20 January 1997 CTF Roundtable Q. 1, 9604996 - : Article XXIX B of Canada-U.S. Treaty

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues:

How to apply Article XXIX B of the Third Protocol of Canada - U.S. Income Tax Convention

Position:

General discussion of the Article and the steps to follow in processing the tax credit

Reasons:

N/A

Article XXIX B of the Canada-United States Income Tax Convention

Introduction

The purpose of this paper is to set out our understanding of Article XXIX B of the Canada-U.S. Income Tax Convention (the "Convention"), to suggest certain standard procedures to compute Canadian tax credit under paragraph 6 of that Article, and to provide guidelines for the Department to process requests for refund under that paragraph. Article XXIX B of the Convention was added by the Third Protocol to the Convention which entered into force on November 9, 1995.

The paper will

(a) set out the deadlines for claiming tax credits provided under paragraph 6 of Article XXIX B of the Convention

(b) provide a brief outline of Article XXIX B

(c) discuss the rules under paragraph 6 of that Article

(d) outline the steps to determine tax credits for U.S. estate taxes

(e) provide two examples to illustrate such steps, and

(f) discuss briefly whether to pay interest on the refund of a tax overpayment.

In the appendices, the following is provided: an overview of U.S. estate tax (Appendix A), a discussion of paragraphs 1, 2, 3 and 4 of Article XXIX B (Appendix B), some examples of U.S. situs property and property not considered to be situated in the U.S. (Appendix C), and a list of information required to process the tax credit (Appendix D).

Deadlines for Claiming Tax Credits under Paragraph 6 of Article XXIX B

The credit provided under paragraph 6 of Article XXIX B of the Convention is available with respect to deaths occurring after November 9, 1995. However, the credit is also available with respect to deaths occurring after November 10, 1988 but before November 10, 1995 if a claim for refund due as a result of the provisions of that Article is filed by the later of one year from November 9, 1995 or the date on which the applicable period for filing such a claim expires under the Income Tax Act (the "Act").

With respect to deaths occurring after November 9, 1995, the credit can be claimed when filing the last return of the decedent or within the normal reassessment period for such a return.

With respect to deaths occurring after November 10, 1988 but before November 10, 1995:

- where on November 9, 1995 the last return has not been filed, the claim could be made on filing or within the normal reassessment period for that return;

- where on November 9, 1995 the last return has been filed but not yet assessed, the claim could be made prior to the file being assessed or within the normal reassessment period of that return;

- where on November 9, 1995 the last return has been filed and assessed, the claim must be made on or before the later of November 9, 1996 and the date on which the normal reassessment period expires;

- where the last return was initially assessed on or before November 9, 1993, the claim for the refund must be filed on or before November 9, 1996; and

- where the last return was initially assessed after November 9, 1993, the claim must be filed within the normal reassessment period for that return.

Article XXIX B of the Convention in General

Article XXIX B of the Convention added by the Third Protocol provides certain relief from double taxation resulting from the imposition of Canadian income taxes and U.S. estate taxes by reason of death. In general, as a result of the provisions of that Article, each of Canada and the U.S. will give up certain tax revenue which would otherwise be collected under their respective tax laws.

In the case of decedents who are residents of Canada immediately before death, Canada will grant a credit for U.S. estate taxes paid in respect of U.S. situs property against Canadian taxes on income which is sourced to the U.S. as determined under the Convention and in certain circumstances on gains derived from the deemed disposition on death of U.S. situs property the gain from which would not be sourced to the U.S. by the Convention.

In the case of decedents who are residents of the U.S. immediately before death, Canada will provide rollover treatment for capital property bequeathed to the spouse of the decedent provided that the transfer would have otherwise qualified for the rollover under subsection 70(6) of the Act if the decedent and his spouse were residents of Canada. Where certain conditions are met and the Canadian competent authority agrees, Canada will provide rollover treatment for capital property bequeathed to a trust for the benefit of the spouse provided that the transfer would have otherwise qualified for the rollover under subsection 70(6) of the Act if the trustees of the spousal trust that were residents or citizens of the U.S. or domestic corporations under the law of the U.S. were residents of Canada.

The U.S. will provide a deduction for charitable gifts bequeathed to Canadian organizations out of property included in the gross estate of the decedent who was a resident of Canada but not a U.S. citizen for purposes of computing the taxable estate of the decedent (for further details please refer to Appendix A attached). For such a decedent, it will also allow a larger amount of the unified credit (from $13,000 to a maximum of $192,800) and, if elected by a decedent who qualifies, a marital credit (to a maximum of $192,800). In addition, if the gross estate of a decedent who was a resident of Canada immediately before death but not a U.S. citizen does not exceed U.S.$1.2 million or its equivalent in Canadian dollars, the U.S. will impose estate tax only on property the gain from the disposition of which would be subject to tax in the U.S. under Article XIII (Gains) of the Convention.

The U.S. will also provide to a U.S. citizen (including a U.S. citizen resident in Canada immediately before death) or a U.S resident a foreign death tax credit for Canadian federal and provincial taxes payable in respect of gains from the deemed disposition of non-U.S. situs property at death.

Rules for Claiming Canadian Tax Credit under Article XXIX B

The first thing one should do with respect to claiming a credit in Canada for U.S. estate taxes is to determine whether the U.S. has the right to levy estate tax on certain U.S. situs property held by a decedent who was a resident of Canada but not a U.S. citizen immediately before death.¹

Paragraph 8 of Article XXIX B of the Convention limits the right of the U.S. to levy federal estate taxes in certain circumstances. Pursuant to that paragraph, if at the time of death the value of the gross estate of a decedent who was a Canadian resident immediately before death but not a U.S. citizen does not exceed $1.2 million in U.S. dollars or its equivalent in Canadian dollars, the U.S. may only impose its estate tax on U.S. situs property forming part of the estate if gains from the disposition of such property would have been subject to income taxation by the U.S. in accordance with Article XIII (Gains) of the Convention. In other words, U.S. federal estate tax can only be levied on U.S. real property (as defined in paragraph 3 of Article XIII of the Convention) and personal property forming part of the business property of a permanent establishment in the U.S. Consequently, if the value of the gross estate of a Canadian resident who is not a U.S. citizen does not exceed U.S.$1.2 million and the estate does not hold the above-noted property, there will not be any U.S. federal estate tax.

Paragraph 6 of Article XXIX B of the Convention provides that Canada shall provide a tax credit to an individual who immediately before death is a resident of Canada or to a trust described in subsection 70(6) of the Act for any federal or state estate or inheritance taxes payable in the U.S. in respect of property situated in the U.S. Since the Canadian tax credit is based on the amount of the U.S. estate taxes payable, it is imperative, therefore, to ensure that the U.S. estate taxes were computed correctly² and they are indeed payable. In this regard, all available credits and deductions either described in Article XXIX B of the Convention or in the Internal Revenue Code (the "Code") (unless they are optional such as the marital credit under paragraphs 3 and 4 of Article XXIX B, see Appendix B attached) must be claimed to arrive at the net U.S. estate tax. Examples of available credits are unified credits, marital credits and state death tax credits. Examples of available deductions are gifts to U.S. government or public charities, funeral expenses, administrative expenses, debt claims, mortgages and liens, and Canadian income tax payable before any credit for U.S. estate tax other than the amount of Canadian income tax payable which is creditable for U.S. tax purposes against U.S. estate tax (for a description of the deduction and credits referred to in paragraphs 1, 2, 3 and 4 of Article XXIX B, please see Appendix B attached). If these credits or deductions are not claimed, the amount by which the estate tax so computed exceeds the estate tax otherwise computed had all credits and deductions been claimed would not be creditable for Canadian tax credit purposes. If, because of the increased unified credit and/or the claim for marital credit available under the provisions of Article XXIX B, there is an entitlement of refund of U.S. estate tax with respect to property situated in the U.S. in respect of deaths occurring after November 10, 1988 and before November 9, 1995, the amount of the U.S. estate tax for which Canada is required to provide a credit will be after that refund and Canada will not be in a position to grant the credit until such time as the final amount of the U.S. estate tax is determined.

Where the decedent is a U.S. citizen or a former U.S. citizen referred to in paragraph 2 of Article XXIX (Miscellaneous Rules), the credit that Canada shall provide will not exceed the amount of the U.S. federal and state estate or inheritance taxes that would have been payable had that decedent not been a citizen or former citizen of the U.S. This means that a separate calculation is required to determine the U.S. estate tax on the premise that the decedent was not a U.S. citizen or former U.S. citizen and by taking into account the deductions, credits and exemptions described in paragraphs 1, 2, 3, 4 and 8 of Article XXIX B of the Convention. This calculation can be done on Form 706-NA which is an estate tax return provided by Internal Revenue Services ("IRS") to compute the estate tax liability of a "nonresident not a U.S. citizen". As the U.S. has progressive rates for federal estate tax and as a U.S. citizen is subject to U.S. estate tax on his world-wide estate, even though a non-resident of the U.S. who is not a U.S. citizen may, depending on the situation, not be entitled to a full unified credit, the estate tax computed in the manner described above in respect of U.S. situs property will often be less than the prorata amount of U.S. estate tax that a U.S. citizen would pay in respect of such property. For example, a decedent who is a U.S. citizen immediately before death has world-wide taxable estate of U.S.$2.4 million including taxable estate situated in the U.S. of U.S.$500,000. After the unified tax credit of U.S.$192,800, U.S. estate tax on his world-wide taxable estate would be U.S.$784,000. Hence, the prorata amount of U.S. estate tax in respect of his taxable estate situated in the U.S. would be U.S.$163,333^(F3). If the decedent were not a U.S. citizen or resident, U.S. estate tax on taxable estate of $500,000 situated in the U.S. after an unified credit of U.S.$40,167^(F4) would only be U.S.$115,633, that is U.S.$47,700 less than the prorata amount of U.S.$163,333 described above.

It should be noted that if the decedent who was a U.S. citizen resident in Canada immediately before death were not a U.S. citizen/resident and the value of the entire gross estate does not exceed U.S.$1.2 million or its equivalent in Canadian dollars, pursuant to paragraph 8 of Article XXIX B, no federal estate tax shall be imposed by the U.S. in respect of U.S. situs property the gains from the disposition of which would not be subject to U.S. tax under Article XIII (Gains) of the Convention. In such a case such U.S. situs property for the purpose of computing the credit which Canada must grant for U.S. estate tax is not included in the gross estate of the decedent. The amount of the U.S. estate tax payable for which Canada must grant a credit will be computed as if the U.S. situs property the gains from the disposition of which could be subject to tax in the U.S. in accordance with the Convention was the only U.S. situs property of the decedent for U.S. estate tax purposes.

The credit that Canada shall grant is also limited to the amount by which the Canadian Federal tax otherwise payable on income, profits or gains referred to in paragraphs 6(a)(i) and 6(a)(ii) of Article XXIX B exceeds the foreign tax credit claimed under paragraph 2(a), 4(a) or 5(b) of Article XXIV of the Convention. In this regard, Canadian Federal tax otherwise payable means the amount of Canadian federal tax before any dividend tax credit, foreign tax credit (including foreign tax credit against federal individual surtax), federal political contribution tax credit, investment tax credit and labour-sponsored funds tax credit.⁵ Note that paragraph 6 of Article XXIX B only provides credits against federal income tax in Canada, not provincial taxes.⁶

Income, profits or gains referred to in paragraph 6(a)(i) of Article XXIX B is income, profits or gains arising in the U.S. in accordance with paragraph 3 of Article XXIV of the Convention. This is U.S. source income which under the provisions of the Convention the U.S. would be allowed to tax if the income was earned by a resident of Canada who was not a U.S. citizen. This includes income from real property situated in the U.S., business income earned through a permanent establishment in the U.S., U.S. source interest, dividends or royalties, gains from disposition of real property situated in the U.S., gains on disposition of personal property forming part of the business property of a permanent establishment in the U.S., U.S. source pension income, and remuneration for employment exercised in the U.S. where the remuneration exceeds U.S.$10,000 and the person was present in the year of death in the U.S. for more than 183 days or the remuneration was borne by a resident of the U.S. or by a permanent establishment of the employer in the U.S. Income which may otherwise be considered U.S. source but which the U.S. does not have right to tax under the Convention is not included. Examples of such income are business income not earned through a permanent establishment in the U.S., gains from disposition of property other than gains on property mentioned above, remuneration earned in the U.S. where it is under U.S.$10,000 or where the person earning the remuneration was not present in the U.S. for more than 183 days in the year of death and the remuneration was not borne by a resident of the U.S. or a permanent establishment of the employer in the U.S.

Paragraph 6(a)(ii) of Article XXIX B is applicable if the value of the entire gross estate at the time of the individual's death exceeds $1.2 million U.S. dollars or its equivalent in Canadian currency. This provision has the effect of adding to income, profits or gains of an individual determined under paragraph 6(a)(i) of Article XXIX B any taxable capital gains of the individual from the deemed disposition at death of property situated in the U.S. which have not been included under paragraph 6(a)(i) of Article XXIX B. Whether or not in a particular situation other amounts not included under paragraph 6(a)(i) of Article XXIX B qualify as amounts under paragraph 6(a)(ii) thereof can only be determined after an examination of the facts and circumstances of the situation.

For purposes of paragraph 6 of Article XXIX B property shall be treated as situated in the U.S. if it is so treated for estate tax purposes under the Code as in effect on March 17, 1995, subject to any subsequent changes thereof that the competent authorities of Canada and the U.S. have agreed to apply for the purposes of paragraph 6 of Article XXIX B. See Appendix C for examples of property situated in the U.S.

While paragraph 6(a) of Article XXIX B applies to individual other than a trust to the extent that U.S estate or inheritance taxes are imposed upon an individual's death, paragraph 6(b) thereof applies to a spousal trust to the extent that U.S. estate or inheritance taxes are imposed upon the death of the individual's surviving spouse. Canada will grant a tax credit for such estate taxes against any Canadian federal tax payable by the spousal trust for its taxation year in which that spouse dies. The credit is limited to the Canadian federal tax payable on income, profits or gains of the spousal trust for that year arising (within the meaning of paragraph 3 of Article XXIV of the Convention) in the U.S. or from property situated in the U.S. at the time of death of the spouse. Thus, although U.S. estate tax may be levied on the estate of the spouse, the spousal trust in Canada will be able to claim a tax credit for such estate tax paid in respect of property owned by the trust at the time of death situated in the U.S.

The tax credit that Canada will grant under paragraph 6 of Article XXIX B shall take into account the deduction for any income tax paid or accrued to the U.S. that is provided under paragraph 2(a), 4(a) or 5(b) of Article XXIV (Elimination of Double Taxation). This means that for purposes of computing the Canadian tax credit for U.S. estate taxes the amount of the Canadian federal income tax payable (including federal individual surtax) is net of the foreign income tax credits that Canada would grant under section 126 and subsection 180.1(1.1) of the Act as determined in accordance with paragraph 2(a), 4(a) or 5(b) of Article XXIV of the Convention.⁷

No Impact on the Amount of Credit that U.S. Is Obliged to Grant under Paragraph 4(b) or 5(c) of Article XXIV of the Convention

Any credit provided by Canada under paragraph 6 of Article XXIX B in respect of a U.S. citizen resident in Canada should not impact on the credit that the U.S. is required to grant under paragraph 4(b) or 5(c) of Article XXIV of the Convention for Canadian income taxes. For example, it would be inappropriate to interpret the words "tax paid or accrued to Canada after the deduction referred to in paragraph (a)" in paragraph 4(b) of Article XXIV to be anything other than the tax paid or accrued to Canada before any credit granted by Canada under paragraph 6 of Article XXIX B. The purpose of paragraph 6 of Article XXIX B is to avoid double taxation by having Canada grant a credit for U.S. estate taxes paid in respect of U.S. situs property. There was no intention to relieve the U.S. from their obligation in whole or in part to provide income tax credits under paragraph 4(b) or 5(c) of Article XXIV of the Convention.

Steps to Determine Canadian Tax Credit for U.S. Estate Taxes:

For what information is needed to perform the following steps, see Appendix D attached.

(I) Steps for U.S. Citizens Resident in Canada:

Marital Credit

The first step is to ensure that the credit under paragraphs 3 and 4 (Marital Credit) of Article XXIX B of the Convention, if claimed, was computed correctly.⁸ As noted in Appendix D attached, if no marital credit is claimed a statement is required from the executor or executrix of the estate stating either that the estate is not eligible to claim the marital credit or, if it is eligible to claim the credit, the reasons why such a credit is not claimed and that it does not intend to claim the credit.

U.S. Estate Taxes Paid as a U.S. Citizen

Ensure that the amount of the U.S. estate tax shown on U.S. Form 706 (U.S. estate tax return for a U.S. resident or U.S. citizen, a copy of which can be found in Appendix A) filed with IRS was reasonable. For deaths occurring after November 9, 1995 we should at least require that a copy of this return be attached to the Canadian income tax return of the decedent if the taxpayer wishes to claim a credit for U.S. estate taxes. We understand that IRS issues a letter (the Estate Tax Closing Letter, a copy of which is attached as Appendix E) to the estate confirming the amount of estate taxes paid or payable. For deaths occurring after November 9, 1995, such a letter may provide evidence of estate taxes paid or payable. For deaths occurring before November 10, 1995, an amended U.S. Form 706 is required to be filed with the request for a tax refund.

U.S. Estate Taxes in respect of U.S. Situs Property

Determine the portion of net U.S. estate taxes payable as a U.S. citizen (both federal and state) (i.e., after all the available credits except the U.S. credit for Canadian taxes have been claimed⁹) that is attributable to U.S. situs property of the decedent by using the following formula:

A x C

B

Where

A is the gross value of the property situated in the U.S. (for more information about what constitutes property situated in the U.S. please refer to Appendix C);

B is the value of the gross value of the worldwide estate as shown on line 1 of Form 706; and

C is the amount of the U.S. federal estate tax on line 16 of Form 706 (i.e., after the unified credit and the state death tax credit but before the death tax credit for Canadian taxes) plus the state estate tax¹⁰ less any marital credit.¹¹

This step is to determine the prorata amount of the U.S. estate taxes payable in respect of U.S. situs property by a U.S. citizen.

U.S. Estate Taxes if the Decedent Were not a U.S. Citizen

Determine the amount of U.S. estate taxes (both federal and state) that would have been paid if the decedent were not a U.S. citizen, taking into consideration all the provisions of Article XXIX B of the Convention. This step will involve a separate calculation of U.S. estate tax using U.S. Form 706-NA which essentially calculates U.S. estate tax for a non-resident/non-citizen of the U.S. in respect of U.S. situs property. Therefore, it is required that if a tax credit under Article XXIX B is claimed in Canada, every estate of a Canadian resident decedent who was a U.S. citizen immediately before death file a copy of U.S. Form 706-NA together with the final T1 income tax return of the decedent to show how much U.S. estate taxes would have been exigible if the decedent were not a U.S. citizen. Note that for these purposes charitable and marital deductions, if applicable, are available without proration if the bequests to qualified charities or to the qualifying spouse¹² are U.S. situs assets which are included in the gross value of the property situated in the U.S. Other amounts of qualified deductions (e.g., funeral expenses, administration expenses, decedent's debts, mortgages and liens) must be prorated. (See lines 1 to 5 of Schedule B of Form 706-NA.) Note also that for the purpose of this calculation, if the value of the worldwide gross estate of the decedent does not exceed U.S.$1.2 million, paragraph 8 of Article XXIX B would apply such that the value of the U.S. situs property the gains from the disposition of which are not subject to tax under Article XIII of the Convention would not be included in the gross estate situated in the U.S. of the decedent.

U.S. Estate Taxes Available for Canadian Tax Credit

The lesser of the amounts obtained in 3 and 4 above is the amount of the U.S. estate taxes that is creditable for Canadian federal tax credit purposes.

Canadian Foreign Tax Credit for U.S. Income Taxes

The next step is to make sure that the Canadian federal foreign tax credit on the T1 income tax return of the decedent for income tax paid or accrued to the U.S. in accordance with paragraphs 3, 4, 5 and 6 of Article XXIV of the Convention was calculated correctly.¹³ Determine the total amount of such foreign tax credits claimed under section 126 and subsection 180.1(1.1) of the Act, if any.

Canadian Federal Tax Payable in respect of Income, Profits or Gains Arising in the U.S.

Determine the amount of the Canadian federal income tax payable (including federal individual surtax under Part I.1 of the Act) before any dividend tax credit, federal foreign tax credit (including foreign tax credit against federal individual surtax), federal political contribution tax credit, investment tax credit and labour-sponsored funds tax credit (hereinafter referred to as the "Canadian Federal Tax Otherwise Payable") in respect of U.S. source income, profits or gains referred to in paragraphs 6(a)(i) and (ii) of Article XXIX B as follows:

For gross estate having a value not exceeding U.S.$1.2 million, use the following formula:

A x C

B

Where

A is the income, profits or gains arising in the U.S. in accordance with paragraph 3 of Article XXIV of the Convention in the year of death (i.e., income, profits or gains that the U.S. has the right to tax under the Convention had the decedent not been a U.S. citizen). These include not only capital gains on deemed disposition on death of U.S. real property (as defined for the purposes of Article XIII of the Convention) and personal property forming part of the business property of a permanent establishment in the U.S. but also other income, profits or gains that arise in the U.S. in the year of death that U.S. has the right to tax under the Convention;

B is the amount referred to in subparagraph 126(1)(b)(ii) of the Act. This is the same amount forming the denominator of the formula referred to in paragraph 126(1)(b) of the Act in computing foreign tax credit for Canadian tax purposes; and

C is the Canadian Federal Tax Otherwise Payable as defined above.

For gross estate having a value exceeding U.S.$1.2 million, use the following formula:

A + D x C

B

where A, B and C are the same as described above and

D is the income, profits or gains from U.S. situs property other than those already included in A. This includes gains on deemed disposition of U.S. situs property other than real property as defined for the purposes of Article XIII of the Convention or personal property forming part of the business property of a permanent establishment in the U.S. (see Appendix C for examples of U.S. situs property);

Canadian Federal Tax Payable for the Purpose of the Tax Credit for U.S. Estate Taxes

Subtract the total amount of foreign tax credits for U.S. income taxes determined in 6 from the amount determined in 7. If the result is nil, there will not be any tax credit for U.S. estate taxes. If the result is positive, the difference will be the amount of the Canadian federal tax payable against which a tax credit may be claimed for U.S. estate taxes payable on U.S. situs property.

Canadian Federal Tax Credit for U.S. Estate Taxes

The lesser of the amount determined in 5 and the amount determined in 8 is the Canadian federal tax credit for the U.S. estate taxes paid in respect of U.S. situs property.

Example I below illustrates the computation of Canadian federal tax credit for U.S. estate taxes paid by a U.S. citizen resident in Canada.

Example I — U.S. Estate Tax Credit with respect to a U.S. Citizen Resident in Canada

Assume the following facts:

(i) Mrs. X died in 1994. Immediately before her death she was a resident of Canada and a U.S. citizen.

(ii) The U.S. exchange rate on the date of her death was U.S.$1 = Cdn.$1.3659

(iii) No foreign tax credit was claimed on the late Mrs. X's 1994 T1 Income Tax Return as no U.S. income tax was paid.

(iv) Mrs. X did not have a spouse at the time of her death to whom she could pass on property. Consequently, she was not entitled to any marital credit under paragraphs 3 and 4 of Article XXIX B of the Convention.

(v) She has already claimed the maximum unified credit of U.S.$192,800 against her U.S. estate tax (see a copy of Mrs. X's estate tax return Form 706 in Appendix F).

(vi) Her estate paid state estate or inheritance tax of U.S.$367 which was equal to the state death tax credit provided by the U.S. federal government for U.S. estate tax purposes.

(vii) Her U.S. situs property at the time of her death was consisted of real property in State Y having a value of U.S.$163,000. The balance of her worldwide gross estate of U.S.$1,671,724 was situated in Canada.

(viii) Allowable deductions from gross estate (namely, funeral expenses and Canadian income tax unpaid in respect of the gains from the deemed disposition of U.S. situs property) amounted to U.S.$175,728.

(ix) The estate of Mrs. X paid U.S. federal and state estate taxes totalling U.S.$361,287.

(x) Mrs. X's 1994 Canadian Federal Tax Otherwise Payable as defined for the purpose of "C" in the formula "A/B x C" in Step 7 above was $235,098.

(xi) The taxable capital gains on the U.S. situs property referred to in (vii) above was $148,320. No capital gains deduction was claimed.

(xii) The amount referred to in subparagraph 126(1)(b)(ii) of the Act was $774,200.

Based on the steps described above with respect to the determination of Canadian tax credit for U.S. estate taxes for Canadian residents who were U.S. citizens, the Canadian tax credit for Mrs. X is calculated as follows:

1. Marital Credit

Mrs. X's spouse passed away before she did. Therefore, the marital credit is not applicable. Since she was a U.S. citizen, full unified credit of U.S.$192,800 has been claimed on her U.S. estate tax return in 1994.

2. U.S. Estate Taxes Paid as a U.S. Citizen

The estate of Mrs. X paid U.S. estate taxes (federal and State Y) of U.S.$361,287.

3. U.S. Estate Taxes in respect of U.S. Situs Property

The only U.S. situs property is the real property in State Y having a value of U.S.$163,000. If this property were disposed of, the gains on the disposition would have been subject to tax in the U.S. in accordance with Article XIII of the Convention.

The gross estate world-wide is U.S.$1,671,724. The total U.S. federal and state estate taxes are U.S.$361,287.

As described in the formula "A/B x C" in Step 3 above where A represents the value of the gross estate situated in the U.S., B represents the entire gross estate everywhere and C represents the U.S. federal and state estate taxes net of all credits except the credit for Canadian taxes, U.S. estate tax at rates applicable to a U.S. citizen in respect of the U.S. situs property would be:

=U.S.$163,000 x U.S.$361,287

U.S.$1,671,724

= U.S.$35,227 or Cdn.$48,117

The amount of the gross estate world-wide of U.S.$1,671,724 is the amount shown on line 1 of Form 706 in Appendix F attached. The amount of U.S.$361,287 is the amount of U.S. federal estate tax of U.S.$360,920 shown on line 16 of Form 706 (i.e., after the amounts of the unified credit and state death tax credit but before the foreign death tax credit) less marital credit of nil plus State Y estate tax of U.S.$367.

4. U.S. Estate Taxes if the Decedent Were Not a U.S. Citizen

In Appendix G attached, a separate calculation is shown by using Form 706-NA for Mrs. X as if she were not a U.S. citizen. As shown in Schedule B of Form 706-NA in Appendix G, a prorata deduction of U.S.$17,132 is claimed resulting in a taxable estate of U.S.$145,868 in that schedule. A unified credit of U.S.$18,799 is claimed on line 7 of Part II of Form 706-NA. U.S. estate taxes (federal and State Y) in respect of U.S. situs property if Mrs. X were not a U.S. citizen is U.S.$18,761 or Cdn.$25,626 (i.e., federal estate tax of U.S.$18,394 on line 14 of Form 706-NA in Appendix G plus State Y estate tax of U.S.$367).

5. U.S. Estate Taxes Available for Canadian Federal Tax Credit

The lesser amount determined in 3 (i.e. Cdn.$48,117) and 4 (i.e Cdn.$25,626) above is Cdn.$25,626.

6. Canadian Foreign Tax Credit for U.S. Income Taxes

Mrs. X did not claim any foreign tax credit in the year of death on her final T1 income tax return because she did not pay any U.S. income tax.

7. Canadian Federal Tax Payable in respect of Income, Profits or Gains Arising in the U.S.

Canadian Federal Tax Otherwise Payable in respect of income, profits or gains arising in the U.S. in this case is Cdn.$45,040.^(F14)

8. Canadian Federal Tax Payable for the Purpose of the Tax Credit for U.S. Estate Taxes

Since there is no foreign tax credit claimed in 6 above, the amount of the Canadian federal tax payable for U.S. estate tax credit purposes is Cdn.$45,040.

9. Canadian Federal Tax Credit for U.S. Estate Taxes

The lesser of the amount of U.S. estate taxes of Cdn.$25,626 determined in 4 above and the amount of Cdn.$45,040 determined in 8 above is Cdn.$25,626. This is the amount of foreign tax credit that Canada would provide to the estate of Mrs. X for U.S. estate taxes paid in respect of U.S. situs property.

The estate of Mrs. X would be entitled to a tax refund from Canada of Cdn.$25,626 plus interest accrued to the date of the refund.

Note: The estate of Mrs. X would also be entitled to a refund from the U.S. of U.S. estate taxes for Canadian federal and provincial taxes paid in respect of gains on the deemed disposition of non-U.S. situs property at death.

(II) Steps For Canadian residents who are not U.S. citizens:

Value of the Gross Estate

Determine if the value of the gross estate exceeds U.S.$1.2 million or the equivalent in Canadian currency. If the value does not exceed that amount, determine whether there are any U.S. assets the gains on the disposition of which would be subject to income taxation by the U.S. in accordance with Article XIII of the Convention. If there is no such asset, the U.S. does not have the right to levy federal estate tax on the estate. Therefore, any U.S. federal estate tax paid would not be creditable for Canadian tax credit purposes. In such a case a refund of the U.S. federal estate tax should be requested from the U.S. tax authority.

If the value of the gross estate exceeds U.S.$1.2 million or if there is U.S. situs property the gains on the disposition of which would be subject to U.S. tax in accordance with Article XIII of the Convention, proceed as follows.

Unified Credit and Marital Credit

Ensure the correct computation of the unified credit under paragraphs 2 and, if applicable, the marital credit under paragraphs 3 and 4 of Article XXIX B of the Convention.¹⁵ As noted in Appendix D attached, if no marital credit is claimed a statement is required from the executor or executrix of the estate stating either that the estate is not eligible to claim the marital credit or, if it is eligible to claim the credit, the reason why such a credit is not claimed and that it does not intend to claim the credit.

U.S. Federal and State Estate Taxes

Ensure the amount of the U.S. estate taxes (both federal and state) paid or payable are correct by reviewing the U.S. estate tax return for non-residents and non-citizens of the U.S. (Form 706-NA) and the appropriate state estate or inheritance tax return. For deaths occurring after November 9, 1995 we should at least require that a copy of this return be attached to the Canadian income tax return of the decedent if the taxpayer wishes to claim a credit for U.S. estate taxes. We understand that IRS issues a letter (the Estate Tax Closing Letter, a copy of which is attached as Appendix E) to the estate confirming the amount of estate taxes paid or payable. For deaths occurring after November 9, 1995, such a letter may provide evidence of estate taxes paid or payable. For deaths occurring before November 10, 1995, an amended U.S. Form 706-NA is required to be filed with the request for a tax refund.

Canadian Foreign Tax Credit for U.S. Income Taxes

Ensure the Canadian federal foreign tax credits for U.S. income taxes paid or accrued in accordance with paragraph 2(a) of Article XXIV of the Convention was calculated correctly. Determine the total amount of the foreign tax credits for U.S. income taxes claimed under section 126 and subsection 180.1(1.1) of the Act.

Canadian Federal Tax Payable in respect of Income, Profits or Gains Arising in the U.S.

Determine the amount of the Canadian Federal Tax Otherwise Payable¹⁶ in respect of U.S. source income, profits or gains referred to in paragraphs 6(a)(i) and (ii) of Article XXIX B as follows:

(i) For gross estate having a value not exceeding U.S.$1.2 million, use the following formula:

W x Z

Y

Where

W is the income, profits or gains arising in the U.S. in accordance with paragraph 3 of Article XXIV of the Convention in the year of death (i.e., income, profits or gains that the U.S. has the right to tax under the Convention for a decedent who was a Canadian resident not a U.S. citizen). These include not only capital gains realized on the deemed disposition on death of U.S. real property as defined for the purposes of Article XIII of the Convention and the personal property forming part of the business property of a permanent establishment in the U.S. but also other income, profits or gains that arise in the U.S. in the year of death that the U.S. has the right to tax under the Convention;

Y is the amount referred to in subparagraph 126(1)(b)(ii) of the Act. This is the same amount forming the denominator of the formula referred to in paragraph 126(1)(b) of the Act in computing foreign tax credit for Canadian tax purposes; and

Z is the Canadian Federal Tax Otherwise Payable.

(ii) For gross estate having a value exceeding U.S.$1.2 million, use the following formula:

W + X x Z

Y

Where

W, Y and Z are the same as above and

X is the income, profits or gains from property situated in the U.S.¹⁷ other than those already included in W. This includes gains on deemed disposition of property other than U.S. real property as defined for the purposes of Article XIII of the Convention or personal property forming part of the business property of a permanent establishment in the U.S.;

Canadian Federal Tax Payable for the Purpose of the Tax Credit for U.S. Estate Taxes

Subtract the amount determined in (D) from the amount determined in (E). If the result is nil, no federal tax credit will be granted for U.S. estate taxes. If the result is positive, the difference will be the amount of the Canadian federal tax payable for the purpose of the tax credit for U.S. estate taxes paid in respect of U.S. situs property.

Canadian Foreign Tax Credit for U.S. Estate Taxes

The lesser of the amount determined in (C) and the amount determined in (F) is the Canadian federal tax credit for U.S. estate taxes paid in respect of U.S. situs property.

Example II below illustrates the computation of Canadian federal tax credit for U.S. estate taxes paid by a Canadian resident who is not a U.S. citizen.

Example II — U.S. Estate Tax Credit with respect to a Canadian Resident Who Is Not a U.S. Citizen

Assume the following facts:

(i) Mrs. Y died in 1991. Immediately before her death she was a resident of Canada who was not a U.S. citizen. The U.S. exchange rate at that time was U.S.$1 = Cdn.$1.15

(ii) She claimed a foreign tax credit of Cdn.$79 under section 126 of the Act on her final T1 income tax return. No foreign tax credit under subsection 180.1(1.1) of the Act was available. U.S. source investment income reported on her final T1 return was Cdn.$543.

(iii) Her marital status on her final T1 income tax return was "widow".

(iv) The Estate of Mrs. Y did not pay any state estate or inheritance tax in the U.S. and therefore was not eligible for any state death tax credit for U.S. estate tax purposes.

(v) All the U.S. situs property owned by the late Mrs. Y at the time of her death was consisted of shares of U.S. public corporations. The aggregate value of these shares was Cdn.$163,018 or U.S.$141,755.

(vi) The value of her worldwide gross estate was Cdn.$3,294,519 or U.S.$2,864,805. The value of the gross estate not situated in the U.S. was, therefore, U.S.$2,723,050.

(vii) A unified credit of U.S.$13,000 was claimed on the U.S. estate tax return of the late Mrs. Y (see Appendix H).

(viii) Allowable deductions (such as funeral expenses and Canadian income tax liability¹⁸) before proration were U.S.$295,025 as shown on line 4 of Schedule B of Form 706-NA in Appendix H.

(ix) The amount of the U.S. federal estate tax shown on the estate tax return Form 706-NA was U.S.$18,947.

(x) Taxable capital gain realized from the deemed disposition at death of the above-noted U.S. situs property was Cdn.$96,504. The total taxable capital gains on Mrs. Y's final T1 income tax return as Cdn.$535,406. Mrs. Y claimed capital gains deduction of Cdn.$14,624 on her final income tax return.

(xi) Net income on Mr. Y's 1991 T1 income tax return was Cdn.$568,820.

(xii) The amount of the Canadian Federal Tax Otherwise Payable as defined in the footnote in respect of Step (E) above for the year 1991 for the late Mrs. Y was $161,758.

Based on Steps (A) to (G) with respect to the determination of Canadian tax credit for U.S. estate taxes for Canadian residents who were not U.S. citizens, the Canadian tax credit of Mrs. Y is calculated as follows:

(A) Value of the Gross Estate

Since the value of the worldwide gross estate exceeded U.S.$1.2 million so that the exception contained in paragraph 8 of Article XXIX B would not apply. In other words, the U.S. may impose estate tax on U.S. situs property the gains from the disposition of which would not have been subject to income tax in the U.S. in accordance with Article XIII of the Convention in addition to those gains from the disposition of property that the U.S. has the right to tax under the Convention.

(B) Unified Credit and Marital Credit

The unified credit is computed to be the greater of (i) U.S.$13,000 or (ii) the proportion of U.S.$192,800 that the value of the gross estate situated in the U.S. is of the value of the gross estate worldwide.

The amount in (ii) is U.S.$9,540 which is calculated as follows:

U. S.$141,755 x U.S.$192,800 = U.S.$9,540

U.S.$2,864,805

Therefore, the unified credit in this case was U.S.$13,000

No marital deduction was available in this case.

(C) U.S. Federal and State Estate Taxes

The amount of the U.S. federal estate tax pursuant to the Form 706-NA was U.S.$18,947 (see Appendix H) or Cdn.$21,789.

(D) Canadian Federal Foreign Tax Credit for U.S. Income Taxes

The foreign tax credit correctly calculated and claimed on the final T1 tax return of the taxpayer was Cdn.$79.

(E) Canadian Federal Tax Payable in respect of Income, Profits or Gains Arising in the U.S.

Assuming that the taxpayer would have specified that the claim for the capital gains deduction was in respect of taxable capital gain realized on property other than U.S. situs property had the taxpayer realized that she needed to specify an amount under subsection 126(5.1) of the Act, the net taxable capital gains on U.S situs property subject to tax in Canada was Cdn.$96,504.

The amount of U.S. source investment income per T1 was $543.

The amount of Canadian federal income tax payable that was attributable to U.S. source income and taxable capital gains on U.S. situs property would be Cdn.$28,326 as computed using the formula:

W + X = Z

Y

where

W is the U.S. investment income of Cdn.$543;

X is the U.S. source net taxable capital gains of Cdn.$96,504;

Y is Cdn.$554,196 which is equal to the net income of Cdn.$568,820 less the capital gains deduction of Cdn.$14,624; and

Z is the Canadian Federal Tax Otherwise Payable of Cdn.$161,758.

(F) Canadian Federal Tax Payable for the Purpose of the Tax Credit for U.S. Estates Taxes

Subtract the foreign tax credit of Cdn.$79 referred to in (D) from the amount of federal tax of Cdn.$28,326 determined in (E). The result is Cdn.$28,247 which is the amount of the federal income tax payable for the purpose of the Canadian federal tax credit for U.S. estate taxes.

(G) Canadian Federal Tax Credit for U.S. Estate Taxes

The lesser of the amount of Cdn.$21,789 in (C) and the amount of Cdn.$28,247 in (F) is the amount of the tax credit that Canada would grant to the estate of Mrs. Y for U.S. estate taxes paid in respect of U.S. situs property.

The estate of Mrs. Y would be entitled to a refund from Canada of Cdn.$21,789 plus interest accrued to the date of the refund.

Interest in respect of Refund of Tax Overpayment

Because of the broad wording of "...notwithstanding any limitation imposed under the law of a Contracting State on the assessment, reassessment or refund with respect to a person's return..." in paragraph 4 of Article 21 of the Third Protocol to the Convention with respect to the application of paragraphs 2 to 8 of Article XXIX B of the Convention, it is our view that the provisions of sections 152 and 164 of the Act would be available to the taxpayer and such provisions should be read without any of the limitations found therein. As a result, pursuant to paragraph 164(3)(d) of the Income Tax Act, interest in respect of a refund of an overpayment should be calculated from the day the overpayment arose, which is, in our view, the later of (i) the date a return was filed and (ii) the date the return was required to be filed.

Conclusion

We have set out above our understanding of the law in respect of Article XXIX B of the Convention and suggested certain steps to facilitate the processing of the tax credit in Canada as provided by paragraph 6 of that Article. The above comments are not meant to answer all the questions regarding that Article. We expect that there will be complicated cases which you may have to deal with on a case by case basis. If we could be of any assistance in dealing with these cases or if you have any question regarding the above, please do not hesitate to contact either Simon Leung (613) 957-2115 or Ken Major (613) 957-2124 of Income Tax Rulings and Interpretations Directorate.

APPENDIX A

A General Description of U.S. Estate Tax

The U.S. imposes federal and state estate taxes on the taxable estate of a decedent. The meaning of taxable estate varies depending on whether or not the decedent is a U.S. citizen/resident immediately before his or her death (see below for more details). Depending on the value of the taxable estate, the U.S. estate tax rates range from a low of 18% to a peak of 55% (see a table of tax rates attached). In addition, for taxable estate exceeding $10 million, an extra 5% tax on the amount of the excess is imposed to the extent that the unified credit of $192,800 and the benefits of any tax rates below 55% are fully recaptured. Thus, the marginal tax rate can be as high as 60%. These tax rates apply to the taxable estate of a decedent who is either a U.S. citizen/resident or a non-resident alien of the U.S.

The tax rates play a very important role in determining the credit that Canadian is obliged to grant under paragraph 6 of Article XXIX B of the Convention to the estate of a decedent who was a U.S. citizen immediately before death. Canadian is not obliged to grant a credit for U.S. estate taxes which exceeds the estate tax liability of the decedent if the decedent were not a U.S. citizen. As a resident of Canada not a U.S. citizen is required under the Code to report in his gross estate for U.S. estate tax purposes only property situated in the U.S., the tax base would be smaller and correspondingly the tax rate would be lower, resulting in lesser federal estate tax than the amount obtained by prorating the federal estate tax of a U.S. citizen that the value of the U.S. situs property is of the value of the worldwide gross estate.

U.S. Citizen/Resident

The taxable estate of a U.S. citizen/resident is the gross estate of such a person situated everywhere in the world less certain deductions allowed. Some of the allowable deductions include marital deduction (i.e., amount of the estate that was passed on to the decedent's spouse who is a U.S. citizen and that would otherwise be included in the gross estate for U.S. estate tax purposes), unpaid income taxes, administrative expenses, funeral expenses, debt claims and gifts to U.S. government or public charities. The executor of the estate of a U.S. citizen/resident is required to file a U.S. estate tax return Form 706 (a copy of which is attached) within nine months after the date of the decedent's death.

The U.S. allows a flat non-refundable unified credit of U.S.$192,800 against its federal estate tax for a U.S. citizen/resident.

Canadian Resident Who is Not a U.S. Citizen

The taxable estate of a resident of Canada who is not a U.S. citizen or a former U.S. citizen immediately before death consists of the gross estate of that person situated in the U.S. less any marital deduction (only to the extent of the property that was passed on to the decedent's spouse who is a U.S. citizen and that would otherwise be included in the computation of gross estate for U.S. estate tax purposes¹⁹) or marital credit available under paragraphs 3 and 4 of Article XXIX B of the Convention, charitable gifts made to Canadian or U.S. charitable organizations as described in paragraph 1 of Article XXI of the Convention, and a proportion of other deductions that would have been allowed if the person was a U.S. citizen that the value of that part of the gross estate situated in the U.S. at the time of the person's death bears to the value of the person's entire gross estate wherever situated. The executor of the estate of such a person is required to file a U.S. estate tax return Form 706-NA (a copy of which is attached) within nine months after the date of death of such a person if at the date of death the decedent's gross estate situated in the U.S. exceeds U.S.$60,000.

For a non-resident alien of the U.S., unless otherwise provided by the estate tax treaties that the U.S. has with the other countries,²⁰ the unified credit is the lesser of U.S.$13,000 and the amount of the federal estate tax. The U.S. does not have an estate tax treaty with Canada but as a result of the Third Protocol, for a Canadian resident who is not a U.S. citizen, the unified credit available under paragraph 2 of Article XXIX B of the Convention is the lesser of

(a) the amount of the federal estate tax and

(b) the greater of

(i) U.S.$13,000 and

(ii) the proportion of U.S.$192,800 that the gross estate of the decedent situated in the U.S. is of the world-wide gross estate of the decedent.

The credit will be reduced by the gift tax credit that was previously claimed by the decedent. The U.S. also provides a state death tax credit (calculated under a standard formula no matter to which state the death tax was paid; see a table of the state death tax credit rates attached) against its federal estate tax.

Canadian Resident who is a U.S. Citizen

The taxable estate is computed in the same manner as a U.S. citizen. That is the taxable estate of a U.S. citizen resident in Canada immediately before death is consisted of the gross estate of such a person situated everywhere in the world less certain deductions described in the section "U.S. Citizen/Resident" above. The executor of the estate of a U.S. citizen or a U.S. resident is required to file a U.S. estate tax return Form 706 (a copy of which is attached) within nine months after the date of the decedent's death.

A Canadian resident who is a U.S. citizen is entitled to a unified credit of U.S.$192,800.

Pursuant to paragraph 7 of Article XXIX B of the Convention, the U.S. is obliged to grant a credit against its federal estate tax imposed in respect of property situated outside the U.S. for Canadian federal and provincial income taxes payable in respect of such property by reason of death of an individual or, in the case of a qualified domestic trust, the individual's surviving spouse.

Note that the credit that Canada is required to provide for U.S. estate taxes on U.S. situs property under paragraph 6 of Article XXIX B of the Convention is only the amount of such estate taxes that would have been payable on such property if the decedent was a non-resident, non-citizen of the U.S. immediately before death.

APPENDIX B

Analysis of Paragraphs 1 to 4 of Article XXIX B of the Convention

Paragraph 1 of Article XXIX B — Charitable Bequests

Paragraph 1 of Article XXIX B provides that a Contracting State shall accord the same death tax treatment to a bequest by an individual resident in one of the Contracting States to a qualifying exempt organization referred to in paragraph 1 of Article XXI of the Convention which is resident in the other Contracting State as it would have accorded if the organization had been a resident of the first Contracting State. This paragraph is only for U.S. estate tax purposes and is particularly aimed at providing a relief for Canadian residents who are not U.S. citizens and who bequeath U.S. situs property to a Canadian registered charity. This is because pursuant to the estate tax provisions under the Code, a U.S. citizen or resident is able to deduct gifts to any public charity organized either in the U.S. or elsewhere. Also under the Code, a Canadian resident who is not a U.S. citizen and who bequeaths property to U.S. public charities is allowed a deduction for U.S. estate tax purposes. Now under this paragraph of Article XXIX B of the Convention for U.S. estate tax purposes, a resident of Canada who is not a U.S. citizen and who bequeaths U.S. situs property to a Canadian registered charity will be treated as if he or she had bequeathed property to a charity organized in the U.S. Under the Code the amount of such bequest will be allowed as a deduction for U.S. estate tax purposes provided that the property so bequeathed, as would always be the case where the entire gross estate is in excess of U.S.$1.2 million, is part of the assets that would be included in the gross estate situated in the U.S. of the decedent. Such deductible bequest would not be subject to proration and would be recorded on line 6 of Schedule B of Form 706-NA.

Since there is no estate tax in Canada, paragraph 1 of Article XXIX B would have no application in Canada.²¹ As confirmed by the Department of Finance, in Canada the deductibility of charitable gifts to U.S. exempt organizations is continued to be governed by paragraph 6 of Article XXI of the Convention and the provisions of the Act.

Paragraph 2 of Article XXIX B — The Unified Credit

Under the Code, the estate of a non-resident and non-citizen of the U.S. (i.e., a non-resident alien of the U.S.) is subject to estate taxes only in respect of its U.S. situs assets and is entitled to a unified credit of U.S.$13,000 (unless otherwise provided in a treaty that the U.S. has with the other countries), while the estate of a U.S. citizen or U.S. resident is subject to U.S. estate taxes in respect of its entire worldwide estate and is entitled to a unified credit of U.S.$192,800.

Paragraph 2 of Article XXIX B increases the unified credit allowed to the estate of a Canadian resident decedent who was not a U.S. citizen immediately before death to an amount between U.S.$13,000 and U.S.$192,800 to take into account the extent to which the assets of the estate are situated in the U.S. This provision is not applicable to U.S. citizens or U.S. residents (defined for purposes of the U.S. estate tax) because such persons are entitled to the full unified credit of U.S.$192,800. The unified credit of a Canadian resident non-U.S. citizen decedent is calculated in the following manner: the proportion of U.S.$192,800 that the gross estate of the decedent situated in the U.S. bears to the worldwide gross estate of such decedent. However, the amount will in no event be less than U.S.$13,000 and will be reduced by any unified credit previously allowed with respect to lifetime gifts made by the decedent. It is also limited to the amount of U.S. federal estate tax imposed on the estate.

In determining the U.S. estate tax of a Canadian resident who was not a U.S. citizen for Canadian tax credit purposes, we have to make sure that unified credit to the extent it could be claimed is claimed by the estate of the decedent. Any available unified credit not claimed would reduce the amount of the U.S. estate tax for purposes of computing the Canadian tax credit.

Paragraphs 3 and 4 of Article XXIX B — The Marital Credit

Under the Code property bequeathed to a decedent's spouse who is a U.S. citizen is deductible (known as the "estate tax marital deduction" in the U.S.) in computing the taxable estate of the decedent for U.S. estate tax purposes. However, such marital deduction is not available for property passed on to a decedent's spouse who is not a U.S. citizen.

The purpose of the marital credit under paragraph 3 of Article XXIX B is to alleviate in appropriate cases the impact of the above-noted estate tax marital deduction restriction. Paragraph 3 of Article XXIX B allows a non- refundable marital credit in addition to the pro rata unified credit allowed under paragraph 2 of Article XXIX B. The marital credit is allowed only in connection with transfers satisfying each of the following five conditions. First, the property bequeathed to the spouse must be "qualifying property" (i.e., it must be property that would have qualified for the estate tax marital deduction under U.S. domestic law if the spouse had been a U.S. citizen and all applicable elections specified by U.S. domestic law had been properly made. Second, the decedent must have been, at the time of death, either a resident of Canada or the U.S. or a citizen of the U.S. Third, the spouse of the decedent must have been, at the time of death of the decedent, a resident of either Canada or the U.S. Fourth, if both the decedent and the spouse were residents of the U.S. at the time of the decedent's death, at least one of them must have been a citizen of Canada. Fifth, the executor or executrix of the decedent's estate is required to elect the benefits of paragraph 3 and to waive irrevocably the benefits of any estate tax marital deduction that would be allowed under U.S. domestic law.

Since the fifth condition is that the executor or executrix of the estate is required to make an election to claim the marital credit, it appears, therefore, that the claiming of such credit is not mandatory. As noted in Appendix D attached, if a marital credit is not claimed on the U.S. estate tax return the executor or executrix of the estate is required to file a statement stating either that the estate is not eligible for the marital credit or, if it is eligible for the credit, the reasons why the credit is not claimed and that it does not intend to claim the credit.

Paragraph 4 of Article XXIX B governs the computation of the marital credit allowed under paragraph 3. It provides that the amount of the marital credit shall equal the lesser of

(i) the amount of the unified credit allowed to the estate under paragraph 2 or, where applicable, under U.S. domestic law before reduction for any gift tax unified credit (i.e., U.S.$192,800), and

(ii) the amount by which the U.S. estate tax that would be imposed on the transfer of qualifying property to the surviving spouse if that property were included in computing the taxable estate exceeds the U.S. estate tax that would be imposed if the property were not so included.

Property that, by reason of paragraph 8 of Article XXIX B, is not subject to U.S. estate tax is not taken into account for purposes of this computation.

The Technical Explanation to the Third Protocol to the Convention provides several examples of the computation of the marital credit. Note that in Examples 1 to 4 therein, the estate would be entitled to a Canadian tax credit under paragraph 6 of Article XXIX B which was not shown in the examples. Note also in Example 5 therein that the estate would be entitled to a U.S. credit for the Canadian income tax imposed by reason of death under paragraph 7 of Article XXIX B, not paragraph 6.

Paragraph 4 of Article XXIX B also provides an ordering rule which states that, solely for the purposes of determining any other credits (e.g., the credit for foreign and state death taxes) that may be allowed under U.S. domestic law to the estate, the marital credit shall be allowed after such other credits. In other words, for the computation of U.S. foreign death tax credit under paragraph 7 of Article XXIX B, the estate tax used is the estate tax before the marital credit. This would not be the case for computing Canadian tax credit because the ordering rule is solely for the purposes of determining other credits under U.S. law. For the purposes of the Canadian tax credit provided under paragraph 6 of Article XXIX B, the U.S. estate tax which is creditable is the estate tax after the marital credit.

APPENDIX C

U.S. Situs Property

U.S. situs property of a decedent generally means that part of the gross estate which at the time of his death is situated in the U.S. if he were a "nonresident alien of the U.S." (i.e., a non-resident and a non-citizen of the U.S.). Such part of the gross estate includes real, tangible and intangible property situated in the U.S. Note that for U.S. estate tax purposes the gross estate of a U.S. citizen (whether or not he or she is a resident of the U.S.) is his or her worldwide gross estate while the gross estate of a non-resident alien of the U.S. is his or her gross estate situated in the U.S.

Real property and tangible personal property has a situs where it is physically located. Tangible property includes, among other things, clothing, jewellery, automobiles, furniture or currency.

Intangible personal property situated in the U.S. includes stock in U.S. corporations²² regardless of the physical location of the shares (Code 2104(a)) and debt obligations²³ of a resident or citizen of the U.S., a domestic partnership or corporation, any estate or trust (but not a foreign estate or trust), and any governmental entities (Code sec. 2104(c)). IRS position with respect to the situs rules for partnership interests is that situs is not determined by reference to the partnership assets but by the place where the partnership conducts its business.²⁴ With respect to interest in a trust, IRS would look through the trust and attribute the underlying assets to the capital beneficiaries in accordance with their respective interest in the trust.²⁵ Decedents who own only income interest (i.e., without any capital interest) in a trust are not required to include such interest in the gross estate.²⁶

The following is considered not to be U.S. situs property for U.S. estate tax purposes for a non-resident alien of the U.S.:

(a) Insurance proceeds on the life of a nonresident alien of the U.S. regardless of where the life insurance was purchased (Code sec. 2105(a));

(b) A deposit in a U.S. bank if the deposit was not connected with a U.S. trade or business and was paid or credited to the decedent's account (Code sec. 2104(c) and sec. 2105(b));

(c) A deposit or withdrawable account with a savings and loan association chartered and supervised under the U.S. federal or state law or an amount held by a U.S. insurance company under an agreement to pay interest thereon (Code sec. 2105(c));

(d) A deposit with a foreign branch of a U.S. corporation or partnership if such branch is engaged in the commercial banking business (Code sec. 2105(b));

(e) A debt obligation of a U.S. corporation if any interest the decedent would have received at the time of death would have been treated for U.S. income tax purposes as income from sources outside the U.S. because less than 20% of the U.S. corporation's gross income from all sources was from sources within the U.S. for the 3-year period (Code sec. 2104(c));

(f) Stock issued by a corporation that is not a U.S. domestic corporation even if the certificate is physically located in the U.S. (Code sec. 2104(a));²⁷ and

(g) Certain U.S. portfolio debt obligations issued after July 18, 1984 if any interest on the obligation would be eligible for the exemption from the withholding tax had the interest been received by the decedent before death (Code sec. 2105(b)).

Bibliography:

1. IRS Publication 448 Federal Estate and Gift Taxes

2. Instruction to complete Form 706-NA issued by IRS

3. Internal Revenue Code sections 861, 871, 2104 and 2105

4. Linda Stillabower and William J. Strain, "US Estate Planning for Canadians with US Real Property: Life After the Protocol", Canadian Tax Journal, (1995) Vol. 43, No. 2, 239-276

5. John H. Gardner, "Cross-Border Dimensions of Estate and Trust Planning: A US Perspective", 1993 Canadian Tax Foundation Conference Report, 39:1 - 39:15

6. Bender's Master Federal Tax Handbook, "Estate and Gift Taxes", 1993 Edition

APPENDIX D

Information Required to Process Canadian Tax Credit

General Information Required for Every Claimant of Canadian Tax Credit for U.S. Estate Taxes

1. A copy of the final T1 return of the decedent.

2. A copy of the original U.S. estate tax return (i.e., Form 706 in respect of a U.S. citizen or a U.S. resident and Form 706-NA in respect of a non- resident/non-citizen of the U.S.).

3. A copy of the state estate or inheritance tax return, if applicable.

4. Proof of payments of estate taxes (federal and states).

5. A copy of the Estate Tax Closing Letter from IRS confirming the filing of the U.S. estate tax return and the tax liability thereon (see a copy in Appendix E) and any similar documents from the state tax authorities with respect to the state estate or inheritance tax return.

6. If applicable, a copy of the amended U.S. estate tax return or other correspondence with IRS requesting a change to the U.S. estate taxes previously calculated as a result of the application of Article XXIX B of the Convention, including a detailed calculation of the revised U.S. estate taxes payable.

7. Information regarding citizenship and residency of the decedent.

8. The U.S. exchange rate used on the U.S. estate tax return (generally, it should be the exchange rate on the date of death).

9. Information regarding whether the estate is eligible for a marital credit. The information should at least include a statement stating

(i) either that the estate is not eligible for the marital credit or, if it is eligible, the reasons why such a credit is not claimed and that it does not intend to claim the credit; and

(ii) that whether a U.S. qualified domestic trust ("QDOT") has been or will be established and, if affirmative, the value of the property that has been or will be transferred to the QDOT.

Additional Information Required for Canadian Resident Decedents Who were Not U.S. Citizens

1. A list or inventory of the assets (including the values thereof) included in the worldwide gross estate of the decedent.

2. A list of items and their values supporting the claim for the allowable deductions on the U.S. estate tax return.

3. Details of the calculation of the various deductions and credits provided in paragraphs 1 to 4 of Article XXIX B of the Convention.

Additional Information Required for Canadian Resident Decedents Who were U.S. Citizens

1. A copy of the U.S. 1040 income tax return with separate information of the decedent's income and deductions (i.e., not combined with those of the spouse) and all the schedules attached to the return.

2. A detailed list of properties which were situated in the U.S. on the date of death and the values thereof which were included in the value of the gross estate of the decedent.

3. A detailed calculation of U.S. estate taxes on the basis that the decedent was not a U.S. citizen immediately before death, taking into account the provisions of paragraphs 1 to 4 of Article XXIX B of the Convention (in other words, the estate tax calculated by using Form 706-NA which is a return for a non-U.S. citizen/non-U.S. resident).

ENDNOTES

¹ If the decedent is a U.S. citizen resident in Canada, even though the decedent may not have any U.S. situs property at death, he or she may still be liable to U.S. estates tax if such tax is greater than the Canadian federal and provincial taxes payable in respect of the non-U.S. situs property by reason of death of the decedent. In such a case, Canada would not grant any credit for such U.S. estate tax. Canada is only required to grant a credit for U.S. estate tax payable on U.S. situs property against Canadian tax imposed on the gains from the disposition of such property on death or on U.S. source income in the year of death.

² For a brief discussion of the U.S. Federal estate tax, please refer to Appendix A attached.

³ $500,000/$2,400,000 x U.S.$784,000 = U.S.$163,333.

⁴ $500,000/$2,400,000 x U.S.$192,800 = U.S.$40,167.

⁵ Note that Canadian Federal tax otherwise payable includes federal individual surtax under Part I.1 of the Act.

⁶ It is not clear whether any province of Canada would grant any foreign tax credit on U.S. estate tax which is in excess of the federal tax credit. Our understanding of the Ontario provincial foreign tax credit provisions is that the Province of Ontario would not provide for such a credit.

⁷ For a detailed discussion of the tax credits that Canada is obliged to grant under paragraphs 4(a) and 5(b) of Article XXIV of the Convention, please refer to a separate paper titled "Some Aspects of Taxation of U.S. Citizens Resident in Canada" issued by this Directorate.

⁸ See further details about the marital credit in Appendix B.

⁹ namely, unified credit, state death tax credit, foreign death tax credit (other than that from Canada) and marital credit.

¹⁰ Depending on the individual state in the U.S., state estate or inheritance tax may not be equal to the amount of the state death tax credit granted by the U.S. federal government.

¹¹ As discussed in Appendix B attached, property that is included in the gross estate for U.S. estate tax purpose and that is passed on to a decedent's spouse who is a U.S. citizen is eligible for an estate tax marital deduction. Where property is passed on to a spouse who is not a U.S. citizen and where all the conditions described in paragraph 3 of Article XXIX B are met, a marital credit can be claimed upon making an election. In this regard, note that U.S. Form 706 and Form 706-NA do not contain a line to report such a credit.

¹² Qualifying spouse means a spouse who is a U.S. citizen.

¹³ Supra footnote 7.

¹⁴ i.e., $148,320/$774,200 x $235,098 = $45,040.

¹⁵ see Appendix B for further details of how to compute the appropriate amount of the unified credit and the marital credit.

16 As defined in Step 7 in the case of decedents who were U.S. citizens resident in Canada, Canadian Federal Tax Otherwise Payable is the Canadian federal tax payable (including federal individual surtax) before dividend tax credit, foreign tax credit (including foreign tax credit against federal individual surtax), federal political contribution tax credit, investment tax credit and labour- sponsored funds tax credit.

¹⁷ see Appendix C for some examples of U.S. situs property

¹⁸ i.e., all the Canadian income tax liabilities before the credit for U.S. estate taxes.

¹⁹ Property that would otherwise be included in the calculation of gross estate for U.S. estate tax purposes and that was passed on to a qualified domestic trust ("QDOT") which was established for the spouse who is not a U.S. citizen also qualifies for the marital deduction. See section 2056A of the Internal Revenue Code.

²⁰ See section 2102(c)(3)(A) of the Code.

²¹ This is also the understanding of the U.S. as can be found in page 14 of "Explanation of Proposed Protocol to the Income Tax Treaty Between the United States and Canada" prepared by U.S. Joint Committee on Taxation, dated May 23, 1995, which states:

"Although this provision (paragraph 1 of Article XXIX B) appears on its face to grant reciprocal benefits, it is in effect only a concession by the United States to allow a U.S. estate tax deduction for charitable bequests by a Canadian resident to a qualifying Canadian resident organization. Charitable bequests by Canadian residents to qualifying U.S. resident organizations are already deductible from the Canadian gains at death tax under the terms of the existing treaty."

²² It appears that options on such stock are also considered to be U.S. situs property. See Treasury Regulation sec. 20.2104-1(a)(4).

²³ Unless the interest payments on such obligations are exempt under section 871(h) of the Code.

²⁴ Rev. rul. 55-701, 1955-2 CB 836; confirmed by Mr. Jeff Thomas of IRS on May 22, 1996.

²⁵ pursuant our telephone conversation with Mr. Jeff Thomas of the IRS on May 22, 1996.

²⁶ supra footnote 21.

²⁷ The shares of a foreign corporation are not U.S. situs property even though the corporation owns U.S. real property interest.