As part of the United States’ budget proposals for fiscal year 2022, President Joe Biden last week formally introduced his tax plan that would raise taxes on wealthy Americans and large corporations. On the same day, the U.S. Treasury released its Green Book, a 114-page detailed explanation of the tax proposals contained within the budget.
On the personal tax side, there are a couple of changes of note: an increase to the top U.S. federal marginal tax rate and the elimination of the preferential tax rate on capital gains for the wealthiest income earners.
18 best online deals in the Canadian retail space right now
Let’s take a brief look at the two proposals, how they compare to Canada’s rules and what impact, if any, they might have on American citizens living in Canada, who, because of the U.S.’s unique citizenship-based taxation system, are required to file annual U.S. tax returns to report their worldwide income.
Increasing the top rate for high earners
Under current U.S. rules, the top marginal tax rate is 37 per cent and this rate for 2021 applies to taxable income of more than US$628,300 for married individuals filing a joint return and US$523,600 for unmarried individuals.
Biden’s proposal would increase the top marginal individual income tax rate to 39.6 per cent and lower the thresholds at which they would apply in 2022 to taxable income over US$509,300 for married individuals filing a joint return, and US$452,700 for unmarried individuals. The actual rate may, however, be higher for those in the top income bracket who earn investment income, because the Biden tax reform plan will preserve the net investment income tax (NIIT, but often called the Obamacare tax) of 3.8 per cent, which applies on top of ordinary income tax for Americans earning income of more than US$200,000. This could mean a potential top U.S. tax rate on ordinary income of 43.4 per cent, instead of 39.6 per cent.
And that’s just the federal tax. The top combined federal/state rate this year for Americans residing in the U.S. can be as low as 37 per cent (for the eight states — Florida, Nevada and Texas among them — without state personal income tax) to as high as 50.3 per cent for Californians with income topping US$1 million — and that’s ignoring the additional 3.8-per-cent NIIT on any investment income.
For 2022, if the proposed rate of 39.6 per cent is added to the top California state tax rate, the combined rate would be 52.9 per cent, which approaches the top 2021 marginal tax rates in provinces such as Ontario, Quebec, British Columbia, New Brunswick and Nova Scotia, where the top rate exceeds 53 per cent. (Newfoundland and Labrador is set to become the highest-taxed province in 2022, since its budget released earlier this week includes a provincial tax hike of 2.5 percentage points for income over $1 million, bringing its top rate to 54.8 per cent for next year.)
Of course, Canada’s top tax rates kick in at much lower threshold — around $220,000 (depending on the province) or the equivalent of US$183,000 using today’s exchange rates — a far cry from the US$523,600 threshold it takes for a single individual to hit the top federal bracket in the U.S. in 2021.
Shlomi Steve Levy, co-founder of Levy Salis LLP and whose legal practice is dedicated to U.S. and Canadian tax and estate planning, isn’t overly concerned about this particular measure as it relates to U.S. expats. “This tax increase does not appear to be dramatic for high-net-worth Americans living in Canada as they are generally subject to a Canadian income tax rate that exceeds their U.S. tax rate, and, in many cases, they can apply their Canadian tax liability as a foreign tax credit against their US tax liability,” he said.
Of more concern to some Americans living in Canada is the proposed hike in the U.S. capital gains tax, which appears to be retroactive, and could have a particularly harsh impact on business owners selling their business.
Capital gains tax
Unlike the Canadian tax system, the U.S. distinguishes between short-term and long-term capital gains. Short-term gains (for assets held for less than one year) are taxed at ordinary income rates, while most realized long-term capital gains, as well as qualified dividends, are taxed at graduated rates, with 20 per cent generally being the highest rate (23.8 per cent after including the NIIT).
According to the Treasury, preferential tax rates on long-term capital gains and qualified dividends “disproportionately benefit high-income taxpayers and provide many high-income taxpayers with a lower tax rate than many low- and middle-income taxpayers.”
To this end, the Biden proposal would tax long-term capital gains and qualified dividends of taxpayers with income of more than US$1 million at ordinary income tax rates. For 2021, this means a top rate of 37 per cent (or 40.8 per cent once the NIIT is added.) For 2022, it would jump to 39.6 per cent (43.4 per cent with the NIIT).
“If this measure were to be adopted, the top U.S. capital gains tax rate would considerably exceed the top Canadian tax rate on capital gains (close to 27%),” Levy said.
From a practical perspective, a high-income U.S. tax filer or a U.S person who sells a business and realizes a substantial capital gain in one tax year, could face a significant incremental tax cost as a result of the Biden plan.
“If a dual U.S.-Canadian citizen sold a highly successful business and realized (significant) capital gains on the sale, the U.S. tax liability on those gains … could easily dwarf the Canadian tax liability,” Levy said.
Most of Biden’s budget proposals are set to take effect on Jan. 1, 2022, but the capital gains tax increase is proposed to be retroactive and will apply to “gains … recognized after the date of announcement.” This may mean either the April 28, 2021, announcement date of the American Families Plan, or May 28, 2021, which was the date of the budget release.
For U.S. taxpayers thinking of selling now to beat the tax, it may already be too late. That said, some commentators have suggested that the effective date may yet be extended to the date of legislative enactment, expected to be this fall.
Finally, the budget also proposes to tax transfers of appreciated property by gift or upon death as realization events for U.S. tax purposes, eliminating the so-called “stepped up basis” rule that currently applies to such transfers. Canada’s system already taxes accrued gains when property is transferred, gifted or someone dies (unless the property is transferred or left to a surviving spouse or partner). I will discuss these changes in a future column.