US Citizens Living in Canada – Cross-Border Tax Considerations

With an estimated one million US citizens living abroad in Canada, many of them are unaware of their US tax filing obligations. The US income tax, estate tax, and anti-deferral regimes all pose difficulties for US citizens living abroad. The following outlines the US tax exposure and various planning opportunities every US citizen living in Canada needs to take into consideration.

US Tax Filing Requirements

Are you a US citizen? While this question seems simple enough, under US law persons can be US citizens in a multiple of ways. Being born in the US, having both US parents, and having one US parent can all trigger US citizenship.[1]         

The United States taxes all of their citizens on all worldwide income earned during a given year.[2] By law, every US citizen is required to file a US income tax return.[3] Many US citizens living abroad are unaware of this fact, either because they earn all income abroad or they pay higher taxes in their residence country (as in Canada). Not filing a US income tax return can result in fines, penalties, and possible criminal charges.[4]          

In addition to the basic personal US income tax return, if a US citizen living in Canada has a Canadian financial account (personal bank / savings account, RRSP, TFSA, stock brokerage account, etc.) with an aggregate balance of US$10,000 or greater the taxpayer must file a Report of Foreign Bank and Financial Accounts (Form TD F. 90-22.1), better known as an FBAR form. Furthermore, if the US citizen owns a RRSP an 8891 form is required and if a TFSA is owned a 3520 form is also required. In other instances, more forms will also need to be filed each and every year.

US Estate Tax

When a US citizen dies, their assets could be subject to the US estate tax regime. Unlike the income tax, the estate tax is riddled with exemptions and as a result only US citizens meeting certain criteria must file a US estate tax return and are possibly subject to an estate tax liability.

Under current law, the US estate tax exemption amount is US$5 million and the tax rate is 35 per cent. What this means is if a US citizen has worldwide assets under US$5 million, no estate tax will be owed. If the value of assets exceeds US$5 million, estate tax might be owed at a rate of 35 per cent of the excess over US$5 million. However, it should be noted the current exemption amount and rate is only valid law until December 31, 2012. On January 1, 2013 the exemption amount will decrease to US$1 million and the tax rate will increase to 55 per cent.[5]

To properly plan for a client’s estate, certain questions must be asked to avoid negative tax consequences. Are both spouses US citizens? Is one spouse a US citizen and the other a Canadian (a mixed marriage)? What about the citizenship status of the children? Do two Canadian citizen residents own US situs property? Each answer can result in a completely different estate plan.

If both spouses are US citizens, certain planning opportunities are available that are not to a mixed marriage. First, the surviving spouse can use any remaining unused exemption amount of the predeceasing spouse. Second, there is an unlimited marital deduction allowed to the surviving spouse. For example, to put the two points together, if a married couple has a net worth of US$7 million and the Will gives all the assets to the surviving spouse, no estate tax is due. This is because by leaving all assets to the surviving spouse you receive a full marital deduction. When the surviving spouse dies, they can utilize the unused US$5 million exemption of the first spouse thus exempting all US$7 million. However, it must be noted this portability of unused exemption is not permanent and is also set to expire on December 31, 2012.[6]

If one spouse is a US citizen and the other spouse is a Canadian citizen, certain planning devices need to be in place. First, if the US citizen spouse dies and the surviving spouse is a Canadian citizen and resident, there is no marital deduction.[7] Thus, to avoid any possible US estate taxes the US citizen’s Will can only bequeath assets up to the applicable exemption amount. One option to defer US estate tax is through a ‘qualified domestic trust’ (QDOT).[8] For example, if a US citizen has assets greater than the exemption amount, those assets can be placed in a QDOT trust and those assets will defer estate tax until the death of the surviving spouse. If the trust does not qualify for a QDOT because of incorrect drafting or encroachment of the QDOT assets, then the estate may be liable for current tax. However, a QDOT trust comes with administration costs and since it does not eliminate estate tax it could be in the best interest of the estate to pay estate taxes at the death of the first spouse depending on a proper mathematical analysis.

The children of two US citizens living in Canada or children from a mixed marriage need to be considered before any estate planning is implemented to ensure no negative US tax consequences. The main concern is when a US citizen child is the beneficiary of a Canadian trust. Under US tax law, if the trust accumulates any income during a given year the US beneficiary will be subject to a “throw-back” tax and interest penalties. This consequence can be avoided by distributing all income realized by the trust to the US beneficiary during the applicable year.

The US estate tax regime can also apply to Canadian citizen residents who own US situs property.[9] US situs property includes US real property and tangible property including but not limited to US stock, bonds, and personal goods.[10] If the net value of all US situs property is greater than the applicable exclusion amount there is US estate tax exposure. However, with proper planning, Canadian citizens / residents can avoid US estate tax exposure. For example, real property can be bought using a Canadian nongrantor trust which, under US tax law, will be deemed the true owner of the property and therefore shielding the Canadian citizen from US estate tax.

It must be noted that in addition to possible US estate tax, a US citizen - Canadian resident is also subject to Canadian taxes at death. Under Canadian law, a resident is deemed to have disposed of all assets at fair market value at death.[11] As a result, US citizens who are Canadian residents need to properly plan to mitigate potential taxes.

CFCs and PFICs

A US citizen resident in Canada must be aware of certain business structures and investments, which could cause negative US tax consequences. Among these structures include controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs).

A CFC is a foreign corporation whose shareholders are US citizens and meet certain requirements.[12] A US shareholder is defined as a person who owns 10 per cent or more of the total combined voting power of all classes of stock that are entitled to vote.[13] In addition, to gain CFC status 50 per cent or more of the vote or value must be owned by US shareholders.[14] The result of meeting this two part test means the US shareholders are subject to Subpart F income,[15] thus requiring current taxation of income attributable to their interest in the CFC and thus eliminating deferral. In addition, US shareholders are required to report their interest in a CFC by filing Form 5471 every year.

CFC status can provide obstacles in many instances. For example, most passive income earned by the CFC is considered Subpart F income.[16] However, there are exceptions such as rents attributable to active business income and Subpart F income subject to high foreign tax.[17] Furthermore, if the CFC provisions do not capture the targeted income during the shareholders ownership of the stock, the Code ensures upon disposition of the stock the shareholder realizes earnings as ordinary income and does not receive preferred capital gain treatment.[18]

A PFIC is a foreign corporation that meets either the passive income test or the passive assets test.[19] The passive income test states a foreign corporation is a PFIC if 75 per cent or more of its gross income for the taxable year consists of passive income.[20] Passive income includes dividends, interest, rents, royalties, annuities, and certain income from contracts and transactions.[21] The passive assets test states a foreign corporation is a PFIC if the average annual percentage of the fair market value of its passive income-producing assets represents at least 50 percent of the value of the entities assets.[22]

The consequence of PFIC status is three possible taxing schemes for its US shareholders. These schemes include the tax and interest regime, the ‘qualifying elective fund’ (QEF), and the mark-to-market regime.[23] It should be noted if a QEF election is not made, there are possible negative tax consequences if an excess distribution is made.

Conclusion

The US citizen, Canadian resident needs to be aware of potential US tax consequences and plan accordingly. In most occasions these negative tax consequences can be reduced or eliminated with proper planning.

Circular 230 Disclosure: Internal Revenue Service regulations provide that, for the purpose of avoiding certain penalties under the Internal Revenue Code, taxpayers may rely only on opinions of counsel that meet specific requirements set forth in the regulations, including a requirement that such opinions contain extensive factual and legal discussion and analysis. Any tax advice that may be contained herein does not constitute an opinion that meets the requirements of the regulations. Any such tax advice therefore cannot be used, and was not intended or written to be used, for the purpose of avoiding any federal tax penalties that the Internal Revenue Service may attempt to impose.

The foregoing information is provided for general informational purposes only and readers are encouraged to consult with their professional advisors as to their specific circumstances.

[1] See 8 U.S.C. §1401(a), (c), (d).

[2] Reg. §1.1-1(b).

[3] The exception to the general rule is if your worldwide income is less than a certain dollar amount you do not need to file an income tax return. For example, if income is less than $9,350 for a single person under 65 years old then no income tax return is due. See also IRC §6651.

[4] See IRC §6651, §7201, §7202, §7203.

[5] The Obama Administration has proposed a 3.5 million exemption and a tax rate of 45 percent.

[6] The Obama Administration has expressed their desire to make this portability permanent.

[7] IRC §2056(d).

[8] IRC §2056A.

[9] IRC §2103.

[10] IRC §2104.

[11] Income Tax Act (Canada) Subsection 70(5).

[12] See IRC §§957, 958.

[13] IRC §951(b).

[14] IRC §957(a).

[15] IRC §951(a)(1)(A)(i).

[16] IRC §954(c)(1).

[17] IRC §954(b)(4), (c)(2), (c)(3).

[18] IRC §1248.

[19] IRC §1297(a).

[20] IRC §1297(a)(1).

[21] IRC §954(c)(1).

[22] IRC §§1297(a)(2) and 1297(e).

[23] See IRC §1291, §1296, §1293