Most Canadian tax residents are familiar with the US estate tax rules and draw comfort from the provisions of the Canada–United States tax treaty (the “US Treaty”). The US Treaty effectively protects individuals against US estate tax on US assets if their total worldwide assets are less than the general US estate tax exemption (which is currently $US 11.18m). They are generally free to acquire US real estate (such as a condo in Florida or Arizona) or US securities (stocks, bonds, mutual funds, ETFs) without the worry of being exposed to a US estate tax liability.
Even if their total worldwide assets exceed the general US exemption, the US Treaty also allows for tax credits that reduce the risk of double taxation. In this way, the US Treaty allows a Canadian resident to claim a credit, against his or her Canadian income taxes on death, for the US estate taxes imposed on US assets. Similarly, it allows a US citizen residing in Canada a credit, against his or her US estate taxes on death, for the Canadian income taxes imposed on assets situated outside the US.
These credits in the US Treaty exist even though Canada and the US have totally different systems of taxes on death. While the US has an estate tax on the fair market value of assets on the date of death, in Canada, the deceased is deemed to have disposed of his or her assets at their fair market value on the date of death, potentially triggering an income tax on the accrued capital gains. While the US has an estate tax, Canada has a (capital gains) income tax.
This disparity in the regimes of the two countries can pose a significant incidence of double taxation when an individual is subject to both Canadian income tax and UK inheritance tax (“IHT”).
As with the US, the UK imposes an inheritance tax regime on both individuals who are domiciled in the UK and those who are not domiciled. [1] If one is domiciled, the IHT is imposed on worldwide assets, subject to an exemption (currently at 325,000 pounds). If one is not domiciled, the IHT is only imposed on UK situs assets, such as UK real estate,[2] shares, certain UK pensions, or cash, subject to the same exemption. The UK IHT rate is generally 40%.
While it is rare for an individual to be both a Canadian tax resident and a UK domicile, it is more common for a Canadian tax resident to be a non-domicile of the UK but to own UK real estate. For example, a Canadian resident may have been assigned to work in the UK when he or she was 30 years old, at which time he/she bought a UK flat for 300,000 pounds. He/she may then have returned to Canada five year later, when the flat was worth 500,000 pounds (approximately $C 800,000 – this becomes the individual’s cost base for Canadian capital gains purposes). If the flat is kept for 30 more years, and the individual dies, as a Canadian resident, and the flat is now worth 3m pounds (approximately $C 5m), on the date of death the individual realizes a capital gains in Canada of $4.2m, which triggers a capital gains tax of $C 1.12m. The individual, who is now a non-domicile of the UK, will also be subject to a UK IHT of 1.07m pounds (40% of 3m less 325k).
Unfortunately, Canada will not allow a credit for the UK IHT on the property: (1) under the Income Tax Act (Canada), Canada only allows foreign tax credits for income taxes paid to a foreign country; here, the IHT would not be considered a tax on income or profits; (2) similarly, under the Canada-UK tax treaty (the “UK Treaty”), Canada is only required to give credits for UK income taxes, and, unlike the US Treaty, there are no provisions dealing with credits for UK estate or inheritance taxes.
As a result, the individual is subject to double taxation: in Canada on any gains accrued since becoming a Canadian resident, and in the UK on the value of the property.
Curiously, this double taxation incidence would not have arisen had the individual sold the UK property before death, as Canada would then allow a credit for any UK capital gains taxes on the sale. In addition, the deceased could have also avoided paying UK IHT if he/she gifted the asset away, provided he/she did not die within the 7 years following the gift (note: if he/she were a Canadian resident at the time of the gift, the gift could have triggered Canadian capital gains tax).
For Canadian residents it is very important to consider the impact of UK IHT when considering whether to purchase, or keep, UK real estate. Navigating the implications of UK IHT can be complex and a comprehensive strategy is needed to assess any future tax risks. Consider consulting with a tax professional to ensure you receive personalized advice on your UK real estate situation and avoid the potential of double taxation.
[1] As with the US concept of domicile, there is not an objective test as to when an individual is a domicile of the UK. It depends on facts and circumstances. Generally, domicile looks at the long-term intentions of the individual (ex., where does the individual intend to spend his or her retirement years. On one hand, you can become a UK domicile on the first day of presence in the UK, if the intention is to stay in the UK indefinitely; on the other hand, you can very well be living in the US for 14 years without having yet become domiciled in the UK, if you intend, for example, to eventually return to your country of origin.
At the same time, the UK does have certain deeming rules that can deem you to become domiciled in the UK for IHT purposes: (1) where you resided in the UK for 15 of the last 20 years; (2) where you had a permanent home in the UK at any time in the prior 3 years; (3) where your domicile of origin was in the UK (example - at birth, your parents’ domicile was in the UK) and you return to the UK; or (4) where you were gifted assets while domiciled in the UK (or gifted UK assets while non-domiciled) and died within the 7 years following the gift – in such a case the IHT would apply to such gifted assets.
[2] Prior to April 6, 2017, there was an ability for non-domiciles to avoid UK IHT on UK real estate by holding it through offshore entities.