In the article, Jonah and Matt provide a review of the tax filing obligations for US citizens in Canada, plus notes on how US rules impact estate planning. Click here to view the article online or scroll down to read their article.
Taxing challenge for US expats
Jonah Z. Spiegelman and Matt C. Altro
August 1, 2014
US citizens in Canada face significant tax challenges. Both countries attempt to impose tax on their worldwide income, and require the disclosure of foreign assets to account for the money they receive. A very good tax treaty provides some assistance in avoiding double taxation, but problems remain. In the end, US citizens have the worst of both worlds: they must report and pay to Canada at very high Canadian tax rates and then report everything again to the IRS. To make matters worse, there are onerous filing obligations for US citizens who own financial assets outside of the US.
There are approximately one million US citizens in Canada. Many of them are not US tax compliant. The IRS has put in place a number of measures in recent years to put pressure on US expats to come forward. Below is a review of the tax filing obligations for US citizens in Canada, and how US rules impact estate planning.
Basic filing requirements
For most tax compliant Americans in Canada, US tax obligations can be fulfilled by simply filing the appropriate forms each year. There are a number of mechanisms built into both the Internal Revenue Code (IRC) and the Canada–US Tax Treaty that are intended to prevent double taxation of a given item of income.
One important means of preventing double tax for US citizens abroad is the Foreign Earned Income Exclusion (FEIE). The FEIE applies to exclude nearly $100,000 in foreign wage income from US taxation as long as the taxpayer is actually living and working in a foreign country.
For income in excess of the FEIE exclusion, or for non-wage income (e.g. dividends, interest, rents and royalties), the IRC provides for Foreign Tax Credits (FTC) whereby tax actually paid to a foreign country is credited against the US tax owing on that particular item or class of income.
Complex rules around the source, timing and character of income can, in some cases, limit the FTCs available to offset the US tax on income taxed elsewhere in the world. However, the FTC system generally works well at avoiding double taxation.
Information reporting requirements
In addition to income tax reporting and calculations, US citizens are required to make substantial disclosures of foreign assets to allow the IRS to track and properly tax earnings sourced beyond its jurisdiction.
Perhaps the most significant example is the Foreign Bank Account Reports (FBAR). Every US person (i.e., citizen or resident) must file annual disclosures of foreign accounts if, at any time during the year, the aggregate balance of such accounts exceeds US$10,000.
The FBAR is now filed electronically and must disclose the account number, financial institution, and maximum balance of any account over which the individual had signing authority during the year. This would include corporate accounts, investment accounts and even jointly held accounts.
US citizens are obligated to make FBAR filings to disclose all financial accounts over which they have signing authority. This would include a checquing account, RRSP, RESP and any corporate accounts that may exist.
US persons also have to file annual returns disclosing interests in foreign trusts, estates, corporations and partnerships and the receipt of substantial gifts from a nonresident.
FATCA – the next generation of offshore tax compliance laws
In 2010, the US passed the Foreign Accounts Tax Compliance Act (FATCA), which increases the probability of discovery if you are a US citizen abroad. Under FATCA, US taxpayers with foreign financial assets valued in the aggregate at $200,000-plus must disclose those accounts on Form 8938, attached to their income tax returns. There is some overlap, but the FATCA and FBAR disclosures remain separate, and are filed with different IRS departments.
The more significant aspect of FATCA, however, is the obligation for foreign financial institutions (FFI) to reveal the identity and assets of US citizen clients, or face 30% withholding on payments made from the US to those institutions.
On February 5, 2014, Canada and the US announced an intergovernmental agreement (IGA) that relieved the Canadian banks’ privacy concerns by permitting such information to be released to the CRA, rather than directly to the IRS. Certain registered investment assets, and smaller banks were also exempted from the rules imposed on FFIs.
However, as part of the new IGA, the IRS and CRA have agreed to a more comprehensive and automatic exchange of information on cross border taxpayers in a mutual effort to curb international tax evasion. It remains to be seen how this will be implemented, but there are expected to be fewer places to hide going forward.
Penalties for noncompliance
The penalties for not complying with US tax obligations can be significant. However, for tax compliant Canadian residents, penalties are usually more significant for failure to comply with the information returns, rather than income tax filings.
The penalties associated with a failure to file income tax returns are generally based on the amount left unpaid. However, because most tax-compliant Canadian resident US citizens have enough FTCs or FEIE available to offset any US tax liability, the penalties for failure to file are often not significant.
In contrast, penalties associated with information returns are set dollar amounts, usually set with the worst offenders in mind. For example, a willful failure to file FBARs can cost the greater of $100,000 per account per year, or 50% of the unreported balances. Even non-willful violations (i.e. those who can show that they didn’t know about the requirement) can still be penalized at $10,000 per account per year.
Most IRS penalties can be waived in part or in full at the discretion of the IRS. The taxpayer bears the burden for showing reasonable cause for noncompliance. However, where good faith ignorance of the reporting requirements can be shown, there is a fairly good history of success with reasonable cause cases. That said, the IRC also allows for criminal penalties, and the tax court has imposed prison time on tax evaders.
Options for catch-up filings
There are three principal avenues for coming into compliance with US tax obligations: participate in a Offshore Voluntary Disclosure Initiative; make a quiet disclosure; or enter the streamlined procedure.
Offshore Voluntary Disclosure Initiative
The OVDI program was launched in 2009 as a means of encouraging US taxpayers with undisclosed foreign assets to come clean with their reporting obligations. The program is available to taxpayers with undisclosed foreign accounts or assets, who are not under audit or criminal investigation. Once the IRS has initiated such investigations, the opportunity to participate in the OVDI is lost.
Generally, the OVDI process involves submitting full income tax and information returns (including FBAR) for the past eight years. On the basis of those disclosures, the OVDI participant agrees to pay reduced penalties (though some penalties are essentially guaranteed).
Rather than participating in the OVDI, some advocate coming into compliance through a quiet disclosure process. Up to six-year’s worth of returns are prepared and submitted to the IRS’s general service center. If any tax is shown to be due on those returns, a cheque would be sent, including applicable interest on tax due in prior years.
The hope in quiet disclosure submissions is that the IRS will not audit these returns, nor impose penalties. In many cases, this has been the result, especially when no tax is due on the filing. It should be noted that this is not an IRS sanctioned compliance route, and the US government has been pressuring the IRS to increase its scrutiny on quiet disclosures. Therefore, there is certainly no guarantee that future quiet disclosures will obtain the positive results that some have enjoyed in the past.
In June 2012, the IRS introduced the Streamlined Procedure for certain low-risk taxpayers seeking to re-enter the US tax system and become compliant. Where eligibility criteria are met, the taxpayer need only submit three years of income tax returns and six years of FBARs. Delinquent tax payments, plus applicable interest, must be remitted with the package. In such cases, the IRS will waive any penalties associated with the past noncompliance.
Most US citizens living in Canada are eligible for the Streamlined Procedure. Indicators of higher risk, which may deny access to this compliance option, include more than $1500 in net tax due per year, financial accounts in offshore jurisdictions, or US sourced income.
Tax Traps for US Citizens living in Canada
The US has enacted many tax rules designed to combat offshore tax evasion, which can cause grief for US citizens in Canada. Even though Canada is not a tax haven, such rules are often of general application, and the Canada – US Tax Treaty (which should provide relief) does not change quickly enough to keep up with US efforts to collect tax from overseas. This section looks at a few of the problems that Canadian advisers need to know about.
These rules may affect income or gains received by a US taxpayer from a passive foreign investment company (PFIC). A PFIC is defined as a foreign (i.e. non-US) corporation with either 75% or more of its gross income from passive sources or 50% or more of its assets held to produce passive income.
Where a US taxpayer holds a minority interest in a PFIC, extraordinary distributions from those shares (or gains realized in the sale of those shares) are subject to a punitive tax regime, commonly referred to as the throwback tax.
The throwback tax is calculated by taking the average distribution from the PFIC over the three prior years. Any distribution exceeding 125% of that average is allocated (or thrown back) over the entire period that the taxpayer has owned the shares. Any income allocated to a prior year is retroactively taxed at the highest marginal rate and accrues interest and penalties forward to the current tax year.
Many Canadian mutual funds are considered to be PFICs. We therefore recommend caution to US citizens in Canada to consider PFIC issues when making investment decisions. Non-controlling interests in Canadian holding companies can also trigger PFIC rules, so careful evaluation of such structures is warranted where US citizens are involved.
The registered retirement savings plan is a Canadian program that encourages retirement savings in two important ways: contributions made to qualifying plans are deductible from income in the year of contribution and any investment growth within that account is not taxable until withdrawals are made.
However, the IRS does not automatically recognize RRSPs as tax deferred retirement savings accounts. The default treatment is the same as any investment account; growth is taxable in the current year and no deductions are allowed for deposits to the account.
The Canada – US Tax Treaty does provide some relief in this situation. Form 8891 may be filed with a Form 1040 return to defer any investment income generated by an RRSP. However, contributions made to an RRSP are not deductible from US taxable income. This can lead to insufficient Foreign Tax Credits, and net US tax payable.
3. TFSA / RESP
A number of other Canadian tax advantaged accounts remain problematic for US citizens resident in Canada. Examples include registered education savings plans and tax-free savings accounts, both considered by the IRS to be trusts, triggering complicated US tax payments and disclosures that have no parallel in Canada. We recommend that US citizens consider avoiding such accounts for this reason.
Estate Planning for US Citizens in Canada
US citizens in Canada have added complexity in the tax aspects to their estate planning as well. Because US estate tax rules apply to citizens, regardless of residency, tax planning for the death of US citizens here must consider both the Canadian deemed disposition and the US rules.
Under current law, the estate of a US citizen decedent is entitled to an exclusion from tax. The exclusion was set at $5 million as of 2010 and is indexed for inflation; in 2014, $5.34 million can pass through an estate free of transfer taxes. Above that exclusion amount the estate tax is levied at a rate of 40% of the fair market value of the assets passed.
The exclusion amount is also reduced for gifts made during life that exceeded the annual gift tax exemption amount (currently, 143,000 per year to a non-citizen spouse and $14,000 per year to anyone else).
In the case of a marriage between a US citizen and a non-US citizen, planning can be incorporated into wills that will reduce the chance of having any estate tax payable. The estate of the non-citizen spouse will not be subject to US estate tax unless it contains assets situated within the US. However, if that spouse leaves everything directly to the US citizen spouse, the combined value on second to die may push the estate into a taxable position.
A very effective means of avoiding this situation is to include special provisions in a spousal trust drafted into the Canadian citizen’s will that would prevent her assets from being includable in the US citizen’s estate on second to die. If drafted properly, the US citizen would still be entitled to income and have access to reasonable amounts of capital from the estate, while not having to include spousal trust property in his US taxable estate.
Likewise, in the event that the US citizen dies first owning more than the applicable exclusion amount, provisions should be included in his will to permit the flexibility to either defer or exempt the tax on assets passing to the non-citizen survivor.
Deferral of estate tax can be achieved through a Qualified Domestic Trust, as provided in section 2056A of the IRC. This would offer ability to pay estate tax later upon withdrawal of capital from the trust, or upon the Canadian spouse’s subsequent death.
In the alternative, there may be marital credits that could be available under the Canada-US Tax Treaty that would offset the tax that is calculated on the US taxable estate.
Properly drafted cross border wills can provide the flexibility to determine the optimal plan only once there is a death, rather than locking into a specific path ahead of time. Such flexibility can be very helpful in the context of changing estate tax rules and asset values.