Sources and References

Primary textbook — Pratt, J.W. and Kulsrud, W.N. Federal Taxation (current edition). Cengage Learning. — Smith, J.K., Raabe, W.A., Maloney, D.M. and Young, J.C. South-Western Federal Taxation (current edition). Cengage Learning.

Supplementary texts — Bittker, B.I. and Lokken, L. Federal Taxation of Income, Estates and Gifts (Warren, Gorham & Lamont). — Kuntz, J.D. and Peroni, R.J. U.S. International Taxation (Warren, Gorham & Lamont). — Reimer, E. and Rust, A. (eds.) Klaus Vogel on Double Taxation Conventions, 4th ed. (Wolters Kluwer).

Statutory and regulatory sources — Internal Revenue Code (26 U.S.C.), Treasury Regulations (26 C.F.R.), IRS Publication 17 (Your Federal Income Tax), IRS Publication 519 (U.S. Tax Guide for Aliens), IRS Publication 515 (Withholding of Tax on Nonresident Aliens and Foreign Entities), Revenue Procedures and Revenue Rulings published in the Internal Revenue Bulletin.

Treaty materials — Convention Between Canada and the United States of America with Respect to Taxes on Income and on Capital (1980), as amended by the Fifth Protocol (2007). Department of Finance Canada technical explanations.

Chapter 1: Overview of the U.S. Tax System

Section 1.1: Structure and Administration

The United States federal income tax is administered by the Internal Revenue Service (IRS), a bureau of the Department of the Treasury, under the authority of the Internal Revenue Code (IRC), codified at Title 26 of the United States Code. Congress enacts tax legislation, the Treasury issues regulatory guidance (Treasury Regulations, Revenue Rulings, Revenue Procedures, and Private Letter Rulings), and the IRS administers and enforces the law through examinations, appeals, and collection.

The U.S. tax system is distinctive in its jurisdictional reach: the United States taxes its citizens and permanent residents (green card holders) on their worldwide income, regardless of where they live or where the income arises. This citizenship-based taxation is exercised by only one other significant jurisdiction (Eritrea) and stands in sharp contrast to Canada’s strictly residence-based system under the Income Tax Act (ITA), which taxes individuals solely on the basis of whether they are resident in Canada during the taxation year.

1.1.1 Federal Tax Administration vs. Canadian Tax Administration

1.1.2 Filing Status

The filing unit in the U.S. individual system is the taxpayer, and filing status determines applicable brackets, standard deduction, and credit eligibility.

Married Filing Jointly (MFJ) generally produces the lowest combined tax liability for two-earner couples and is the most commonly chosen status. It requires that both spouses be U.S. citizens or residents for the full year (or that a nonresident alien spouse elect to be treated as a resident under IRC § 6013(g)).

Head of Household (HOH) provides more favourable brackets than Single for an unmarried taxpayer who pays more than half the cost of maintaining a home for a qualifying person (a dependent child, dependent parent, etc.) for more than half the year.

Married Filing Separately (MFS) is generally unfavourable — it triggers the highest effective rates among married couples and disqualifies many credits — but is occasionally used to isolate one spouse’s income for AGI-based phase-outs (e.g., income-driven student loan repayment).

Section 1.2: The Federal Rate Structure

The federal income tax rate structure for individuals uses progressive marginal rates. For 2024, the ordinary income brackets are:

Long-term capital gains (assets held more than 12 months) and qualified dividends receive preferential rates of 0%, 15%, or 20% depending on taxable income level. High-income taxpayers additionally pay the 3.8% Net Investment Income Tax (NIIT) under IRC § 1411 on the lesser of net investment income or the excess of modified AGI over the threshold ($200,000 single / $250,000 MFJ).

Section 1.3: The Tax Cuts and Jobs Act (TCJA) of 2017

The Tax Cuts and Jobs Act (Pub. L. No. 115-97), effective January 1, 2018, was the most sweeping reform of U.S. federal income tax law since the Tax Reform Act of 1986. AFM 463 operates within the post-TCJA framework. Key individual changes:

• Top marginal individual rate reduced from 39.6% to 37%.
• Standard deduction roughly doubled — $13,850 single / $27,700 MFJ for 2023 (indexed for inflation), making itemizing less common.
• Personal exemptions eliminated (previously $4,050 per taxpayer and dependent).
• Child Tax Credit increased to $2,000 per qualifying child ($1,600 refundable as ACTC in 2023).
• SALT deduction capped at $10,000 (federal deduction for state/local income, sales, or property taxes).
• Mortgage interest deduction limited to $750,000 of acquisition indebtedness (down from $1,000,000).
• Moving expense deduction restricted to active military only.
• Miscellaneous itemized deductions subject to the 2%-of-AGI floor eliminated entirely.

Key corporate changes:

• Corporate rate reduced from a graduated rate structure (top rate 35%) to a flat 21%.
• 100% bonus depreciation for qualified property placed in service 2017–2022 (phasing down 20% per year thereafter).
• Interest expense deduction limited to 30% of adjusted taxable income (IRC § 163(j)).
• U.S. multinational corporations shifted to a territorial (participation exemption) system via IRC § 245A.
• New regimes: GILTI (IRC § 951A), BEAT (IRC § 59A), FDII (IRC § 250).

Many TCJA individual provisions are set to sunset after December 31, 2025 (reverting to pre-TCJA law), absent further Congressional action — a significant planning issue in practice.

Chapter 2: U.S. Individual Taxation

Section 2.1: Gross Income — IRC § 61

IRC § 61(a) defines gross income as “all income from whatever source derived”, including (but not limited to):

• Compensation for services (wages, salaries, tips, bonuses, fringe benefits)
• Business income (net of ordinary and necessary business expenses)
• Interest income
• Dividends
• Rents and royalties
• Gains from dealings in property
• Alimony (for divorce agreements executed before January 1, 2019)
• Pension and annuity income
• Partnership and S corporation distributive shares
• Gambling winnings and prizes

The breadth of IRC § 61 reflects the all-inclusive income concept: unless a specific exclusion in the Code applies, an accession to wealth is taxable. This contrasts with some other systems that use an enumerated list of taxable sources.

2.1.1 Exclusions from Gross Income

Sections 101 through 140 of the IRC enumerate items specifically excluded from gross income:

Section 2.2: Computing Taxable Income

The calculation flows in two stages: from gross income to AGI (the “above-the-line” stage), then from AGI to taxable income.

2.2.1 Above-the-Line Deductions (IRC § 62)

2.2.2 Standard Deduction (2024 Tax Year)

An additional standard deduction of $1,950 (single) or $1,550 (married, per qualifying spouse) applies for taxpayers who are age 65 or older or blind.

2.2.3 Itemized Deductions (IRC § 63(d) and Schedule A)

Taxpayers may elect to itemize if their Schedule A deductions exceed the standard deduction. Major categories:

Medical Expenses (IRC § 213): Unreimbursed medical expenses exceeding 7.5% of AGI are deductible. Eligible expenses include doctor and hospital fees, prescription drugs, medical equipment, and health insurance premiums paid out-of-pocket. Long-term care insurance premiums are deductible subject to an age-based cap.

State and Local Taxes (SALT — IRC § 164): Deductible state/local taxes include income taxes (or sales taxes, at the taxpayer’s election), and real property taxes. Post-TCJA, the aggregate SALT deduction is capped at $10,000 ($5,000 MFS). This cap disproportionately affects taxpayers in high-tax states such as California, New York, and New Jersey.

Mortgage Interest (IRC § 163(h)): Qualified residence interest on debt up to $750,000 of acquisition indebtedness on a qualified residence (principal or second home) is deductible. Interest on home equity debt is deductible only if the loan proceeds were used to buy, build, or substantially improve the residence.

Charitable Contributions (IRC § 170): Cash contributions to qualified charitable organizations are deductible up to 60% of AGI; contributions of appreciated property are generally deductible at fair market value, limited to 30% of AGI. Carryovers of excess contributions are permitted for five years.

Casualty and Theft Losses (IRC § 165(h)): Post-TCJA, personal casualty losses are deductible only if they arise from a federally declared disaster. The deductible amount is the lesser of the decrease in FMV or the adjusted basis, reduced by $100 per casualty and then by 10% of AGI.

Section 2.3: Tax Credits

Unlike deductions (which reduce taxable income), credits reduce tax liability dollar-for-dollar and are therefore more valuable per dollar of benefit. Credits may be refundable (generate a refund even when no tax is owed), nonrefundable (limited to the tax liability), or partially refundable.

Section 2.4: Self-Employment Tax

Self-employed individuals (sole proprietors, general partners, single-member LLC owners not classified as employees) pay self-employment (SE) tax in lieu of the employee and employer shares of FICA taxes:

• Social Security: 12.4% on net self-employment income up to the wage base ($168,600 in 2024).
• Medicare: 2.9% on all net self-employment income, plus an Additional Medicare Tax of 0.9% on net self-employment income exceeding $200,000 (single) / $250,000 (MFJ) — IRC § 1401.

One-half of SE tax is deductible as an above-the-line deduction (IRC § 164(f)), approximating the employer-side deduction available to corporations.

Section 2.5: Alternative Minimum Tax (AMT)

The Alternative Minimum Tax (IRC §§ 55–59) is a parallel tax calculation designed to ensure that high-income taxpayers who benefit from numerous preferences and deductions still pay a minimum amount of federal income tax.

Key AMT preferences and adjustments include:

• Standard deduction (not allowed for AMT)
• SALT deduction (not allowed for AMT)
• Accelerated depreciation in excess of ADS
• Incentive stock option (ISO) spread at exercise
• Percentage depletion in excess of adjusted basis
• Tax-exempt interest on certain private activity bonds

AMT Exemptions (2024):

• Single: $85,700 (phase-out begins at $609,350)
• MFJ: $133,300 (phase-out begins at $1,218,700)

Post-TCJA, the substantially higher exemptions mean AMT primarily affects upper-middle-income taxpayers who exercise ISOs or have large SALT deductions (if not already blocked by the $10,000 cap).

Section 2.6: Qualified Business Income (QBI) Deduction — IRC § 199A

Enacted by the TCJA, IRC § 199A allows non-corporate taxpayers to deduct up to 20% of qualified business income (QBI) from a domestic pass-through entity (sole proprietorship, S corporation, or partnership).

For taxpayers with taxable income below the threshold ($191,950 single / $383,900 MFJ in 2024), the deduction is simply 20% of QBI. Above the threshold, the deduction is limited to the greater of:

• 50% of the W-2 wages paid by the business, or
• 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property.

Specified Service Trades or Businesses (SSTBs) — law, health, consulting, financial services, athletics, and the arts — are ineligible for the QBI deduction once taxable income exceeds the threshold (phased out within a $50,000 / $100,000 range above the threshold).

Chapter 3: Sourcing and Taxability of Income — Foreign Tax Credits

Section 3.1: Source of Income Rules (IRC §§ 861–865)

Whether income is U.S.-source or foreign-source determines:

1. Whether a foreign person (NRA or foreign corporation) is subject to U.S. tax on that income.
2. The amount of foreign income that can enter the FTC limitation formula for U.S. taxpayers.

Section 3.2: Foreign Tax Credit (FTC) — IRC §§ 901–909

U.S. citizens and residents earning income from foreign jurisdictions frequently pay income taxes to those jurisdictions. The foreign tax credit prevents double taxation by allowing a credit against U.S. income tax liability.

3.2.1 Creditable Foreign Taxes

To be creditable, a foreign levy must be:

1. A tax — a compulsory payment not tied to a specific economic benefit.
2. An income tax — imposed on net income (as opposed to a gross-receipts tax, VAT, or customs duty).
3. Paid or accrued by the taxpayer (not reimbursed).

The Treasury Regulations under § 901 impose a jurisdictional nexus requirement: to be creditable, the foreign tax must apply only to income with sufficient nexus to the foreign country.

3.2.2 FTC Limitation — IRC § 904

The FTC is limited to prevent a taxpayer from using foreign taxes on foreign income to offset U.S. tax on U.S.-source income:

Credits are computed within separate “baskets”:

• General limitation basket — active business income, non-passive foreign income
• Passive income basket — dividends, interest, rents, royalties, and other passive income

Separating baskets prevents cross-crediting — the use of excess credits from high-taxed foreign income to shield low-taxed passive income.

Excess FTCs may be carried back one year and forward ten years (IRC § 904(c)).

Section 3.3: Foreign Earned Income Exclusion — IRC § 911

U.S. citizens or resident aliens living abroad may elect the Foreign Earned Income Exclusion (FEIE) if they meet either the bona fide residence test or the physical presence test.

FEIE exclusion amount: $126,500 for 2024 (indexed annually). Only earned income (wages, salaries, professional fees) qualifies — not pensions, dividends, interest, or capital gains. A companion housing exclusion or housing deduction covers excess housing costs.

The FEIE and FTC cannot be applied to the same income. Taxpayers earning income in Canada generally find the FTC more advantageous because Canadian taxes typically exceed the FEIE’s equivalent tax cost, resulting in excess FTCs that can shelter other income.

Chapter 4: Special Topics for Americans in Canada

Section 4.1: Dual Filing Obligations

A U.S. citizen residing in Canada faces obligations under both Canadian and U.S. tax law simultaneously:

• Canada: Taxable as a Canadian resident under the ITA on worldwide income; subject to CRA assessment and audit.
• United States: Taxable as a U.S. citizen on worldwide income regardless of residence; required to file Form 1040 by June 15 (automatic extension for those residing abroad, with further extension to October 15 available on Form 4868).

The Canada-U.S. Tax Treaty coordinates these regimes but does not eliminate U.S. filing obligations; it only provides mechanisms to avoid double taxation (primarily through FTCs and treaty-based exemptions).

4.1.1 The Substantial Presence Test — IRC § 7701(b)

A non-citizen, non-green-card holder may become a U.S. tax resident if they meet the substantial presence test: present in the U.S. for at least 31 days during the current year AND at least 183 days during the current and prior two years (counting all days in the current year, 1/3 of days in the prior year, and 1/6 of days in the second preceding year).

A person who meets the substantial presence test may claim closer connection to Canada (Form 8840) or invoke the Canada-U.S. Treaty tie-breaker to be treated as a Canadian resident for treaty purposes, filing Form 1040-NR and Form 8833 to disclose the treaty position.

4.1.2 RRSP Treatment

The Registered Retirement Savings Plan (RRSP) has no direct U.S. counterpart. Under U.S. domestic law, an RRSP is a foreign grantor trust, meaning all income earned inside the RRSP would normally be currently includible in the U.S. citizen’s gross income annually as it accrues.

However, Article XVIII(7) of the Canada-U.S. Tax Treaty allows a U.S. citizen residing in Canada to elect to defer U.S. tax on RRSP (and RRIF, DPSP) earnings until amounts are distributed. The election must be made annually by filing Form 8833 (Treaty-Based Return Position Disclosure) with the U.S. return. Previously Form 8891 was used for this purpose, but it was discontinued after 2014; Form 8833 now serves this function.

4.1.3 TFSA — Tax-Free Savings Account

The Tax-Free Savings Account (TFSA) presents significant complications for U.S. persons:

• In Canada, the TFSA is a registered account in which investment income accumulates and may be withdrawn completely tax-free.
• Under U.S. domestic law, the IRS treats a TFSA as a foreign grantor trust (since the Canadian legislation does not restrict the character of income or require it to be held for retirement). This classification triggers annual reporting obligations:
  • Form 3520 (Annual Return to Report Transactions with Foreign Trusts) — due April 15, with extension to October 15.
  • Form 3520-A (Annual Information Return of Foreign Trust with a U.S. Owner).
  • All income earned inside the TFSA is currently taxable on the U.S. return, eliminating the Canadian tax-exemption benefit for U.S. persons.

Practically, many U.S. citizens in Canada choose not to open a TFSA or hold only cash deposits (to minimize reporting and taxable income) rather than equity portfolios inside the TFSA.

4.1.4 FBAR and FATCA Reporting

FBAR — FinCEN Form 114: Under 31 U.S.C. § 5314 and Bank Secrecy Act regulations, a U.S. person who has a financial interest in, or signatory authority over, a foreign financial account or accounts with an aggregate maximum value exceeding USD $10,000 at any point during the calendar year must file FinCEN Form 114 electronically with FinCEN (not the IRS) by April 15 (extended automatically to October 15). Penalties for wilful non-filing can be the greater of $100,000 or 50% of the account balance per violation.

FATCA — Form 8938: IRC § 6038D, enacted as part of the Foreign Account Tax Compliance Act (FATCA), requires U.S. persons to attach Form 8938 to their tax return disclosing specified foreign financial assets above reporting thresholds ($50,000 for single filers in the U.S.; higher thresholds apply to those abroad). FATCA also requires foreign financial institutions (including Canadian banks) to report U.S. account holders to their local tax authorities under Intergovernmental Agreements (IGAs), which in turn share the data with the IRS.

Section 4.2: Canada-U.S. Treaty — Residency Tie-Breaker (Article IV)

Where an individual is resident in both countries under each country’s domestic law (a dual resident), their residency for treaty purposes is determined by the following sequential tie-breaker in Article IV(2):

1. Permanent home — taxed as a resident of the country where the individual has a permanent home available. If a permanent home is available in both, proceed to step 2.
2. Centre of vital interests — taxed in the country with which personal and economic relations are closer (family, employment, social ties, location of business, administration of estate, etc.).
3. Habitual abode — if centre of vital interests cannot be determined, the country in which the individual has a habitual abode.
4. Nationality — if the individual has a habitual abode in both or neither, the country of which they are a citizen (nationality).
5. Competent authority — if the individual is a citizen of both or neither, the two competent authorities (IRS and CRA) resolve the matter by mutual agreement.

A successful tie-breaker claim for Canada means Canada has primary residence-based taxing jurisdiction. The U.S. retains the right to tax U.S.-source income (interest, dividends, capital gains from U.S. real property, etc.) but must give up residence-based taxation. The tie-breaker claim must be disclosed on Form 8833 (Treaty-Based Return Position Disclosure).

Section 4.3: Departure Tax and Entry to the U.S.

Departure from Canada: When a Canadian resident ceases to be a resident (e.g., by moving to the U.S.), Canada deems the individual to have disposed of most property at fair market value on the date of departure (ITA § 128.1). This departure tax crystallizes accrued capital gains in Canada.

Entry to the U.S.: The U.S. does not have a concept analogous to Canada’s departure tax for incoming residents. However, the Treaty provides that where Canada has imposed departure tax on an individual’s property, the U.S. will recognize the FMV at the time of Canadian departure as the individual’s cost basis in that property for U.S. purposes. This is confirmed in Article XIII(7) of the Fifth Protocol, preventing double taxation on the same accrued gain.

Expatriation — IRC § 877A: U.S. citizens and long-term residents (green card holders for at least 8 of the last 15 years) who relinquish citizenship or residency are subject to a mark-to-market exit tax on the unrealized gains on their worldwide assets as of the day before expatriation, subject to a $866,000 exclusion (2024). This applies to “covered expatriates” who meet any of: (i) average annual net income tax over five preceding years ≥ $201,000 (2024), (ii) net worth ≥ $2 million, or (iii) failure to certify five years of U.S. tax compliance.

Chapter 5: U.S. Corporate Taxation

Section 5.1: Types of Business Entities

The U.S. tax system offers a wide spectrum of entity classifications, each with distinct implications for taxation at the entity and owner levels.

5.1.1 C Corporation Taxation — IRC § 11

C corporations are treated as separate taxable entities subject to a flat 21% corporate income tax (post-TCJA). The corporate taxable income calculation mirrors the individual calculation in broad structure but with important differences:

Corporate deductions include all ordinary and necessary business expenses (IRC § 162), depreciation (MACRS), interest (subject to § 163(j) limitation), compensation, rent, and research and development costs (IRC § 174, now requiring 5-year amortization post-TCJA).

Double taxation: Corporate earnings are taxed at 21% at the entity level; distributions to shareholders (dividends) are taxed at the qualified dividend rate (0/15/20%) at the individual level. The combined effective rate can be substantial. For example, $1.00 of corporate income yields $0.79 after corporate tax; if distributed, the shareholder pays 15% on $0.79, leaving $0.6715 — an effective combined rate of 32.85%.

5.1.2 S Corporation — IRC §§ 1361–1379

An S corporation is a pass-through entity for tax purposes: income, loss, deduction, and credit items flow through pro rata to shareholders based on share ownership throughout the year.

S election eligibility requirements (IRC § 1361):

• Domestic corporation only
• No more than 100 shareholders (members of the same family count as one shareholder)
• All shareholders must be U.S. citizens or residents (no nonresident aliens, no foreign trusts, no C corporations as shareholders)
• Only one class of stock (though voting/non-voting differences are permitted)

A shareholder-employee of an S corporation must receive reasonable compensation (subject to FICA/payroll taxes) for services performed. Any remaining profits distributed are not subject to SE tax — a common tax planning technique.

5.1.3 Partnership Taxation — IRC §§ 701–777

A partnership is not itself a taxpayer; rather, it files an information return (Form 1065) and issues Schedule K-1s to each partner reporting their distributive share of income, deductions, and credits. Partners include their distributive shares on their own returns.

Outside basis: A partner’s basis in the partnership interest determines the deductibility of losses and the tax treatment of distributions. Outside basis is increased by contributions, allocations of income/gain, and increased share of liabilities; reduced by distributions and allocations of loss/deduction.

Section 754 election: Allows a step-up (or step-down) in the inside basis of partnership assets when a partnership interest is sold or when a partner dies, aligning inside and outside basis and preventing double taxation.

Section 5.2: U.S. Trade or Business and Effectively Connected Income

5.2.1 U.S. Trade or Business (USTB)

A foreign person (nonresident alien individual or foreign corporation) is subject to U.S. federal income tax on U.S.-source income only to the extent that income is effectively connected with the conduct of a U.S. trade or business (USTB). The IRC does not define USTB; courts have found it requires a regular, continuous, and considerable commercial activity within the U.S.

The IRS uses two tests to determine ECI status for investment income (interest, dividends):

• Asset-use test: Was the income derived from assets used in or held for use in the USTB?
• Business-activities test: Were the activities of the USTB a material factor in the realization of the income?

5.2.2 FDAP Income — IRC §§ 1441–1442

Fixed, Determinable, Annual, or Periodical (FDAP) income from U.S. sources earned by a foreign person is subject to 30% gross withholding tax (no deductions allowed), collected at source by the withholding agent. FDAP categories include dividends, interest, rents, royalties, annuities, salaries paid to nonresidents, and prizes.

The withholding agent (the U.S. payor) is legally liable for withholding and remitting the tax, and files Form 1042 and Form 1042-S. A foreign person who believes a lower rate applies (due to a treaty or Code exemption) submits Form W-8BEN (individuals) or Form W-8BEN-E (entities) to the withholding agent to claim the reduced rate.

Treaty reductions to FDAP withholding rates (Canada-U.S. Treaty):

Section 5.3: Permanent Establishment

Under the Canada-U.S. Tax Treaty Article V, a Canadian corporation is subject to U.S. federal income tax on its business profits only if it has a permanent establishment (PE) in the United States, and only to the extent the profits are attributable to that PE.

Activities that do NOT create a PE (Treaty Art. V(6)):

• Using facilities solely for the storage, display, or delivery of goods
• Maintaining a stock of goods solely for the purpose of storage or display
• Maintaining a fixed place solely for purchasing goods or collecting information
• Maintaining a fixed place solely for preparatory or auxiliary activities

Section 5.4: Book-to-Tax Adjustments

U.S. corporations prepare financial statements under U.S. GAAP and file a separate tax return on Form 1120. Reconciling GAAP income to taxable income is done on Schedule M-1 (for corporations with < $10 million in total assets) or Schedule M-3 (for larger corporations with ≥ $10 million in assets).

5.4.1 Common Reconciling Items

Additions to book income (increase taxable income relative to book):

• Federal income tax expense per books (not deductible for tax; taxable income is pre-tax)
• Non-deductible meals (50% limit: only 50% of qualifying business meals is deductible post-TCJA; entertainment is entirely non-deductible)
• Capital losses in excess of capital gains (corporations cannot deduct net capital losses against ordinary income; carryback 3 / carryforward 5 years)
• Non-deductible penalties and fines paid to governments (IRC § 162(f))
• Life insurance premiums on key employees (where corporation is beneficiary — not deductible)
• Excess book depreciation over tax depreciation (in early asset life if book uses straight-line and tax uses MACRS)

Subtractions from book income (decrease taxable income relative to book):

• Excess tax depreciation over book depreciation (MACRS, bonus depreciation)
• Tax-exempt interest (municipal bond interest included in book income but excluded from taxable income)
• Dividends received deduction (DRD)
• Life insurance proceeds received (excluded from taxable income under IRC § 101)
• Prepaid income — amounts recognized for tax on receipt but deferred for GAAP

5.4.2 MACRS Depreciation

The Modified Accelerated Cost Recovery System (MACRS) under IRC §§ 167–168 provides prescribed asset lives and depreciation methods:

Bonus depreciation (IRC § 168(k)): For qualified property placed in service after September 27, 2017, 100% first-year expensing was available through 2022. The bonus percentage phases down: 80% (2023), 60% (2024), 40% (2025), 20% (2026), 0% (2027+) absent legislation.

IRC § 179 Expensing: Corporations and individuals may elect to immediately expense (deduct in full in the year of purchase) up to $1,220,000 (2024) of qualified business property, subject to a phase-out once total property placed in service exceeds $3,050,000.

Section 5.5: Earnings and Profits

Earnings and profits (E&P) is a tax-specific measurement of a corporation’s economic ability to pay a dividend. It has no direct GAAP equivalent.

Classification of distributions from E&P:

1. Dividend — Distribution from current or accumulated E&P; ordinary income to the shareholder (or qualified dividend if criteria met).
2. Return of capital — Distribution in excess of E&P but within the shareholder’s stock basis; reduces stock basis (nontaxable).
3. Capital gain — Distribution in excess of both E&P and stock basis; taxed as gain from sale of stock.

Section 5.6: Dividends Received Deduction (DRD) — IRC § 243

U.S. corporations that receive dividends from other domestic corporations may deduct a portion of those dividends to mitigate the multiple layers of corporate tax:

The DRD is limited to the same percentage of the corporation’s taxable income (before the DRD) to prevent the DRD from creating a net operating loss (unless the loss is due to the DRD itself).

Section 5.7: Net Operating Losses — IRC § 172

Post-TCJA, a corporation’s net operating loss (NOL) may only be carried forward (no carryback, except limited exceptions for farming losses and certain insurance company losses). The NOL deduction is capped at 80% of taxable income in the carryforward year. There is no limit on the number of years an NOL may be carried forward.

Section 5.8: Repatriation of Foreign Income — International Tax

5.8.1 The Territorial System and § 245A DRD

Post-TCJA, the U.S. moved toward a participation exemption (territorial) system for U.S. multinational corporations. IRC § 245A provides a 100% dividends received deduction for the foreign-source portion of dividends received by a domestic corporation from a specified 10%-owned foreign corporation (SFC) — effectively exempting repatriated foreign earnings from U.S. tax.

The § 245A DRD applies only to C corporations (not individuals or S corporations). Foreign tax credits are not available with respect to dividends for which the DRD is claimed.

5.8.2 GILTI — IRC § 951A

The Global Intangible Low-Taxed Income (GILTI) regime requires U.S. shareholders of controlled foreign corporations (CFCs) to include annually in their gross income their pro-rata share of the CFC’s GILTI.

GILTI is broadly the CFC’s net income in excess of a 10% deemed return on qualified business asset investment (QBAI — the net tax basis of tangible depreciable property used in the CFC’s trade or business). Income from tangible assets (earning a normal return) is excluded; the excess (attributable to intangibles and high-profit activities) is included as GILTI.

Effective tax rates on GILTI:

• Corporate shareholders: The § 250 deduction reduces GILTI inclusion by 50% (dropping to 37.5% post-2025), and an 80% FTC is allowed on foreign taxes paid by the CFC, resulting in an effective rate of 10.5% (rising to 13.125% after 2025).
• Individual shareholders: No § 250 deduction; GILTI is taxed at ordinary individual rates, potentially at 37% — a major tax planning concern for U.S. shareholders of Canadian-controlled CFCs.

5.8.3 Subpart F Income — IRC §§ 951–964

Subpart F requires U.S. shareholders of CFCs to include certain types of CFC income currently in their gross income, regardless of whether any distribution is made:

• Foreign Personal Holding Company Income (FPHCI): Dividends, interest, rents, royalties, annuities, and gains from sales of property generating passive income.
• Foreign Base Company Sales Income: Sales income from property manufactured outside, and sold for use outside, the CFC’s country of incorporation, between related parties.
• Foreign Base Company Services Income: Service fees earned in connection with services performed for related parties outside the CFC’s country.
• Insurance income: Certain insurance premiums for risks outside the CFC’s country.

The policy rationale: Subpart F prevents deferral of passive and base-eroding income in low-tax jurisdictions. GILTI supplements Subpart F by catching active income in low-taxed CFC regimes.

Chapter 6: State and Local Taxation

Section 6.1: Overview of the State Tax System

The United States has a multi-layered tax system: federal (IRS), state (50 separate systems), and local (counties, cities, school districts). Most U.S. states levy corporate and/or personal income taxes, plus sales and use taxes and property taxes.

6.1.1 State Income Tax Conformity

States generally begin with federal taxable income (or federal AGI for individuals) and apply state-specific modifications. The degree to which states follow federal law is described by their conformity approach:

• Rolling conformity: The state automatically adopts IRC changes as enacted (e.g., Virginia, New York). These states adopted TCJA immediately.
• Static (fixed-date) conformity: The state conforms to the IRC as it existed on a specific date (e.g., New Hampshire, Oregon use different fixed dates). These states may not have incorporated all TCJA provisions.
• Selective conformity: The state explicitly adopts or rejects specific federal provisions (e.g., California does not conform to bonus depreciation or GILTI).

6.1.2 State Corporate Income Tax Rates (Selected States, 2024)

Combined effective rate: In high-tax states such as California, the combined federal (21%) and state (8.84%) corporate income tax rate can reach approximately 27.3% before considering state apportionment.

Section 6.2: Nexus and Apportionment

6.2.1 Nexus

Nexus is the minimum connection between a business and a state that gives the state constitutional authority to impose a tax.

The landmark Supreme Court decision South Dakota v. Wayfair, 585 U.S. 162 (2018) confirmed that physical presence is not required for sales tax nexus — economic presence (e.g., making $100,000 in sales or 200 transactions in a state) suffices. Most states have extended economic nexus concepts to income tax as well, creating nexus for companies with no physical presence in the state.

Public Law 86-272 (15 U.S.C. §§ 381–384) provides a federal statutory protection from income tax nexus for companies whose only in-state activity is soliciting orders for the sale of tangible personal property, where orders are sent outside the state for approval and the goods are shipped from outside the state. This protection does not apply to services, intangibles, or digital goods.

6.2.2 Apportionment

A company with nexus in multiple states must apportion its income among those states rather than paying tax on total income to each state. The traditional Massachusetts formula equally weighted three factors:

The modern trend is single-sales-factor (SSF) apportionment, which weights only the sales factor. SSF favours companies with significant in-state tangible presence (property/payroll) but sales primarily outside the state — it reduces their tax burden, attracting corporate investment. Most large states (California, New York, Illinois, Texas) use SSF or heavily-weighted sales factors.

6.2.3 Combined Reporting and Unitary Tax

Many states require (or allow) combined reporting for a unitary business — a group of corporations operating as a single integrated enterprise across multiple states. All income of the unitary group is combined, and then the state’s apportionment formula is applied to determine each entity’s state income.

Worldwide combined reporting (used historically by some states) includes foreign affiliates in the combined group. Most states now permit a water’s-edge election that limits the combined group to domestic entities plus foreign entities with significant U.S. sales.

Section 6.3: State Taxation of Foreign Corporations

A foreign corporation (non-U.S.) with nexus in a U.S. state must comply with that state’s income tax filing requirements, regardless of the Canada-U.S. Tax Treaty provisions. The Treaty limits federal taxing jurisdiction (requiring a PE before U.S. taxation of business profits) but does not bind state and local governments directly, as the Supremacy Clause has been interpreted inconsistently in this context.

In practice, most states conform to the PE concept for foreign corporations, but the specific state analysis must be conducted separately.

Chapter 7: Cross-Border Issues and Treaty Application

Section 7.1: The Canada-U.S. Tax Treaty Framework

The Convention Between Canada and the United States of America with Respect to Taxes on Income and on Capital (commonly, the “Canada-U.S. Tax Treaty”) was signed in 1980 and has been amended by five Protocols: 1983, 1984, 1995, 1997, and 2007 (Fifth Protocol). The Fifth Protocol introduced significant changes, including the Limitation on Benefits clause and amendments to the treatment of hybrid entities.

The Treaty is implemented in the United States through its status as a self-executing treaty under Article VI of the U.S. Constitution (the Supremacy Clause), alongside the saving clause (Treaty Art. XXIX) which preserves the U.S. right to tax its own citizens and residents regardless of treaty provisions.

Key Treaty Articles:

Section 7.2: Limitation on Benefits (LOB) — Article XXIX-A

The Limitation on Benefits (LOB) clause, introduced by the Fifth Protocol (2007), prevents treaty shopping — the use of the Canada-U.S. Treaty by residents of third countries who structure themselves as Canadian or U.S. entities solely to access treaty benefits.

A qualified person entitled to treaty benefits includes:

• An individual resident in Canada or the U.S.
• A publicly traded company listed on a recognized stock exchange in either country
• A governmental entity or political subdivision
• A tax-exempt organization or pension fund
• A company passing the ownership-and-base-erosion test: more than 50% of each class of shares owned by qualifying residents, AND less than 50% of gross income paid (deductible) to non-qualifying persons

Companies that do not qualify as a qualified person may still access treaty benefits under the derivative benefits test (the income would have qualified if paid directly to the person’s owners) or the active trade or business test (the income is connected to a substantial active business in the country of residence).

Section 7.3: Mutual Agreement Procedure (MAP) — Article XXVI

The Mutual Agreement Procedure (MAP) allows residents of either Canada or the U.S. who believe they are being taxed in a manner inconsistent with the Treaty to present their case to the competent authority of their residence country (the IRS or the CRA). The two competent authorities then endeavor to reach a mutual agreement resolving the double taxation.

The taxpayer must initiate MAP within three years of the first notification of the action resulting in the inconsistent taxation. MAP does not suspend the collection of the disputed tax (the taxpayer may need to pay and seek a refund). The Fifth Protocol introduced a mandatory arbitration provision (Article XXVI(6)) for cases not resolved within two years.

Section 7.4: Applying Treaty Rules to Common Cross-Border Scenarios

7.4.1 Canadian Employee Temporarily Working in the U.S.

Under Treaty Article XV, employment income of a Canadian resident for services performed in the U.S. is taxable in the U.S.. However, an exemption applies if all three conditions are met:

1. The employee is present in the U.S. for no more than 183 days in any 12-month period commencing or ending in the fiscal year concerned.
2. The remuneration is paid by, or on behalf of, an employer who is not a resident of the U.S.
3. The remuneration is not borne by a PE of the employer in the U.S.

If all three conditions are met, the employment income is taxed only in Canada.

7.4.2 Pensions and the Canada Pension Plan — Article XVIII

CPP/QPP benefits paid to a U.S. resident are taxable only in Canada (the source country) at a rate not exceeding 25% under Treaty Article XVIII(5). For a U.S. resident receiving CPP, only 85% of the CPP benefit is included in Canadian taxable income (the same inclusion rate applied to U.S. Social Security under Article XVIII(5) as interpreted through the Treaty Technical Explanation).

U.S. Social Security benefits paid to a Canadian resident are taxable only in Canada under Article XVIII(5), with 85% of the benefit included in Canadian income.

Private pension income is generally taxable only in the country of residence of the recipient under Article XVIII(1), with a 15% withholding cap in the source country.

7.4.3 Capital Gains on Real Property — Article XIII

Gains derived by a Canadian resident from the alienation of real property situated in the U.S. (including shares of a corporation more than 50% of whose value derives from U.S. real property) are taxable in the U.S. under Treaty Article XIII(3).

The Foreign Investment in Real Property Tax Act (FIRPTA) — IRC § 897 — imposes U.S. tax on gains by a foreign person from the disposition of a U.S. Real Property Interest (USRPI). The withholding mechanism under IRC § 1445 requires the buyer to withhold 15% of the amount realized (unless an IRS withholding certificate reduces this) and remit it to the IRS. The foreign seller must file a U.S. tax return (Form 1040-NR or 1120-F) to report the gain and claim a refund if the withholding exceeds the actual tax.

Chapter 8: Tax Planning Strategies and Cross-Border Structures

Section 8.1: Entity Selection for Cross-Border Business

When a Canadian business seeks to establish U.S. operations, the choice of entity has profound tax implications:

8.1.1 Branch Profits Tax — IRC § 884

The branch profits tax (BPT) imposes an additional tax on foreign corporations with U.S. branches to equate the U.S. tax burden on branches with that on subsidiaries (where dividends are subject to 30% FDAP withholding). The BPT is imposed at 30% (reduced to 5% under the Canada-U.S. Treaty Art. X(6)) on the “dividend equivalent amount” — essentially the after-tax ECI not reinvested in U.S. assets.

8.1.2 Transfer Pricing — IRC § 482

Where related parties (a U.S. subsidiary and its Canadian parent, for example) transact with each other, the IRS (and CRA) require that transactions be priced at arm’s length — as if the parties were unrelated. IRC § 482 grants the IRS authority to allocate income, deductions, and credits between related parties to prevent tax avoidance through mispricing.

OECD Transfer Pricing Methods (also referenced by the IRS):

• Comparable Uncontrolled Price (CUP)
• Resale Price Method (RPM)
• Cost Plus Method (CP)
• Profit Split Method (PSM)
• Transactional Net Margin Method (TNMM)

Penalties: IRC § 6662 imposes a 20% accuracy-related penalty (increased to 40% for gross valuation misstatements) on transfer pricing adjustments unless the taxpayer had a contemporaneous transfer pricing documentation study (IRC § 6662(e)).

Section 8.2: Thin Capitalization and Interest Deductibility

8.2.1 IRC § 163(j) — Business Interest Limitation

Post-TCJA, a taxpayer’s business interest deduction is limited to:

ATI is computed as taxable income adjusted for non-business items, plus business interest expense, plus depreciation/amortization (the D&A add-back expired for years after 2021, significantly tightening the limit).

Disallowed interest carries forward indefinitely. Certain small businesses (average annual gross receipts ≤ $29 million for 2024) and certain real property trades or businesses (with an election) are exempt from § 163(j).

8.2.2 Earnings Stripping and the Canada-U.S. Treaty

Under the Treaty, interest paid by a U.S. corporation to its Canadian parent is generally eligible for 0% withholding (Treaty Art. XI). This makes intercompany debt financing attractive. However, the § 163(j) limitation constrains the deduction, and the IRS closely scrutinizes related-party debt for whether it constitutes true debt (respecting it for tax purposes) or disguised equity.

Section 8.3: Tax Planning for U.S. Citizens in Canada — Key Strategies

8.3.1 Using the Foreign Tax Credit Effectively

A U.S. citizen in Canada typically pays Canadian income tax at rates higher than the U.S. rate on the same income. Using the FTC effectively requires:

• Matching income baskets: Canadian income tax on passive income generates passive FTCs usable only against U.S. passive income; general category Canadian tax applies against general category U.S. income.
• Timing of income recognition: Coordinating the year in which Canadian and U.S. income is recognized to maximize FTC utilization.
• Avoiding the FEIE if FTCs are sufficient: The FEIE disqualifies use of FTCs for the same income, so if Canadian taxes fully offset U.S. tax, the FTC-only approach is preferable.

8.3.2 RRSP vs. U.S. Retirement Accounts

A U.S. citizen in Canada cannot contribute to a U.S. IRA or 401(k) unless they have U.S.-source earned income. Contributing to an RRSP (with the Treaty-based deferral election) achieves a functionally similar result: tax deferral on Canadian earned income.

The RRSP deduction on the Canadian T1 reduces Canadian taxable income in the year of contribution (no matching U.S. deduction without treaty position). On distribution, RRSP withdrawals are taxable in Canada (with 25% non-resident withholding if the individual has since moved to the U.S.), and taxable in the U.S. with a credit for Canadian withholding tax.

8.3.3 Controlled Foreign Corporation Pitfalls for Canadians

A U.S. citizen in Canada who owns shares of a Canadian private corporation may inadvertently be a U.S. shareholder of a CFC. If the U.S. citizen owns (directly or indirectly) more than 50% of the vote or value of a foreign (Canadian) corporation, that corporation is a CFC. Consequences:

• Subpart F income (passive income earned inside the CCPC) is currently includible in the U.S. citizen’s gross income.
• GILTI applies to the CFC’s high-return active income.
• Form 5471 (Information Return of U.S. Persons with Respect to Certain Foreign Corporations) must be filed annually.

This is a major trap for Canadian accountants advising U.S. citizen clients who operate incorporated businesses in Canada — income that is legitimately deferred inside a CCPC for Canadian purposes may be currently taxable in the U.S. as Subpart F or GILTI.

Chapter 9: Comprehensive Examples and Exam Preparation

Section 9.1: Comprehensive Individual Tax Calculation — U.S. Citizen in Canada

Section 9.2: Comprehensive Corporate Tax Calculation — Canadian Corporation with U.S. Branch

Section 9.3: Summary Comparison — U.S. vs. Canadian Tax System

Section 9.4: Key IRC Section Reference

Chapter 10: Practice Problems

Section 10.1: Individual Tax Problems

Section 10.2: Corporate Tax Problems

These notes draw on Pratt & Kulsrud’s Federal Taxation*, Smith, Raabe, Maloney & Young’s* South-Western Federal Taxation*, the Internal Revenue Code, Treasury Regulations, and IRS Publications 17, 515, and 519. All dollar thresholds reflect 2024 tax year figures unless otherwise noted.*