Tax Consequences for U.S. Persons in Canada

Given the close relations between Canada and the U.S., it is not uncommon to find U.S. citizens living in Canada. Some may be in Canada as the result of a temporary employment transfer, while others may have been living here for several years. As a U.S. citizen, you continue to have obligations for U.S. tax purposes, even though you may be resident in Canada. Note that these obligations also apply to “Green Card” holders who are treated like U.S. citizens for U.S. tax purposes. This bulletin outlines various U.S. tax obligations that these U.S. persons need to be aware of, even while living in Canada.

U.S. income tax requirements

Liability for U.S. income tax is based on citizenship, as well as residence. As a U.S. person, you must file annual U.S. income tax returns regardless of where you live or how long you have been away from the U.S. For U.S. tax purposes, you must report your worldwide income from all sources. You can, however, claim a credit against your U.S. tax liability for taxes you pay in Canada or where the income is earned. In many cases, the credit will be enough to eliminate any U.S. tax liability since Canadian taxes are generally higher.

As a result of the U.S. alternative minimum tax (AMT), in some cases prior to 2005, there was an additional U.S. tax liability that couldn’t be eliminated with a foreign tax credit claim. However, for taxable years beginning after December 31, 2004, the U.S. AMT rules have changed so that many U.S. persons resident in Canada may not be subject to the additional AMT. Note that other non-tax information reporting requirements may apply.

Canadian tax law will limit foreign tax credit claims allowed to U.S. persons. It is Canada’s position that foreign tax credits will only be permitted for taxes that would be paid by Canadian residents (non-U.S. persons) in a similar situation. This may result in additional tax costs for U.S. persons living in Canada.

Filing deadlines

Normally you must file your U.S. return for a particular year no later than April 15th of the year following the year in issue. However, there is an automatic extension to June 15th if you are resident outside the U.S. on April 15th. For example, if you are a U.S. person and are resident in Canada on April 15, 2007, you must file your 2006 U.S. tax return by June 15, 2007.

Penalties

If you ignore your U.S. filing obligation because you do not owe any U.S. taxes and the Internal Revenue Service (IRS) discovers that you did not file, you may lose the right to make certain important elections, such as the election to defer income earned in a Registered Retirement Savings Plan (RRSP) or Registered Retirement Income Fund (RRIF) (discussed in the next section), or to claim the “foreign earned income exclusion”. In the case of the foreign earned income exclusion, the exclusion could be denied if the tax return is not filed within one year of the original April 15th deadline for that year.

In addition to penalties and the potential loss of certain elections, problems can arise when you decide to return to the U.S. if you have not complied with your U.S. tax obligations while you were away. Previously unpaid taxes and late returns (which may subject you to interest and penalties) can make returning to the U.S. much more difficult.

In other cases, problems may arise on your death if you die owing unpaid taxes or if you failed to file returns, especially if your executor is also a U.S. person (perhaps, a son or daughter living in the U.S.). For example, the executor can be held personally liable for the unpaid tax liabilities of the estate.

If you travel on a U.S. passport, you may have difficulty getting your passport renewed if you cannot provide evidence that all required tax filings have been made.

Some taxpayers – especially those who do not plan on ever living in the U.S. again – take the position that the IRS will never catch up with them if they live in Canada and even if the U.S. government does, it would never be able to collect. Well, that’s not true. Under the Canada-U.S. tax treaty, the IRS can solicit the Canada Revenue Agency’s (CRA’s) assistance in collecting unpaid taxes from U.S. persons residing in Canada which the IRS has established to have been due in the last 10 years.

If you have not been filing your U.S. income tax returns, it appears that the IRS will permit you to file tax returns for the past three years to bring yourself up to date (note that if you have a tax liability in any of the past three years, the IRS will want two more years of past returns for a total of five years). However, the IRS reserves the right to go back further than five years. Contact your BDO tax advisor for assistance with filing your U.S. income tax returns.

U.S. reporting rules for RRSPs and RRIFs

If you own a Canadian RRSP or RRIF, under U.S. domestic law, you are required to include income and gains earned inside your RRSP or RRIF in your taxable income for U.S. tax purposes on a current year basis, rather than when this income is withdrawn (which is the case for Canadian tax purposes). Due to this timing mismatch, double taxation can result. However, there is relief under the Canada-U.S. tax treaty, which allows a U.S. person to elect to defer recognition of the income and gains in their U.S. taxable income until such time as the income is withdrawn from their RRSP or RRIF. Where this election is made, the timing of the taxation of the accrued RRSP or RRIF income will be the same in Canada and the U.S.

But, the election can generally only be made if you file your U.S. income tax return for the year in question on time. As discussed below, Form 8891 is used to make the election to defer RRSP and RRIF income not yet withdrawn.

The IRS has special reporting requirements for U.S. persons who have RRSPs or RRIFs (which apply whether or not an election has been made to defer current taxation of income earned in the RRSP or RRIF for U.S. purposes). For 2003 U.S. individual tax returns and subsequent years, the IRS released Form 8891 (note that there were other reporting requirements for years prior to this). Form 8891 must be completed if you hold an interest in an RRSP or RRIF, and the form must be attached to your U.S. tax return. The three purposes of this form, are as follows:

• to report distributions received from Canadian RRSPs and RRIFs,
• to report contributions and undistributed earnings, and
• to make the election to defer U.S. income tax on income in an RRSP or an RRIF that has accrued, but has not been distributed.

A separate Form 8891 must be filed for each RRSP or RRIF for which there is a filing requirement. In the situation where you and your spouse file jointly, Form 8891 must be filed for each spouse. Annuitants and beneficiaries who are required to file Form 8891 will not be required to file Form 3520 – the Annual Return to Report Transactions with Foreign Trusts.

The IRS has indicated that taxpayers must retain supporting documentation for the information required to be reported, including Canadian forms T4RSP, T4RIF, or NR4 and periodic or annual statements issued by the custodian of the RRSP or RRIF.

Other Canadian deferred income plans

As discussed earlier, Canada and the U.S. have worked together over the years to ensure that treatment of RRSPs and RRIFs by each is consistent. However, you should not assume this is true for all Canadian investments where special tax rules apply. For example, problems can arise where a U.S. person holds a Registered Education Savings Plan (RESP) or a Retirement Compensation Arrangement (RCA), as discussed below.

Canadian RESPs

U.S. persons living in Canada can invest in RESPs – but doing so may have negative consequences for U.S. tax purposes. The main disadvantage is that, unlike RRSPs and RRIFs, U.S. persons cannot elect to defer the taxation of income earned in an RESP.

The U.S. tax implications for RESPs depend mainly on the residency of the contributing parent and the beneficiary child.

Contributing Parent is a U.S. Citizen or Resident (Foreign Grantor Trust): The income earned within the plan (excluding unrealized capital gains, but including Canadian Education Savings Grants) is taxable to the parent for U.S. tax purposes. There are no income tax consequences upon withdrawal of the funds. However, there is an element of double taxation. As noted, for U.S. tax purposes, the plan income will be taxable to the parent, but for Canadian tax purposes the income will generally be taxable in the hands of the child when they go to university or college.

Contributing Parent is Not a U.S. Citizen or Resident (Foreign Nongrantor Trust): The income earned within the plan is not taxable to any party when earned. However, if the child is a U.S. citizen or resident, the accumulated income is taxable to the child upon withdrawal of the funds. A special prescribed tax and interest charge is calculated based on the accumulated income distributed from the plan, which achieves roughly the same result as if the income were taxed as it was earned over the life of the RESP.

Since an RESP is a foreign trust, U.S. persons who invest in them are subject to the U.S. reporting requirements for foreign trusts. The ability to obtain the tax treatment as described above can be jeopardized if the proper U.S. tax reporting forms are not completed. In certain cases, a portion of the original RESP contributions may be taxable to the beneficiary, if the appropriate forms are not filed. To understand the required reporting requirements, contact your BDO advisor.

If you are considering contributing to an RESP for your child in order to take advantage of the Canada Education Savings Grant, it is important to consider the consequences described above. In certain cases, it would be better for another relative in Canada (who is not a U.S. person) to set up the RESP. For example, if a U.S. person marries a Canadian and they have a child (who is not a U.S. person), contributions by the parents of the Canadian spouse could be made for a grandchild, thereby avoiding the U.S. issues.

RCA payments

RCAs are a special type of trust established by an employer for an employee’s retirement. The treaty deferral provisions under the Canada-U.S. treaty for RRSPs and RRIFs again do not apply to payments out of RCAs. As a result, if a U.S. person resident in Canada receives a payment out of an RCA there may be a mismatch with respect to both the income earned in the RCA and the contributions. For U.S. purposes, the contribution will be taxed as employment income at the time the employer contributes to the RCA and income in the RCA will be taxed as it is earned. For Canadian purposes, the contribution and the accumulated income are ultimately taxable when paid out to the employee (refundable tax is charged first, but is later refunded as payments are made to the beneficiary). Of course, the timing can provide a benefit where you are present in Canada for a short period or where you are contemplating giving up Canadian residence. But, RCAs may not be advisable for U.S. persons who will not return to the U.S.

If you are considering a Canadian deferred income plan, consult with your BDO advisor to determine the tax consequences from both a U.S. and Canadian tax perspective.

U.S. Social Security

As a U.S. person resident in Canada, if you receive U.S. Social Security payments, you will effectively have to include 85% of the payments in your Canadian income tax return. However, you will not be subject to tax on this income in the U.S., as you will be able to deduct the amount by claiming a treaty exemption on your U.S. income tax return.

Investments in foreign corporations

As mentioned, U.S. persons must report their worldwide income for U.S. tax purposes. If a U.S. person invests in a foreign corporation (such as a Canadian corporation held by a U.S. citizen living in Canada), a potential deferral exists to the extent the U.S. person is not taxed until actual distributions are made by the foreign corporation. To prevent a deferral benefit on certain types of income, the U.S. has certain anti-deferral regimes in place. If you own or are considering the purchase of shares of certain types of non-U.S. corporations, you must be careful that you don’t become subject to these anti-deferral regimes, which can capture foreign income earned in respect of the shares.

Two significant U.S. anti-deferral regimes include:

• Controlled Foreign Corporations (CFCs), and
• Passive Foreign Investment Companies (PFICs).
  

Note that a third anti-deferral regime alsob existed – known as Foreign Personal Holding Companies (FPHCs), However, the rules related to this regime were repealed effective for taxable years beginning January 1, 2005.

Generally speaking, if you are considering an interest in a non-U.S. corporation where more than 50% of the shares (based on votes and value) are owned by U.S. persons, or more than 75% of a corporation’s income is passive income, or 50% or more of the corporation’s assets are passive assets, you may be taxable for U.S. purposes under one of the two existing anti-deferral regimes. These regimes impose tax on a current basis, or on a deferred basis with an interest charge, on income earned by a U.S. person through the foreign corporation. For example, you may be required to include a portion of the passive income of the non-U.S. corporation in your taxable income in the year the income is earned by the corporation, even though you have not yet received an actual distribution from the corporation related to that passive income. This treatment can result in mismatches with the timing of Canadian tax and result in double taxation.

Another consequence under the PFIC regime (and the former FPHC regime) is that in certain situations, shares acquired by inheritance do not receive a “stepped-up basis” for U.S. tax purposes, which means that the person inherits the shares at their original cost, not at the fair market value of the shares on the date of death. Note, however, that with the repeal of the FPHC rules, a number of related issues will be eliminated where certain conditions are met.

Some Canadian estate planning for U.S. persons can put you right into the anti-deferral regime rules, especially the onerous PFIC rules. As just one example, although shares of an operating company may be exempt from these rules, the use of a Canadian holding company can create passive asset holdings and significant problems.

When U.S. persons are involved in Canadian estate freezes, U.S. income tax issues can arise, as well as estate and gift tax issues (discussed below). It is important to consider all of the U.S. tax issues when U.S. persons hold Canadian corporations. There is a potential for double taxation and significant penalties for not complying with U.S. tax filing requirements if U.S. tax rules are not considered.

The rules regarding U.S. persons investing in non-U.S. corporations are complex. If you are considering taking an interest in a private Canadian corporation or reorganizing an existing corporation, consult with your BDO tax advisor.

Estate tax

U.S. income tax is not the only concern for U.S. persons residing in Canada. On your death, U.S. estate tax will apply to the fair market value of your entire worldwide estate, not just those assets situated in the U.S. The estate tax is then applied at graduated rates to this amount.

In June 2001, the U.S. passed a law that phases out the estate tax over the next decade. Under the legislation, the estate tax rate is gradually reduced and the exemption amounts gradually increased. Based on the changes made, the estate tax will be repealed for the 2010 year. However, this change may not be permanent.

Unlike Canadian tax law, the 2001 changes were contained in legislation referred to as a reconciliation act, and consequently, it was necessary to include a “sunset clause” to comply with U.S. law. Ignoring the legalities, what this really means is that the changes enacted will not apply after December 31, 2010. So, unless further steps are taken, the repeal of the estate tax will only actually last for one year – 2010. In 2011, the system will revert back to the rules that applied just before the 2001 reconciliation bill was enacted. Unfortunately, it is difficult to predict whether further steps will be taken to make this repeal permanent, or to perhaps continue the rules as they apply for 2009.

From a practical point of view this will make planning much more difficult. Planning for a nine-year phase out could be quite different than a plan under the assumption that some sort of estate tax will remain after the phase out period ends.

How the estate tax applies

Estates of U.S. persons are subject to U.S. estate tax based on the fair market value of worldwide assets and are entitled to a “unified credit”, which effectively exempts a portion of the estate from estate tax. For U.S. persons, the unified credit is based on an effective exemption amount of $2.0 million U.S. for 2007 and will remain at $2.0 million U.S. until 2009 when it will increase to $3.5 million U.S., as shown in the table below. As well, the top estate tax rates are being reduced, also shown below. Other graduated rates remain unchanged. Estate tax can be reduced by a marital credit for a transfer of property to a spouse if the spouse is a U.S. citizen or, if the spouse is not a U.S. citizen, on a transfer of property to a “qualified domestic trust”.

For 2007, the graduated estate tax rates and the unified credit are as follows:

Unlike the U.S., Canada does not have an estate tax. But, when Canadian residents die, they are deemed to dispose of all their capital property at fair market value, unless the property flows to a spouse. Fortunately, any U.S. estate tax that has to be paid on death may be eligible as a credit against Canadian income tax in the year of death on U.S. source gains and income. Similarly, any Canadian income taxes resulting from death may be eligible as a credit against U.S. estate tax.

U.S. income tax rules

Under current U.S. tax rules, where an asset is subject to estate tax, the heirs of the deceased generally inherit the asset with a cost base for U.S. income tax purposes equal to fair market value on the date of death (though there are exceptions to this general rule). This means that someone who inherits property will only be liable for tax on any appreciation in value that accrues while they own the property – they will not be taxed on any appreciation in value that occurred while the property was owned during the lifetime of the deceased. However, when the estate tax is fully repealed in 2010, this rule will no longer apply. As previously mentioned, if the system reverts back to the rules before the 2001 reconciliation bill was enacted, these rules will apply once more for 2011 and subsequent taxations years, subject to changes.

Though the rules are complicated, for U.S. estate tax purposes when the estate tax is fully repealed for 2010, two general rules will apply regarding the cost base of property inherited on death:

• Where property is transferred by a U.S. person to another U.S. person on death, the new owner will assume the property at its original cost for U.S. tax purposes.
• Where a U.S. person transfers property on death to a non-resident alien, the property will be disposed of by the deceased at fair market value. So, if a U.S. person dies in 2010 and leaves U.S. property to a Canadian resident (who is not also a U.S. citizen), the Canadian will not end up paying tax on any appreciation in value that occurred during the lifetime of the deceased.

Given that the estate tax exemption amount provided for a tax-free transfer of smaller estates, the income tax rules have also been changed to provide for various cost base increases on death. For smaller estates, this change will ensure that accrued capital gains will not be passed on to the next generation, to be taxed in their hands.

Gift tax

U.S. persons are subject to gift tax on the direct or indirect transfer of property by gift. The gift tax is imposed on the donor and applies to the extent that the value of the property transferred exceeds allowable exclusions and deductions. As well, reporting requirements are generally imposed on U.S. persons who receive aggregate foreign gifts in excess of $12,000 U.S. during the year in 2006 or 2007. Like the estate tax, the gift tax rate is decreasing each year until 2009.

As previously mentioned, an estate freeze of a Canadian corporation can result in gift tax concerns if the freeze is not properly structured. If you give or receive a gift valued at more than $12,000 U.S. in 2006 or 2007, you should discuss the consequences with your BDO tax advisor.

Foreign tax credits

Canada has become more aggressive on its taxation of worldwide income. To claim a foreign tax credit on foreign income, the income has to be subject to tax in the foreign jurisdiction (in other words, it can’t be exempt in the foreign country). This will likely increase the overall tax cost of U.S. persons who are residents of Canada, since they are no longer able to “force” foreign sourced income to maximize foreign tax credit claims in Canada.

Relinquishing U.S. citizenship

Given the onerous reporting requirements the U.S. imposes on its citizens regardless of where they reside, some U.S. citizens living permanently in Canada may wonder whether it is advantageous (for tax purposes) to relinquish their U.S. citizenship. Unfortunately, there are rules in place which strengthen the U.S. government’s ability to tax U.S. source income after an individual leaves the U.S. at the rates applicable to U.S. citizens rather than at lower tax rates that apply to non-resident aliens.

There have been recent changes to the tax rules that apply if you relinquish U.S. citizenship. When you expatriate after June 3, 2004, you will be subject to U.S. tax as though you continue to be a U.S. citizen if you meet one of the following conditions:

• Your average annual net income tax liability for the five years preceding the date you relinquish your citizenship exceeds $136,000 for 2007 ($131,000 for 2006),
• Your net worth on the date you relinquish your citizenship exceeds $2 million,
• You fail to certify under penalties of perjury that you have complied with all of your tax obligations for the preceding five tax years, or
• You have not given notice of your expatriation.

The expatriate tax will also apply if you are present in the U.S. for more than 30 days in any calendar year during the 10 years following the date you relinquish citizenship (60 days for individuals working in the U.S. for an unrelated employer). Dual citizens and minors who have had no substantial contact with the U.S. will not be subject to the new rules, although they will need to provide certification that they have complied with their U.S. tax obligations.

Note also that the expatriate tax will apply only if it is greater than the amount of tax that would otherwise be imposed if you were taxed as a non-resident alien. Certain adjustments will be made to income and deductions in this calculation.

If you expatriated before June 4, 2004, the expatriate tax applies only if your primary purpose for giving up U.S. citizenship was to avoid U.S. tax. Under these former rules, the U.S. presumes that you gave up your citizenship to avoid U.S. tax on your worldwide income if your average annual U.S. income tax liability for the five preceding years exceeds $124,000 U.S. (for 2004), or your net worth on the date you relinquish your citizenship is $622,000 U.S. (for 2004) or more. However, for expatriations before June 4, 2004, you could request a ruling within one year of expatriation to prove that tax avoidance was not the motive for relinquishing your citizenship. This rulings process was eliminated for expatriations after June 3, 2004.

If you are considering relinquishing your U.S. citizenship, contact your BDO tax advisor to determine how these rules will affect you.

Summary

We strongly encourage all clients to comply with IRS filing requirements. It is important to remember that although you are a Canadian resident, as a U.S. citizen or Green Card holder, you continue to have U.S. tax obligations. It’s to your advantage to maintain yourself in good standing for future dealings with the U.S. authorities, particularly if you plan to return to the U.S. one day.

Don’t let the situations discussed above happen to you – ensure that all of your required U.S. tax obligations are met on a timely basis. Your BDO tax advisor is ready to help.

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