Virtually every country in the world uses place of residency to determine whether or not you are subject to tax, with the notable exception of the United States of America.
The U.S. assesses taxability based upon citizenship, not where you reside. In other words, no matter where you live, if you are a U.S. citizen, you are expected to file a U.S. income tax return. That doesn’t necessarily mean you’ll end up paying tax to the US, but it does mean there are filing requirements and, importantly, the potential for very substantial penalties if you fail to meet those filing requirements.
Basic Filing and Reporting Requirements
All U.S. citizens living in Canada should be filing an annual U.S. tax return that reports worldwide income. The return, known as Form 1040, doesn’t eliminate your requirement to file a Canadian tax return—you still have to do that and, more to the point, you’ll want to since the foreign tax credits arising from Canadian taxes will serve to largely mitigate the potential for double taxation (i.e., both U.S. and Canada). Foreign tax credits let you use any Canadian income tax you pay to reduce the U.S. taxes that would otherwise be payable on the same income.
There are other mandatory U.S. informational filing requirements in addition to the annual Form 1040. The most common and significant of these additional requirements is a summary of your financial investments. If you have one or more accounts (including registered investment accounts) in a foreign (meaning non-U.S.) country and the aggregate value of those accounts is over $10,000, you are expected to file a Report of Foreign Bank and Financial Accounts (“FBAR”) using Form FINCen 114E.
You should be aware that under the U.S. FATCA law, Canadian financial institutions are now required to identify and report on accounts held for US citizens. This information is reported to Canada Revenue, who provides it to the Internal Revenue Service as part of their annual information exchange. Starting in 2020, U.S. tax numbers are required to be provided as part of this exchange. Failure to file the FBAR could lead to some very significant penalties. There is a possibility that penalties could be waived or reduced if you either demonstrate reasonable cause for failing to file or certify that failing to file was non-willful. However, recognize that foreign investment reporting and collecting tax from non-resident U.S. citizens has been a major priority in the U.S. in recent years.
Other Foreign Asset Reporting Requirements
If you have certain foreign (i.e., non-U.S.) assets exceeding $200,000 USD at the end of the year, or exceeding $300,000 USD at any point in the year, you are required to disclose these assets in an additional form with your U.S. income tax return. The specified assets include, but aren’t limited to, bank accounts, RRSPs, stocks, pensions/annuities, partnerships, trusts, debt instruments, mutual funds and insurance contracts. The required form is Form 8938, Statement of Specified Foreign Financial Assets. This reporting requirement is over and above the FBAR filing requirement described above.
What to Do if You Haven’t Filed in the Past
Although many of these filing and reporting requirements aren’t new, they certainly are getting more IRS attention than in the past. Financial institutions, like your Canadian bank, are required to report more information about U.S. citizens to the IRS and even simply travelling to the U.S. can trigger attention to your situation. Accordingly, many people are looking for the most painless way to become compliant.
The good news is that the IRS is willing to offer relief from penalties if you are a current or former U.S. citizen living in Canada and you’ve been unaware of your U.S. income tax obligations.
If you are currently a U.S. citizen and have been living outside the U.S., you may file with the IRS under their Streamlined Filing Procedures (“Streamline”) and no penalties will be imposed. The required documents include three years of past income tax returns due, FBARs for the past six years and a statement certifying that the failure to file the returns was a result of “non-willful conduct.”
If you have expatriated after March 18, 2010, or are planning to expatriate and have never filed a U.S. tax return, you might qualify for the Relief Procedures for Certain Former Citizens. Though similar to the Streamlined, which provides the abatement of penalties on late filed returns under the procedure, this program will also forgive up to $25,000 in tax, avoid any penalty interest charges and the U.S. “exit tax” that can apply when a final return is not filed on a timely basis. The required documents include six years of past income tax returns and FBARs including the year of renunciation and a statement certifying that the failure to file the returns was a result of “non-willful conduct.”
Bear in mind that the potential for relief is intended to apply to those that inadvertently did not comply with the filing requirements. If the IRS believes you knew you should be filing, but didn’t do so anyhow, then it may be harder to get the relief.
Since each situation is different, it is important to determine whether you qualify for one of the programs and which one is better suited for your situation.
Key U.S./Canadian Taxation Differences
All income tax regimes are not the same and there are some critical differences between taxation in Canada and the US that you need to be aware of. These include:
- TFSA – As the name suggests, income earned in a Tax Free Savings Account is certainly tax free in Canada but unfortunately, it is taxable for U.S. purposes. Therefore, in general, TFSAs aren’t a great choice for U.S. citizens residing in Canada.
- RESP – Like the TFSA, income earned in a Registered Education Savings Plan isn’t immediately taxable in Canada but is considered taxable income in the U.S. Citizens of the U.S. residing in Canada should revisit whether it is worthwhile to establish or maintain RESPs.
- Capital gains – The Canadian capital gains exemptions, such as the lifetime capital gains exemption and the Principal Residence Exemption, are not applicable for U.S. income tax purposes. However, you may be able to claim $250,000 USD capital gains exclusion on the sale of your primary residence for U.S. tax purposes if certain criteria are met.
Other Thoughts
As your life, financial affairs and estate planning get more complex, so do the potential US/Canadian taxation implications. Below are a few items that frequently arise in tax and estate planning matters involving U.S. citizens residing in Canada.
Passive Foreign Investment Company (PFIC)
A PFIC is a non-U.S. corporation that derives most of its income from passive sources such as dividends, interest and rent. Similarly, a corporation where at least half of the assets produce passive income is a PFIC. Most Canadian mutual fund companies will be considered PFICs. Your own Canadian holding company may also be a PFIC.
U.S. citizens receiving distributions from PFICs are subject to additional tax and annual reporting requirements. Accordingly, individuals with these types of investments may want to revisit their investment portfolios and structures.
Controlled Foreign Corporations (CFC)
What’s a CFC? Basically, any non-U.S. corporation is a CFC for U.S. tax purposes if more than half of the corporation is owned by one or more U.S. citizens.
U.S. citizens holding shares in a CFC may be required to report their pro-rata share of the corporation’s income on their U.S. income tax return, even if the corporation does not distribute the income. There may also be further reporting and disclosure requirements.
In 2018, the new tax regime was introduced for what the U.S. calls “Global Intangible Low Taxed Income” or GILTI. Starting January 2018, income earned through a Canadian corporation that is controlled by U.S. citizens must be classified as GILTI or not. If income is classified as GILTI, it is included in the income of the individual shareholder in the year it is earned, and the ability to offset the tax on the income with foreign tax credits is limited. Whether the income is considered GILTI or not and what reporting and disclosures are required depends on several factors.
Foreign Trusts
Distributions from foreign trusts, meaning non-U.S. trusts, may have to be included on your U.S. income tax return even if the trust has been subject to Canadian income tax. There may also be an interest component added to income stemming from the distribution. Further, it may be that distributions of capital (not taxable in Canada) will be treated as income distributions for U.S. purposes. Lastly, there may be additional annual reporting requirements. In other words, if you are party to a non-U.S trust, you have much to consider.
U.S. Estate and Gift Tax
Staying consistent with taxing worldwide income regardless of your country of residence, the value of your worldwide assets is subject to U.S. estate taxes at the time of your death less the applicable exemption/exclusion amounts. There are ways to mitigate this as part of your estate planning.
U.S. taxpayers are also subject to gift tax on the lifetime transfer of assets. Like estate taxes, there is an exclusion amount, but it is important to realize the exclusion amount is shared with estate tax. In other words, any exclusion used to shelter gift tax will reduce the ability to shelter subsequent estate taxes. You can, however, gift certain amounts (subject to annual and lifetime limits) without triggering gift tax or lifetime exclusion erosion.
Giving up Your U.S. Citizenship
Because U.S. taxes are based upon citizenship, the most basic way to eliminate U.S. taxation and reporting requirements is to relinquish citizenship. However, there are many aspects to this decision, not all of which are investment or tax driven. Moreover, giving up your US citizenship may be a lengthy and complicated process and may trigger substantial “exit taxes” if your net worth is greater than $2,000,000. We urge you to discuss all aspects of giving up your U.S. citizenship with qualified professionals before taking any action.
If you have any questions regarding the filing of US returns, please contact your tax advisor at Cameron Izard Snell LLP for more information.