Americans living in Canada have it rough when it comes to taxes. Not only do they have to navigate the Canadian tax system like all other Canadian residents, but they also have to take into account the tax rules from the south of the border at the same time. As discussed in a separate blog post, the U.S. is one of the few countries in the world that taxes its citizens regardless of where they live. Dealing with taxes can sometimes feel like trying to ride a unicycle while juggling a set of bowling pins at the same time.
While it would be impossible to address all topics in a single article, this is a list of some of the most common issues U.S. citizens living in Canada have to deal with in the tax world.
1. TFSAs
Tax Free Savings Accounts (TFSAs) are great, tax-efficient accounts for Canadians. Canada allows individuals to contribute a set amount of after-tax dollars into a TFSA each year. Earnings and growth within a TFSA are generally not taxable, even when amounts are subsequently withdrawn. For those familiar with U.S. tax concepts, this is similar to a Roth IRA, but in many ways it’s even better, since it doesn’t have the same retirement age requirement for a distribution to be nontaxable.
Unfortunately, however, the U.S. does not grant TFSAs the same beneficial tax status that Canada does. It will tax the accountholder on the TFSA income and gains as they’re earned, as if it were a regular investment account. The Tax Free Savings Account is not so “tax free” for the U.S. Not only this, but it’s possible a TFSA may be considered a foreign trust for U.S. tax purposes, requiring additional reporting with hefty penalties for late or missed filings (we’re talking minimum $10,000 USD penalties per form per year in many cases).
For U.S. citizens living abroad, make sure you’re aware of the U.S. tax consequences before opening a TFSA. Consider whether the benefits from the Canadian tax savings outweigh the U.S. tax and compliance costs.
2. RESPs
Registered Education Savings Plans (RESPs) are Canadian plans designed to encourage parents or grandparents to save for their children’s or grandchildren’s education. After-tax dollars are contributed to an RESP, which then grow tax free. Further, there’s a partial government match of contributions made. It’s a slam dunk for Canadian tax purposes.
Similar to TFSAs, however, the U.S. offers no such tax benefits to U.S. citizens living in Canada with an RESP. Further, the government match portion would be taxable income to you for U.S. tax purposes. Fortunately, guidance issued by the IRS in 2020 provided some relief to the foreign trust filing obligations related to RESPs, but U.S. citizens living in Canada should still be aware of how it will impact their U.S. tax and filings.
3. Principal Residence Exemption
When you sell your home in Canada, you generally don’t pay any Canadian income tax on any gain thanks to the principal residence exemption. The U.S. does offer a principal residence exclusion, but it is much more limited in its applicability. Further, the amount of gain excluded from income for U.S. tax purposes is limited to $250,000 USD ($500,000 USD if married filing jointly). If you, a U.S. citizen, are selling a home you’ve owned for a while that has appreciated significantly in value, don’t get too cozy with the idea of the sale being tax free. This could be a situation where Uncle Sam swoops in and takes a cut.
4. PFICs
The U.S. does not like its taxpayers parking investments offshore where it can’t tax them. As such, there is a complex regime for what the U.S. calls Passive Foreign Investment Companies (PFICs) to effectively claw back tax on income from certain foreign investments by applying a nasty interest charge to certain distributions and limiting the ability to use favourable tax rates on long-term capital gains, among other things. The rules surrounding PFICs are very complex. Unfortunately, common Canadian investments including mutual funds, ETFs, REITs, and index funds often meet the definition of a PFIC. What could be a seemingly standard Canadian investment could be a huge headache for U.S. tax purposes requiring complex annual reporting and punitive tax rules. Be sure to consult with your investment advisor and a U.S. tax professional before investing to make sure you navigate these rules as effectively as possible.
5. Foreign Corporations
Many self-employed Canadians set up corporations to take advantage of lower corporate tax rates and some tax-deferral related to investments held inside a corporation, as well as to benefit from the liability protection that a corporation provides. The U.S., however, has some very complicated anti-deferral regimes targeted at U.S. taxpayers placing their income or investments in foreign corporations. Depending on your ownership stake in the corporation and who else owns it along with you, these complex regimes may apply to you. The most common scenarios are the application of what’s referred to as Subpart F as well as a regime called Global Intangible Low-taxed Income (GILTI).
For Subpart F, the most common issue for individual taxpayers is when their corporation earns certain types of passive income, such as interest, dividends, gains, rental income, royalties, etc. There are other types of Subpart F income as well, though they’re less common with individual shareholders. Generally, a corporation pays tax at the corporate level, and the shareholder is only taxed once the earnings are distributed in the form of dividends. However, Subpart F essentially looks through the corporation and taxes the individual shareholder on that income as it’s earned, regardless of when it’s distributed out. This can create a timing mismatch between when the U.S. taxes the shareholder (in the year the corporation earns the passive income) and when Canada taxes the shareholder (in the year the earnings are distributed as dividends). This can be a big problem when it comes to claiming foreign tax credits, and may result in the same income being taxed twice – once by the U.S. and once by Canada.
GILTI is aimed at companies parking their intellectual property in low-tax foreign jurisdictions. However, it also happens to affect individuals owning foreign companies without a lot of fixed assets. This means that professionals such as doctors, lawyers, accountants, and consultants also often get caught by this regime. While the rules and calculations are different from Subpart F, it creates a similar outcome – the shareholder is taxed regardless of when earnings are actually distributed, and it hampers the taxpayer’s ability to line up the U.S. tax treatment with Canada to avoid double tax.
The above issues relating to corporations are by no means exhaustive, but U.S. citizens in Canada need to be cautious when pursuing common Canadian tax strategies with corporations – it can result in some very unfavourable U.S. tax consequences as well as some extremely onerous reporting requirements.
6. Lifetime Capital Gains Exemption
Canada allows for qualified capital gains up to a certain amount to be exempt from tax. This is commonly used when selling small businesses, as well as in Canadian succession planning, including through estate freezes and family trusts. While this may make for good Canadian tax strategies, there is no corresponding capital gains exemption for U.S. tax purposes. As such, U.S. citizens living in Canada need to be aware that their Canadian estate planning may not work so smoothly once the U.S. issues are thrown into the mix.
7. Foreign Trusts
The U.S. has complex rules regarding how it treats trusts, particularly foreign trusts. Many of these trusts will require very detailed reporting for grantors or beneficiaries, and some of this reporting carries significant penalties if filed late or incorrectly. Some forms carry a minimum penalty of $10,000 USD or 5% of the value of the trust, whichever is higher. The IRS is very fond of issuing these penalties automatically, and they’re difficult to fight. Not only that, but some of these filings have different due dates than a regular Form 1040 (the U.S. equivalent of a T1), meaning there’s more for taxpayers and their advisors to keep track of.
Among the myriad of complex tax rules for foreign trusts is something called the “throwback tax.” At a high level, this is a punitive regime through which the U.S. essentially retroactively taxes U.S. beneficiaries in the year a distribution is made. It treats the distribution as if it had been made in previous years when the income itself was actually accumulated by the trust. It requires very detailed reporting and can result in an unexpected tax bill in many instances.
8. Gift Tax
As a general rule, gifts in Canada are treated as taxable dispositions – there isn’t really a distinction between gifting an asset and selling one. There are some exceptions, such as between spouses, but the rules are generally fairly straightforward when it comes to gifts for Canadian tax purposes.
The U.S., however, has an entirely separate gift tax regime that functions somewhat independently of the income tax. U.S. gift taxes are imposed on the giver of a gift based on the value of the gift, not the gain of the gifted asset. This means that gifting cash, which generally by its nature doesn’t have guilt-in gains, can still result in tax for U.S. citizens. And yes, you read correctly – the giver is generally taxed, not the recipient. There are annual exemption amounts as well as a lifetime unified credit that may minimize or eliminate the tax actually owed, but such gifts may require additional reporting beyond a simple income tax return.
9. Estate Tax
The U.S. also has an estate tax on the worldwide assets of Americans, regardless of where they live. It works differently than the deemed disposition that is deemed to occur at death for Canadian tax purposes – instead, similar to the gift tax, it’s a tax on the value of the assets above a certain exemption amount. The tax treaty between the U.S. and Canada does provide some relief for any double taxation that may occur, and currently the exemption amount is quite high, but Americans abroad should take care to ensure their succession planning contemplates the U.S. estate tax.
10. Capital Dividend Account Distributions
Canada, as a general rule, has greater flexibility with how it treats corporate distributions for tax purposes than the U.S. does. One key example is a Canadian concept called the Capital Dividend Account (CDA). The CDA is a where nontaxable income is tracked at the corporate level to be subsequently distributed to shareholders. A common instance where this applies is when a corporation realizes capital gains. In Canada, only 50% of a capital gain is taxable (this is slightly different from the U.S., which instead taxes the full gain, but at a preferential rate if it’s a long-term capital gain). The 50% nontaxable portion of a capital gain serves to increase the CDA, which the corporation can then elect to distribute to the shareholders when it so chooses, even before distributing the taxable portion. As a result, shareholders can receive tax-free distributions from a corporation for Canadian tax purposes. The U.S., however, does not have a similar concept. As a result, what may be tax free in Canada, may in fact be taxable by the U.S.
Americans in Canada should be careful to avoid situations where, due to the timing mismatch of when income is taxable in each country, there is no foreign tax credit relief. If you have the ability to control or influence corporate distributions, you should consult with a U.S. tax advisor to navigate this issue effectively and avoid double taxation.
While the above list is a good high-level overview of the most common issues Americans living in Canada may face, it’s by no means comprehensive. Be sure to work with a U.S. tax professional to help you navigate the complexities of the U.S. tax system and align it as much as possible with your Canadian tax planning. Here at Blomfield Tax, we’re happy to help you plan accordingly. Reach out today to see how we can help.
This post is for informational purposes only and should not be relied upon as official tax advice.