Part 7: Responding to the Sec. 965 “transition tax”: Why the transition tax creates a fictional tax event that allows the U.S. to collect tax where it never could have before


cross posted from citizenshipsolutions

    by John Richardson


This is the seventh in my series of posts about the Sec. 965 Transition Tax and whether/how it applies to the small business corporations owned by taxpaying residents of other countries (who may also have U.S. citizenship). These small business corporations are in no way “foreign”. They are certainly “local” to the resident of another country who just happens to have the misfortune of being a U.S. citizen.

The first six posts in my “transition tax” series were:

Part 1: Responding to The Section 965 “transition tax”: “Resistance is futile” but “Compliance is impossible”

Part 2: Responding to The Section 965 “transition tax”: Is “resistance futile”? The possible use of the Canada U.S. tax treaty to defeat the “transition tax”

Part 3: Responding to the Sec. 965 “transition tax”: They hate you for (and want) your pensions!

Part 4: Responding to the Sec. 965 “transition tax”: Comparing the treatment of “Homeland Americans” to the treatment of “nonresidents”

Part 5: Responding to the Sec. 965 “transition tax”: Shades of #OVDP! April 15/18 is your last, best chance to comply!

Part 6: Responding to the Sec. 965 “transition tax”: A “reprieve” until June 15, 2018

This post will draw on the lessons/discussion from the first six posts. Yesterday Karen Alpert and I participated in an interview about the “transition tax” which was organized by “TaxLinked“. We discussed the impact of the “transition” tax from both the “microeconomic” (how it impacts individuals) and “macroeconomic” (how it impacts countries) perspective.

Microeconomic Perspective:

In Part 4 of this series of posts I specifically compared the impact of the Sec. 965 “transition tax” on “Homeland Americans” to the impact on “Residents of other countries“. I explained how the Section 965 “transition tax” was a good (or at least not bad) thing for Homeland Americans, but was a disaster for the residents of other countries. This was a “microeconomic” discussion of the effects of the “transition tax”. Another good “microeconomic” discussion of the Sec. 965 “transition tax” is on Virginia La Torre Jeker’s blog here.

Macroeconomic Perspective:

The purpose of this post is to discuss the effects of the Sec. 965 “transition tax” on other countries, from a macroeconomic perspective. In other words:

“In what respect or respects does the “transition tax” directly impact the economies of Canada and other countries?

The answer is as follows:

The Section 965 “transition tax” creates a “fictitious tax event” that allows the United States to enter another country and impose taxation on a pool of capital:

1. That the other country has primary taxing jurisdiction over; and

2. Before the other country exercises that “taxing jurisdiction”.

Here is the sequence of events that explains how this happens:

1. An individual living in Canada creates a Canadian Controlled Private Corporation.

2. That private corporation earns profits. Some of the profits are paid out as dividends or salaries to the shareholder. In many cases that Canadian Controlled Private Corporation operates as a “private pension plan”. What is not paid out remains in the company as “undistributed earnings”.

3. Canada will NOT impose taxation on those “undistributed earnings” until those earnings are actually distributed.

4. The United States (via the Sec. 965 “transition tax”) “deems” those undistributed earnings to be taxable (to the individual shareholder), as though they have actually been distributed. To put it simply: The United States imposes U.S. taxation on those “undistributed earnings” before they have actually been distributed.

5. Because the United States is imposing taxation on the “undistributed earnings” as though they were actually distributed, the United States essentially “beats Canada to the tax grab” (“front-running”) and receives tax revenue from the “undistributed earnings”.

6. By receiving tax revenue from the “undistributed earnings”, the United States is siphoning money out of the Canadian economy. (This is the “macroeconomic” effect of the “transition tax” and other forms of U.S. taxation imposed on Canadian residents).

7. As I have previously argued, Section 5 of Article 10 of the Canada U.S. Tax Treaty prevents the United States from imposing taxation on the undistributed earnings of Canadian corporations (for good reason).

8. By “beating Canada to the tax grab”, the United States will generate revenue from individuals in Canada that it would never have generated. Why? Because if the taxation had occurred ONLY upon an actual distribution to the shareholder, both Canada and the United States would have imposed taxation on those distributions at the same time. Both Canada and the United States would have imposed taxation on those distributions at the same time. The use of “foreign tax credit rules” (found in Internal Revenue Sec. 901), would result in the U.S. tax owed being largely offset by the Canadian tax paid, leaving little or no tax revenue for the United States to actually recover.

This is what Karen describes in the “interview excerpt” in the following tweet. I encourage you to listen to this:

To put it simply: Because of the U.S. policy of imposing worldwide taxation on the residents of other countries, many aspects of U.S. taxation result in the “confiscation” of assets located in other countries. The “transition tax” – by creating a “fictitious tax event” – is a timely and exceptionally brazen example of how this confiscation works.

“Fictitious tax events” and beating the country of primary taxing jurisdiction to the “grab”

The Sec. 965 “transition tax” is a tax that is (1) imposed retroactively and (2) without any actual “realization event”. In general, it is unusual to impose taxation without a specific realization event. Because, the Sec. 965 transition tax is in effect a “confiscation” that is not based on a “realization event”, I have compared the Sec. 965 “transition tax” to the “Offshore Voluntary Disclosure Program” (“OVDP). One might also (because there is no actual sale or purchase of assets) compare the Sec. 965 “transition tax” to the S. 877A Exit Tax. Both the Sec. 877A Exit Tax and the Sec. 965 “transition tax” are taxes imposed without any “realization event”. Notice also that the “Exit Tax” and the “transition” tax BOTH create “fictitious tax events”, which allow the U.S. to impose taxation, before the other country can impose taxation (because the other country imposes tax based on an actual event and NOT on a “fictitious event”).

By way of comparison:

The Sec. 877A Exit Tax would allow the U.S. to impose taxation on Canadian pensions before Canada would impose taxation on the pension.

The Sec. 965 “transition tax” would allow the U.S. to impose taxation on the “undistributed earnings” of Canadian corporations, before Canada would impose taxation on those earnings.

Note that both are examples of how the United States, by “imposing worldwide taxation on those who have tax residency in other countries”, has created an opportunity to (1) create “fictitious income” and (2) impose taxation on that “fictitious income”. As the Sec. 965 “transition tax” demonstrates, this results in the confiscation of assets located in those countries.

Do these preemptive U.S. tax strikes against the tax/capital base of other countries violate tax treaties? Do they violate international law?

This is a topic that requires further research and investigation. For the moment I will leave you with an article written by Oz Halabi in 2012 titled:

“Expatriation Tax – Renouncing A Tax Treaty”

In 2012 the “transition tax” had not yet been invented. But, the Sec. 877A Exit Tax had been invented. Of interest at page 10 Mr. Halabi writes:

Although international law does not prohibit countries from imposing exit taxes on their residents, there could be situations where the levy of a tax on capital gains by a legislative fiction in one country infringes on a bilateral tax treaty.

In this respect, the Netherlands Supreme Court has ruled that the tax on a fictitious alienation in specific circumstances can be incompatible with treaty law. If a taxable event was allocated for tax purposes to one state, the other state cannot by a later legal fiction attribute taxing rights to itself regarding a purchase or alienation that did not occur.

Netherlands Supreme Court, 5 September 2003, No. 37,651

Hmmm …

Part 5 of Article X of the Canada U.S. tax treaty, specifically prohibits the United States from imposing taxation on the undistributed earnings of Canadian corporations. This means that the taxing rights to the “undistributed earnings” of Canadian Corporations are allocated to Canada under the treaty. The United States should NOT be allowed, through a later legal fiction (the Sec. 965 “transition tax”) to attribute taxing rights to itself to a distribution of earnings which did NOT occur.

This is just plain common sense.

You will find Mr. Halibi’s complete article and thought provoking article here:


Definitely food for thought …

John Richardson