Cross-border Gifts – Application of Article XIII – Gains
Last month, we described a situation where a Canadian resident, nonresident alien of the US used the Canada – US Income Tax Convention (“Treaty”) to reduce their overall tax liability on employment income earned in the U.S. The second part of our Treaty example concerns the use of Article XIII to treat gains similar for U.S. and Canadian tax purposes to reduce the overall tax on the gain. The facts, amounts and details, while theoretical, represent clients’ situations we have recently assisted with.
A Canadian resident, non-U.S. resident non-U.S. citizen (“NRNC”) purchased shares in a public company for a cost of $10,000. She gave her daughter, a Canadian resident and U.S. citizen the shares as a graduation gift when the shares were worth $50,000. Under Canadian tax law, a transfer of property to a non-arms length party for consideration less than fair market value results in a disposition by the transferor at fair market value and an acquisition by the recipient for the same amount. As a result, the mother was subject to Canadian capital gains tax on a gain of $40,000 ($50,000 fair market value minus $10,000 cost basis) and the daughter received property with a cost basis for Canadian tax purposes of $50,000. If the daughter were to immediately dispose of the stock, she would not have a taxable gain for Canadian tax purposes.
However, under US tax law, when a gift is made, the recipient’s basis in the gift is the original basis of the property in the hands of the NRNC. In this case, the daughter’s basis for U.S. tax purposes would be $10,000 (her mother’s basis in the shares). When the daughter sells the shares, she realized a gain for U.S. tax purposes using a basis of only $10,000. As a result, tax is potentially paid twice on the appreciation of the shares, once in Canada when the mother gives the shares to her daughter and a second time when her daughter sells the shares. No foreign tax credit can be used since different taxpayers paid tax here.
The easy solution is for the mother to sell the shares before any gift is made and give the cash to her daughter. Often clients take actions without considering the tax consequences and their advisors are left to advise on the tax treatment after the transaction has occurred.
Article XIII, paragraph 7 of the Treaty allows a taxpayer to elect to have a disposition occur in one country where it occurred under domestic law in the other country. The common use of this paragraph is to assist Canadian residents moving to the US who are subject to the Canadian deemed disposition rules. The Technical Notes to the Treaty confirm that this paragraph can be used in other situations such as a transfer of property for less than fair market value.
In our client’s situation, the daughter elected on her U.S. tax return to have a disposition of the shares occur for U.S. tax purposes as it did for Canadian tax purposes. As a result, she obtains a cost basis in the shares of $50,000 from the disposition of the shares at the time of the gift. This will prevent taxation twice on the same gain.