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Tax treaty could help prevent a nasty bite

I once heard that the definition of a tax pro is someone who tells you about problems you didn't know you had, then fixes them in a way you don't understand. This has never been truer than in the area of U.S. estate taxes. Most Canadians aren't aware that they could be subject to U.S. estate tax.

There are three groups of people who are potentially liable for U.S. estate tax: U.S. citizens (no matter where in the world you live), U.S. permanent residents (those who live in the United States), and anyone who owns U.S. "situs" property (assets located in the United States).

Today, I want to help Canadian citizens who are resident in Canada -- known as non-resident aliens (NRAs) -- but who own U.S. situs property.

The Property

First, you could be liable for U.S. estate tax on the following types of assets: U.S. real estate, tangible personal property located in the United States (including artwork, jewellery, furnishings, vehicles, and boats), stocks in a U.S. company, debt obligations (bonds, debentures, notes, accounts receivable, written or oral promises), interests in U.S. mutual funds (but not U.S. equity funds offered by Canadian fund companies), business assets, and certain intangibles such as patents and trademarks.

Assets held in your registered plans may also be caught if they are otherwise considered to be U.S. situs assets.

You'll be glad to know that some assets escape the U.S. estate tax net for NRAs, specifically: Life insurance proceeds, U.S. bank deposits, some less common debt obligations, and works of art on loan for exhibition in the United States.

The Treaty

Your first line of defence is to rely on the Canada-U.S. tax treaty, which provides relief in five ways: Prorated exemption: There is an estate tax exemption that shelters the first $1.5-million (U.S.) (in 2005) of a U.S. citizen's or resident's estate.

NRAs are not entitled to the full exemption, but you can claim a prorated exemption: $1.5-million (in 2005) multiplied by the value of your U.S. situs property divided by the value of your worldwide property (all your assets).

Marital credit: If you leave your U.S. assets to your spouse upon death, you'll be entitled to a marital credit which is equal in amount to the prorated exemption. So, your credits are doubled up in this case.

Foreign tax credit: If you have to pay U.S. estate tax on a particular asset, you can claim a foreign tax credit on your Canadian tax return, but only to offset the capital gains taxes in Canada on that same specific asset.

If there are no Canadian capital gains taxes on that asset at the time of your death, you won't benefit from a foreign tax credit.

Small estates relief: If your worldwide estate is worth less than $1.2-million, you won't face U.S. estate tax on any assets, with the exception of U.S. real estate, and certain business assets located in the United States.

Donated amounts: If you donate U.S. situs property to charity, you'll avoid U.S. estate tax on that particular asset.

For most, the treaty will be sufficient to solve a U.S. estate tax problem. If not, other planning will have to be done.

Tim Cestnick, FCA, CPA, CFP, TEP, is a tax specialist and author of Winning the Tax Game 2005 and The Tax Freedom Zone.

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