to the transaction; (ii) at the time of the transaction, has no intent to dispose of or discontinue such trade or business; and (iii) has a fair market value which is substantial as compared to the U.S. target corporation. The Active Trade or Business Exception can be critical to achieving tax-deferral for U.S. owners of U.S. target companies. Each component of the Active Trade or Business Exception is subject to complex rules and interpretations. Even if the Active Trade or Business Exception is satisfied, if an owner of the U.S. target would own, directly, indirectly or pursuant to certain attribution rules, 5% or more of the outstanding voting power or value of the Canadian corporation immediately after the exchange, the exchange will generally be taxable to such U.S. target owner unless that person enters into a “gain recognition agreement” with the Internal Revenue Service. A gain recognition agreement is an agreement whereby a U.S. target owner agrees that if a “gain recognition event” occurs within a five-year period following the initial transfer, such U.S. target owner will also recognize at the time of such “gain recognition event” the gain that existed in their equity holdings at the time of the initial transfer. Code Section 367(a) also does not generally apply to any transfer of property by a U.S. person to a Canadian corporation which is, or will be immediately after such transfer, treated as an “inverted corporation” (i.e., a U.S. domestic corporation for U.S. federal income tax purposes) under Code Section 7874(b). The business activities, employee headcount, and employee compensation of the Canadian acquiring corporation in Canada will also generally be relevant in determining whether a Canadian corporation is, or will be immediately after such an exchange, an “inverted corporation”. Because determining whether tax-deferral may be available for U.S. shareholders of a U.S. target company can have a significant impact on structure, pricing and other material transaction terms, it is best for Canadian corporations evaluating acquisitions of U.S. target companies to analyze as early as practical whether the Active Trade or Business Exception (or any other exception under Code Section 367(a)) may be available.

Generally, an “inversion” is a transaction in which a non-U.S. corporation directly or indirectly acquires substantially all of the properties held by a U.S. corporation or partnership, after which the former owners of that U.S. corporation or partnership are in control of the acquiring non-U.S. corporation. Inversion transactions can take many different forms.  Over the years, inversion transactions have continually drawn scrutiny, perceived to be transactions pursuant to which a U.S. company effectively changed its domicile to a non-U.S. jurisdiction and, accordingly, reduced its U.S. income tax liability. In response, Congress enacted the anti-inversion rules under Code Section 7874 as a means of discouraging inversion transactions and preserving the U.S. tax base. Under Code Section 7874, if a non-U.S. corporation (the “non-U.S. acquiror”) acquires, directly or indirectly, substantially all of the assets of a U.S. corporation or U.S. partnership (the “U.S. domestic target”), and the former owners of the U.S. domestic target hold stock in the non-U.S. acquiror constituting at least 80%, by vote or value, of all issued and outstanding stock of the non-U.S. acquiror after the transaction by reason of their ownership in the U.S. domestic target, then the non-U.S. acquiror will be treated as a U.S. domestic corporation for U.S. federal income tax purposes. If stock constituting at least 60%, but less than 80%, of the aggregate voting power or value of the non-U.S. acquiror is held by the former owners of the U.S. domestic target after the transaction by reason of their ownership in the U.S. domestic target, then the non-U.S. acquiror is generally respected as a non-U.S. corporation, but it would thereafter be subject to various disadvantages for U.S. federal income tax purposes for a period of 10-years after the inversion transaction. Code Section 7874 and the Treasury Regulations and administrative guidance promulgated thereunder contain a number of exceptions and additional rules applicable to determining whether an inversion transaction has occurred. For example, shares issued by the non-U.S. acquiror in a public or private financing which is related to the acquisition are disregarded in determining what percentage of the non-U.S. acquiror is owned by former owners of the U.S. domestic target. An “inversion” transaction in which the non-U.S. acquiror is treated as a U.S. domestic corporation for U.S. federal income tax purposes may have certain benefits, including permitting its acquisition of the U.S. domestic target to constitute a tax-deferred transaction (if the requirements applicable to the acquisition structure are met) and permitting future tax-deferred acquisitions of other U.S. companies. On April 7, 2021, the U.S. Department of Treasury released a report outlining the Biden Administration’s “Made in America Tax Plan” (the “Plan”). As part of the Plan, the Biden Administration proposed to expand the existing anti-inversion rules. Under the Plan, a non-U.S. acquiror that acquires a U.S. domestic target would be treated as a U.S. domestic corporation for U.S. federal income tax purposes if either (i) the former owners of the U.S. domestic target hold stock of the non-U.S. acquiror constituting 50% or more (presumably by vote or value, although the Plan is not specific in that regard) of the non-U.S. acquiring corporation after the transaction by reason of their ownership in the U.S. domestic target, or (ii) the non-U.S. acquiror is subsequently managed and controlled from within the United States. It remains uncertain whether the Plan will be enacted into law and, if so, what anti-inversions may be included in ultimately enacted legislation.

Canadian persons and entities owning a significant interest in a U.S. corporation or U.S. entity classified as a “disregarded entity” for U.S. federal income tax purposes should ensure they are compliant with IRS Form 5472 filing requirements to avoid substantial U.S. federal income tax penalties. IRS Form 5472, “Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business” must be filed by: (i) any U.S. corporation which has a Canadian shareholder that owns, directly or indirectly, 25% or more of the voting power or value of that corporation; (ii) any U.S. entity classified as a “disregarded entity” for U.S. federal income tax purposes that has a Canadian owner; and (iii) any Canadian corporation engaged in a U.S. trade or business within the United States; provided, in each case, that a “reportable transaction” occurs. The scope of “reportable transactions” requiring the filing of IRS Form 5472 is very broad, and generally includes, without limitation, capital contributions, intercompany debt financing arrangements and other transactions that have the potential to reduce U.S. federal income tax liabilities or result in assets being transferred to, or distributed from, the entities listed above. The failure to file penalty for Form 5472 is $25,000, which may be increased by an additional $25,000 to the extent the Form is 90 days late. An additional $25,000 penalty may be assessed each 30 days thereafter. The U.S. federal income tax rules implementing Form 5472 also require the maintenance of certain records in accordance with applicable regulations. The failure to maintain those records in the prescribed manner may also be assessed a penalty of $25,000. Certain Canadian owners of the entities listed above may also have IRS Form 5471 (a form similar to IRS Form 5472) or other reporting obligations, which may also be subject to significant failure to file penalties. The timely filing of these often overlooked IRS Forms is critical to avoiding substantial IRS penalties.

An often overlooked exception to U.S. withholding taxes may result in a lower overall U.S. tax burden. The Foreign Account Tax Compliance Act (“FATCA”) was enacted in an effort to ensure that U.S. taxpayers could not avoid U.S. federal income tax on investment income through the use of non-U.S. accounts or entities. FATCA requires that certain foreign financial institutions (“FFIs”) and nonfinancial foreign entities (“NFFEs”) comply with information reporting requirements intended to identify U.S. account holders or U.S. owners. FFIs generally include banks, investment companies or similar financial institutions, and certain non-U.S. trusts while NFFEs generally include any entity that is not a financial institution. Under FATCA, a withholding agent that does not obtain proper documentation from its beneficial owners as required for compliance with applicable FATCA reporting requirements (e.g., an IRS Form W-9, W-8BEN, W-8BEN-E or other applicable form) is generally required to withhold 30% of a withholdable payment to an FFI or NFFE. For these purposes, a “withholdable payment” is defined as (i) any payment of interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income (collectively, “FDAP Income”), if such payment is from sources within the United States, and (ii) any gross proceeds from the sale or other disposition of any property of a type which can produce interest or dividends from sources within the United States (e.g., capital gains of stock of a U.S. corporation). However, in December of 2018, Treasury issued Proposed Regulations which would remove gross proceeds from the definition of a “withholdable payment”, and thereby eliminate the withholding requirements on gross proceeds described in (ii) above. The Preamble to the Proposed Regulations noted that financial institutions faced significant administrative burdens in complying with such withholding requirement for gross proceeds and that it was no longer necessary given widespread compliance with the FATCA regime. While these Proposed Regulations have yet to be finalized, the Preamble provides that taxpayers may generally rely on the Proposed Regulations until such time that final Treasury Regulations are issued. Accordingly, only payments of U.S.-source FDAP Income are currently subject to FATCA withholding and reporting requirements.

A Canadian which holds a partnership interest in a U.S. or non-U.S. partnership that has “effectively connected income” (“ECI”) is subject to U.S. tax withholding with respect to the Canadian partner’s allocable share of the partnership’s ECI.  That withholding tax must be remitted by the partnership to the IRS irrespective of whether any distributions are made by the partnership in that tax year and irrespective of the Canadian partner’s ultimate U.S. federal income tax liability for that tax year.  For this purpose, a “partnership” includes any entity classified as a partnership for U.S. tax purposes, including a limited liability company or “LLC” classified as a partnership. ECI generally includes all income from U.S. sources that is connected with the conduct of a U.S. “trade or business”. The term “trade or business” generally includes the performance of personal services, but also includes and excludes specific types of activities. The determination of whether activities rise to the level of constituting a trade or business requires specific analysis. Canadian partners in partnerships with ECI will be required to obtain a U.S. taxpayer identification number and to file a U.S. federal income tax return, as the activities of a partnership constituting a trade or business will be attributed to the Canadian partner. A Canadian partner will generally be eligible to claim a credit for their share of the ECI withholding tax remitted by the partnership in determining their aggregate U.S. tax liability. Accordingly, the withholding tax is not an additional tax. In addition to the foregoing, a Canadian which transfers or disposes of an interest in a partnership with ECI is generally subject to a 10% U.S. withholding tax, unless an exception applies. Exceptions to the 10% U.S. withholding tax generally assessed against transferors of interests in U.S. partnerships will be discussed in a subsequent blog post.

The CARES Act, signed into law on March 27, 2020 in the wake of the onset of the Covid-19 pandemic, contained numerous changes to U.S. federal income tax law. One such change applied to the deductibility of net operating losses (“NOLs”). Legislation enacted in December 2017 commonly known as the “Tax Cuts and Jobs Act” (the “TCJA”) prohibited the carrying back of NOLs to prior tax years and limited the amount of NOLs which could be deducted in any particular tax year to 80% of a corporate filer’s taxable income. Reversing course, Section 2303 of the CARES Act delayed the effective date of certain limitations in the TCJA by allowing a corporate taxpayer’s NOLs arising in a taxable year beginning after December 31, 2017 and before January 1, 2021 to be carried back to the five years preceding the taxable year of such loss. In addition, the CARES Act eliminated the taxable income limitation applicable to the deductibility of NOLs for tax years beginning after December 31, 2017 and before January 1, 2021 (with additional rules applying to tax years beginning after January 1, 2021). Recent SEC filings suggest that SEC-registered companies anticipate receiving refunds, in the aggregate, in excess of $5 billion. Due to the reduction of the U.S. corporate tax rate from 35% to 21% as a result of the TCJA, some corporate taxpayers may benefit significantly more than others, due to the ability to carry NOLs back to tax years in which a higher U.S. federal income corporate tax rate applied. Other corporate taxpayers may be unable to fully, or even partially, utilize accumulated NOLs due to not having taxable income in the five tax years preceding the year of a particular loss. NOL provisions in merger and acquisition agreements should be carefully analyzed in the wake of the CARES Act to ensure that the potentially significant benefits from the ability to carry back NOLs are appropriately negotiated.

Current closures at the Internal Revenue Service (“IRS”) have caused significant delays in obtaining an Employer Identification Number (“EIN”) for some U.S. businesses formed by Canadians, including new U.S. subsidiaries formed by Canadian companies. An EIN is a nine-digit number that the IRS assigns to businesses, which is necessary for many essential tasks, including making U.S. federal tax filings, hiring employees, or opening and maintaining a U.S. bank account. Applicants with a “U.S. Responsible Party” (i.e., a CEO, CFO, or President with a U.S. Social Security Number or Individual Taxpayer Identification Number) are generally able to obtain an EIN through the IRS’ online application portal, which remains open. Most applicants lacking a U.S. Responsible Party must submit their applications to the IRS via telephone, fax, or mail. However, due to the COVID-19 outbreak, the IRS has temporarily closed its EIN call center, fax lines, and mail-processing center. Accordingly, applicants lacking a U.S. Responsible Party may not be able to obtain an EIN until the IRS reopens one of these channels. As the IRS has not yet indicated when such reopening might occur, applicants lacking a U.S. Responsible Party are left with only one course of action. These applicants can submit a Form SS-4 via certified mail to the IRS for processing when the IRS reopens its mail-processing center. In doing so, such applicant can attest to having “applied for” an EIN and provide the official date of its application (being the date the application was mailed). While an EIN submitted via certified mail will generally be processed in the order received, the actual processing of the application will not begin until the IRS reopens its mail-processing center. In the ordinary course of business, the EIN-by-mail process can take up to one month. However, given the ongoing uncertainty surrounding COVID-19, the actual processing time of EIN applications submitted via certified mail may be far longer.

As Covid-19 continues to spread, many countries, including the United States and Canada, are increasingly closing their borders in an attempt to slow the rate of infection. This precaution may, however, have unintended tax consequences for Canadians who find themselves stranded on the U.S. side of the border for the duration of the shutdown. Under the substantial presence test, Canadians who are present in the United States for at least 31 days during the current year, and 183 days in the aggregate during the current calendar year and the two preceding calendar years, will be considered U.S. residents for U.S. federal income tax purposes. Specifically, this three-year test is calculated by adding: (i) all days present in the United States during the current year; plus (ii) one-third of any days present in the United States during the previous year; plus (iii) one-sixth of any days present in the United States for the year before that. If that sum equals or exceeds 183 days, then such Canadian citizen may be subject to U.S. federal income tax on their worldwide income. Accordingly, it is important for Canadians that are currently stranded in the United States to take proactive steps to avoid this potentially adverse result. To do so, there are a number of measures an individual can take depending on their circumstances. If a Canadian citizen is in the United States based on a certain type of visa (e.g., teachers, trainees, or students) or overstays due to a medical condition that prevents them from leaving, then such individual may be able to exclude days from the substantial presence calculation by filing an IRS Form 8843. This form allows the individual to claim an exemption and maintain their status as a nonresident of the United States for U.S. federal income tax purposes. Alternatively, Canadian citizens that are not in the United States under a qualifying visa or prevented from leaving due to a medical condition may file an IRS Form 8840 to claim a “Closer Connection Exemption.” Under this exemption, Canadian citizens that meet or surpass the 183-day threshold can still be treated as nonresidents of the United States by substantiating that they have closer connections to Canada based on residential ties including, without limitation, family, location of principal home, social ties, economic ties, etc. However, the Closer Connection Exemption is only available if the Canadian citizen was present in the United States for fewer than 183 days during the current taxable year. If neither of the above exemptions apply, a stranded Canadian citizen can still avoid U.S. taxation by claiming an exemption under the United States-Canada Tax Treaty. To do so, the individual should file an IRS Form 1040NR, i.e., a U.S. Nonresident Alien Income Tax Return, and attach a completed IRS Form 8833, which specifies the treaty provisions under which the taxpayer is claiming an exemption. If pursuing this course of action, Canadian filers should be sure to include reference to Covid-19-related travel bans as justification for meeting the substantial presence test. To further bolster their position, a stranded Canadian citizen should also maintain documentation that evidences their attempts, as well as inability, to return to Canada, which could help further corroborate their position as a non-U.S. resident. While little can be done about the current shutdown, stranded Canadian citizens can consider prudent measures to take in the meantime so as to avoid any unnecessary U.S. tax liability. Dorsey & Whitney regularly represents taxpayers in navigating the above process. If you have any questions or would like to learn more, please contact us.

We have written about this in the past [here], but the message bears repeating each year. It is easy to overlook that employment agreements, change-in-control agreements, and severance agreements with U.S. taxpayers frequently contain provisions that subject them to U.S. Internal Revenue Code Section 409A ("Section 409A"), and failure to comply can result in onerous tax penalties. However, to the extent that rights under such agreements are not yet vested, it may be possible to correct them before year-end without penalty. Even if rights under an agreement are vested, in some cases correction is available with payment of reduced penalties under IRS correction programs. It is important to remember that U.S. residents, and U.S. citizens regardless of country of residence, are taxed on worldwide income. This means that compensatory arrangements for employees and directors who are U.S. citizens working outside the U.S. will be subject to U.S. federal income tax. If compensation arrangements have not been reviewed for Section 409A compliance, we recommend doing so now, especially with respect to arrangements that will or may become vested during 2019. For a more detailed explanation, see our Dorsey publication from October 6, 2015 here.

While the recently enacted U.S. tax reform legislation did not overhaul executive compensation to the extent proposed in early forms of the bill, Section 162(m) of the U.S. Internal Revenue Code was dramatically revised in a way that affects Canadian companies that file reports with the SEC and that employ, or may in the future employ, executives in the United States. Previously, Section 162(m) limited the amount of compensation that an SEC reporting company that was a “domestic issuer” for securities law purposes, or its subsidiaries, could deduct with respect to its most senior executives. Important for many of our Canadian clients, we believe that under the rule changes, U.S. tax deductions for compensation paid to key executives of any SEC reporting company, including foreign private issuers, and their subsidiaries, will now be subject to the limitations of Section 162(m). In addition, the rule changes eliminate a major exception for qualifying performance-based compensation. This article identifies the important changes to Section 162(m) and addresses the limited transition and grandfathering opportunities companies should now consider. Section 162(m), as amended, limits the amount of compensation an SEC reporting company can deduct with respect to its CEO, CFO, and the next three highest earners in the company’s controlled group to US$1 million per individual per year. As mentioned above, compensation paid to key U.S. executives of foreign private issuers likely no longer escapes the reach of Section 162(m). It appears that regulations that formerly exempted key employees from public companies that were not subject to SEC proxy statement requirements (i.e., were not obligated to file a summary compensation table) have been undermined by the revised Section 162(m). Included in Section 162(m)(3) is now a statement that covered employees, aside from the CEO and CFO, are determined without regard to whether the compensation of such employees is required to be reported to shareholders. Absent any future clarifying regulations from the U.S. Treasury to the contrary, foreign private issuers should take note that certain key employees will be considered covered employees under Section 162(m) going forward. To the extent that compensation paid to a covered employee was intended to be claimed as a compensation expense deduction on a corporation’s U.S. federal income tax return, it will be important to recognize that any such compensation in excess of US$1 million annually to a covered employee will not be deductible. A major exception that exempted qualifying performance-based compensation from the reach of this limitation has been removed effective in 2018. Therefore, whereas public companies had been able to deduct large compensatory payments above the basic US$1 million limit to key executives relating to the exercise of stock options and/or the issuance of stock awards payable because of the achievement of pre-set performance objectives, this exception will no longer be available going forward. Removal of the performance-based exception will disadvantage public companies that have intentionally structured their compensation to be predominantly performance-based in order to deduct key employee compensation to the greatest extent possible. However, the overall reduction in the U.S. corporate income tax rate from 35% to 21% in the tax legislation will more than compensate for any lost deductions in most cases. Once an executive is a “covered employee” of a company for purposes of Section 162(m), the executive now will remain a covered employee forever. As a result, compensation deductions for payments made after an executive is no longer among the company’s top earners, whether received as severance, or even paid to beneficiaries after an executive’s death, will be limited under Section 162(m). While there have been reports of some companies reacting to the loss of the performance-based compensation exception under Section 162(m) by shifting executive compensation formerly payable as performance-based to base salary, the impact on employers generally remains to be seen. We encourage companies to discuss with U.S. tax counsel how the revisions to Section 162(m) may impact the ability to deduct compensation paid to key officers who are covered employees. In particular, a transition rule under the new Section 162(m) rules exempts remuneration paid pursuant to written binding contracts in effect as of November 2, 2017, from the new rules, so long as such contracts have not been materially modified or extended. The transition rule may impact whether and to what extent a company decides to modify arrangements such as employment agreements, deferred compensation plans, and bonus plans. Understanding how the transition rules impacts a company’s existing arrangements will allow for planning opportunities to maximize compensation deductions and the tracking of disallowed compensation deductions going forward.

Tax reform efforts by Congress are ongoing, and the substance of the tax bills remains fluid. However, for foreign corporations with U.S. operations, there are some specific potential risks to consider, such as additional limitations on the deductibility of interest, the migration from a “worldwide” system of taxation to a territorial system, and the use of certain border adjustments. Canadian corporations with U.S. operations may want to consider including a risk factor in their periodic reports or offering documents regarding the potential impact of U.S. tax reform. A sample risk factor (based on the current iteration of the tax bills) is below. As the tax bills are amended during the legislative process, the language of the risk factor may need to be edited prior to use. Possible U.S. federal income tax reform could adversely affect us. The new U.S. administration and certain members of the U.S. House of Representatives have stated that one of their top legislative priorities is significant reform of the Internal Revenue Code. Proposals by members of Congress have included, among other things, changes to U.S. federal tax rates, imposing significant additional limitations on the deductibility of interest, allowing for the expensing of capital expenditures, the migration from a “worldwide” system of taxation to a territorial system, and the use of certain border adjustments. There is substantial uncertainty regarding both the timing and the details of any such tax reform. The impact of any potential tax reform on our business and on holders of our common shares is uncertain and could be adverse. [Prospective investors should consult their own tax advisors regarding potential changes in U.S. tax laws.]

A Canadian company (the employer) historically has not issued equity-based awards to employees of its U.S. subsidiaries, but it now is considering doing so. Past posts have addressed potential U.S. income tax pitfalls and the need for careful review of the plan and award agreements prior to the grant of restricted stock units (RSUs) and deferred share units (DSUs) to individuals who are subject to U.S. federal income tax on compensatory income. You can read the DSU blog entry here and the RSU blog entry here. Let’s assume careful review and drafting have addressed potential U.S. tax issues in terms of the written documents. What are common mistakes that can arise in administering the U.S. awards? A common error with respect to RSUs awarded to U.S. employees is to overlook the correct timing of U.S. employment tax obligations (as distinguished from federal income tax withholding obligations). Confusion can arise when, for U.S. tax purposes, the substantial risk of forfeiture lapses earlier than the year in which the RSUs will be settled/paid out. For purposes of this discussion, when we use the term “vesting” it means the lapse of a substantial risk of forfeiture. Below are examples of how confusion can arise. Many RSUs provide for immediate settlement upon satisfaction of service-based vesting conditions. In such a case (and absent any “retirement vesting” provision as discussed below) federal income tax and FICA are due essentially at the same time, i.e. when the RSUs vest and are paid out. Some RSUs by their terms delay the income tax event by deferring the payment until an event or date that will occur later than vesting. However, in contrast to income tax withholding, which occurs when shares or cash in settlement of RSUs are actually or constructively received, the FICA tax event cannot be delayed. FICA tax is due for RSUs upon vesting, even if payment/settlement is delayed. One common oversight is failing to take into consideration the impact that “retirement vesting” in an RSU award will have on FICA tax timing. In the absence of retirement vesting provisions, an RSU that has a service-based vesting period frequently will be settled (shares delivered or cash settlement) immediately upon vesting. In such a case, both federal income and FICA withholding will apply at the time of vesting/settlement. In contrast, if an RSU award provides that it will not be forfeited if the individual retires prior to the scheduled vesting date, the RSU will be vested when the participant becomes eligible to retire (because there will be a lapse of the service-based substantial risk of forfeiture), notwithstanding that settlement of the RSU may not occur until the original settlement date. Even if the RSU will be settled on the earlier of the scheduled vesting date and the date of retirement, this will not solve the problem. This is because the risk of forfeiture lapses when the participant is eligible to retire, whether or not he or she in fact retires at that time. Thus FICA taxes will be due at grant if the individual already has met the criteria for retirement, or at the time during the vesting period that an individual first meets the criteria for retirement. This obligation to withhold and pay employment taxes before the RSUs are settled/paid out may be an unpleasant surprise for the employer and the participant. There are some alternative timing rules for FICA withholding that can provide some (but not complete) relief. We’ll discuss them in a future post. As a reminder, U.S. taxpayers are taxed on worldwide income, regardless of where they reside. U.S. taxpayers are: (i) U.S. citizens regardless of residency; (ii) non-resident aliens (“green card” holders); and (iii) non-citizens, non-green card holders who have a “substantial presence” in the United States under the U.S. income tax laws (but exceptions to this category apply – careful analysis of the facts and applicable tax treaties required).

Canadian companies should carefully structure and document loans and advances to their U.S. subsidiaries. If loans to U.S. subsidiaries are not properly structured and documented, such loans may be recharacterized as equity investments for U.S. federal income tax purposes, and important U.S. tax benefits will be lost. Properly structured loans are treated as debt for U.S. federal income tax purposes with favorable tax treatment. The U.S. subsidiary may deduct interest paid in computing taxable income. Such interest payments to its Canadian parent corporation are generally not subject to U.S. withholding tax under the Canada – U.S. income tax treaty. Repayment of the principal amount is generally not subject to U.S. tax for both the U.S. subsidiary and Canadian parent corporation. Loans which are recharacterized as an equity investment do not qualify for favorable tax treatment. The U.S. subsidiary cannot deduct interest paid in computing taxable income. Interest and principal payments will be treated as dividends to the extent of current or accumulated earnings and profits of the U.S. subsidiary. Dividends are subject to U.S. withholding tax of 5% or 15% under the Canada – U.S. income tax treaty. Loans should be properly documented with promissory notes and, in some cases, loan agreements. This documentation should include, at a minimum: an unconditional obligation to pay a sum certain by the U.S. subsidiary, a stated interest rate, the applicable currency (Canadian or U.S. dollars), payment terms (demand or one or more fixed dates), a maturity date, and creditors’ rights provisions. Evidence showing that the U.S. subsidiary has a reasonable expectation of repaying the loan is very important. At a minimum, internal projections should be prepared showing the U.S. subsidiary has the capacity to repay the loan. For larger loans, consideration should be given to obtaining a debt capacity report from a financial advisory or accounting firm. Beginning in 2018, new regulations under Code Section 385 will require that certain loans meet detailed documentation rules to avoid automatic recharacterization as equity. U.S. and Canadian transfer pricing rules will require certain documentation supporting the interest rate charged on the loan. A discussion of the transfer pricing rules is beyond the scope of this summary.

Canadian companies and their outside counsel occasionally ask about the ability to grant early exercise incentive stock options (“ISOs”) to limit the impact of the U.S. alternative minimum tax (“AMT”) to their U.S. employees. However, due to fairly counterintuitive U.S. federal tax regulations, structuring options in this manner may expose optionees to negative tax consequences in the event of a disqualifying disposition (defined below). This post reviews the tax effects of early exercise ISOs and compares the tax results to alternative structures. Early Exercise ISO Tax Consequences With any early exercise option, the optionee is permitted to initially exercise their entire stock option by paying the full option exercise price, but will receive back restricted stock with the same vesting schedule as the original option. Employees will usually file a Section 83(b) election as permitted within 30 days following the transfer of the restricted stock. In 2004, final ISO regulations clarified that Section 83(b) elections filed on restricted shares acquired via early exercise ISOs are only effective for AMT purposes and not for ordinary compensation tax purposes. In the best case where both ISO holding periods are met (the shares acquired via ISO are held at least two years from the date of grant and at least one year from the date of exercise, prior to sale), the entire spread between the sale price and the exercise price paid will be taxed as long-term capital gain. However, if either holding period is not met, a “disqualifying disposition” occurs. Assuming that an 83(b) election was timely filed within 30 days following exercise, then upon a disqualifying disposition, the difference between the fair market value of the shares on the date the underlying restricted stock vests less the exercise price paid for the shares is compensation income that will be reported on the employee’s Form W-2 in the year of sale (or if less, the amount realized in the sale less the exercise price).[1] In addition, the capital gains holding period will only begin on the date the underlying restricted stock vests.[2] To the extent the stock price increased or decreased from the date of restricted stock vesting, such change will be short-term or long-term capital gain or loss, as applicable. This tax result means that early exercise ISOs become risky to an optionee in the event of a disqualifying disposition. While reducing AMT income is a positive result, a disqualifying disposition results in a potentially large amount of compensation income and/or short-term capital gain. The optionee often has little control over whether a disqualifying disposition will occur, such as if all shares are sold in connection with an acquisition of the issuer or if the optionee’s shares are repurchased following termination from employment. Early Exercise NSO Tax Consequences As compared to an ISO, the exercise of a non-qualified stock option (“NSO”) is not a preference item for AMT purposes. If an optionee early exercises a NSO, an 83(b) election will be respected for compensation purposes and the optionee will only recognize compensation income equal to the fair market value of the shares on the date of exercise less the option’s exercise price. This income will be subject to applicable withholding for federal and state payroll taxes, including FICA. However, if the option is early exercised shortly following the option grant date, as is often the case, there is typically minimal (or zero) spread to recognize as compensation up front. The 83(b) election also starts the capital gains holding period. Thereafter, the vesting of the underlying restricted stock received upon the early exercise will not result in any further compensation income to the optionee. Upon disposition of the stock, capital gain or loss will be recognized in the year of sale, which will be long-term if the stock is held at least one year from the date of early exercise. Therefore, in contrast to early exercise ISOs, early exercise NSOs can reduce the exposure to gain being characterized as short-term capital gain to the one year after the early exercise, provided the 83(b) election is timely filed. In addition, by exercising and filing an 83(b) election shortly following grant, recognition of compensation income may be limited or eliminated. Early exercise ISOs have an overhang for up to two years following the date of grant where a disqualifying disposition could result in both compensation income and short-term capital gain recognition. For these reasons, as illustrated in the examples below, we find early exercise NSOs to be preferable to early exercise ISOs in most cases. This is especially true with respect to companies where (i) there is a possibility of acquisition within two years following the date of grant, (ii) the optionees have sufficient capital to early exercise the awards, and (iii) the optionees see a meaningful upside for the company at the time of early exercise (or the amount needed to early exercise is relatively small). Example 1 A startup company grants early exercise ISOs for 1000 shares to an employee at $0.05 per share on June 1, 2017, subject to a vesting schedule where 50% vests on June 1, 2018, and the remaining 50% vests on June 1, 2019.  Participant early exercises on June 5, 2017 while shares are still worth $0.05 per share and files an 83(b) election recognizing $0 in income, which is effective only for AMT purposes. Upon exercise, the participant receives restricted shares with the same two-year vesting schedule. When 50% of the shares vest on June 1, 2018, the fair market value has risen to $5 per share. On March 1, 2019, the company is sold via a stock purchase agreement for $10 per share. All unvested equity awards are accelerated and the shares held by the participant are sold in the deal, resulting in a disqualifying disposition, as both ISO holding periods were not met. Participant recognizes compensation income equal to the spread between FMV on the date the restricted stock vested less the exercise price paid: For the 500 shares that vested on June 1, 2018, 500 x $(5.00 - .05) = $2,475. For the 500 shares that vested in connection with the March 1, 2019, transaction, 500 x $(10.00 - .05) = $4,975. Total compensation income recognized due to disqualifying disposition is $2,475 + $4,975, or $7,450. The capital gains holding period begins on the date of restricted stock vesting. Because both tranches of restricted stock vested less than a year prior to the March 1, 2019, transaction, the $10,000 received in the stock sale less (i) $7,450 previously recognized as compensation income and (ii) $50 in total exercise price paid, or $2,500, is short-term capital gain. Example 2 Assume the same facts as Example 1, but with an early exercise NSO instead: The 83(b) election on June 5, 2017, results in $0 in compensation recognition and also begins the capital gains holding period. No compensation income is recognized with the vesting of the underlying restricted shares, as there is no disqualifying disposition concept applicable, and the 83(b) election was effective for compensation tax purposes. Upon the sale of the company on March 1, 2019, the entire $10,000 received minus the $50 amount paid in exercise price, or $9,950, will be recognized as long-term capital gain. Example 3 Assume the same facts as Example 1, but with a regular ISO grant (without the early exercise feature) that is exercised immediately prior to the March 1, 2019, transaction: No compensation income recognized at the time of exercise under the ISO rules. The March 1, 2019, sale of the shares will be a disqualifying distribution, characterizing the full $10,000 received minus the $50 amount paid in exercise price, or $9,950, as compensation income.   [1] U.S. Treas. Reg. Sec. 1.422-1(b), Ex. 2. [2] Id.

Occasionally, we will see Canadians or Canadian companies assume that they can authorize as many shares for issuance as they want when forming a Delaware corporation, or that they can authorize shares without par value. That’s technically true, but Delaware will make you pay dearly for it, up to $180,000 per company per year. A Delaware corporation must pay the state an annual franchise tax. This tax is initially based on the number of authorized shares. Provided the authorized shares have a stated par value, the tax assessment can be re-calculated on an assumed par value basis using a formula that involves the number of shares authorized for issuance by the certificate of incorporation, the number of shares actually issued and outstanding, the par value of the shares, and the issuer’s total assets. For a properly formed Delaware subsidiary, the annual tax is usually $175. The tax is often more for an operating parent company, but by setting the authorized capital and par value appropriately, the tax can be managed. Unfortunately, we have seen situations where Delaware companies have been formed or acquired without adequate advice, resulting in a $180,000 annual tax. Among other situations, this can occur when no par value shares are authorized, or when the number of shares authorized is a large number compared to a small number of shares actually outstanding, and the franchise tax obligation may fluctuate annually based on the company’s total assets.

If a non-U.S. corporation (the “Company”) is a “passive foreign investment company” or “PFIC” for any tax year during which a U.S. shareholder owns shares in the Company, certain adverse U.S. federal income tax consequences of the acquisition, ownership, and disposition of shares will generally apply to such U.S. shareholder. A U.S. shareholder will be subject to the rules of Section 1291 of the Internal Revenue Code (described below) with respect to (a) any gain recognized on the sale or other taxable disposition of shares and (b) any “excess distribution” received on the shares. A distribution generally will be an “excess distribution” to the extent that such distribution (together with all other distributions received in the current tax year) exceeds 125% of the average distributions received during the three preceding tax years (or during a U.S. shareholder’s holding period for the shares, if shorter). Under Section 1291 of the Code, any gain recognized on the sale or other taxable disposition of shares, and any “excess distribution” received on shares, must be ratably allocated to each day in a U.S. shareholder’s holding period for the respective shares. The amount of any such gain or excess distribution allocated to the tax year of disposition or distribution of the excess distribution and to years before the entity became a PFIC, if any, would be taxed as ordinary income (and not eligible for certain preferred rates applicable to capital gains). The amounts allocated to any other tax year would be subject to U.S. federal income tax at the highest tax rate applicable to ordinary income in each such year, and an interest charge would be imposed on the tax liability for each such year, calculated as if such tax liability had been due in each such year. A U.S. shareholder that is not a corporation must treat any such interest paid as “personal interest,” which is not deductible. For a U.S. shareholder who is an individual that invests in stock of a corporation and holds such stock for more than 12 months, any gain on the sale of such stock is generally subject to a 20% tax rate applicable to long-term capital gains. However, if the stock held is stock in a PFIC, any gain on the sale or other disposition of such PFIC stock is generally taxed at the highest ordinary income tax rate of 39.6%, plus the applicable interest charge, which is not deductible. In addition, in most cases, a Medicare tax of 3.8% on investment income will apply to certain individuals, estates and trusts. Certain elections may be available to U.S. shareholders in certain situations to mitigate such adverse tax consequences.