Many people assume that the US and Canadian tax systems for individuals are similar. Not true. There are some important differences. Accordingly, the purpose of this article is to point out some of these important differences that can cause problems for the uninformed. By no means is this article intended to be exhaustive… simply informative.
How individuals are taxed
The US is one of the only countries in the world that taxes on a citizenship basis. If you are a US citizen or a US “green card” holder, your income is taxed on a worldwide basis pursuant to US law no matter where you reside. Many people are not even aware that they are a US citizen. This issue is a complex immigration matter and often will require a US immigration lawyer’s assistance.
Canada, does not tax on a citizenship basis. Instead, like most countries around the world, Canada taxes on a residency basis. To the extent that you are a “resident” of Canada, you are taxed on your worldwide income. There is no statutory definition of residency in the Canadian Income Tax Act and therefore the common law on such a subject is relevant. The Canada Revenue Agency’s administrative views are published in Interpretation Bulletin IT-221R3. Simply put, Canada’s system of residency is very much a “facts and circumstance” test. In other words, an individual’s facts and circumstances will determine whether or not they are resident in Canada for income tax purposes. The US also taxes residents but the determination of residency is a statutory test and is dependent upon the number of days that the individual was physically in the US during the current year and the previous two years. This test, the so-called “substantial presence” test, is formulaic and objective (we briefly discuss the substantial presence test in our January 5, 2009 blog). Accordingly, a US citizen who is resident in Canada would be subject to double taxation (both from the US and from Canada) were it not for the Canada-US Income Tax Treaty (the “Treaty”). Such a Treaty (one of many that those countries have in place with other countries around the world) does an admirable job of eliminating double taxation for such a person. However, the Treaty is not perfect and in some cases the US citizen who is resident in Canada can be subject to adverse tax consequences if their affairs are not planned carefully.
The US has an estate tax… Canada does not
The US has an estate tax that applies on the value (as opposed to gains) of a decedent’s estate. The US estate tax applies to its citizens and to people who are “domiciled” in the US. Domiciliary is a facts and circumstances test and therefore people who are not US citizens have to be cognizant of whether or not they are domiciled in the US so as to try and avoid the US estate tax upon death. The US estate tax also applies to non-citizens and non-domicillaries to the extent that such people hold US situs property (such as US stocks and US real property). At present, US citizens are exempt from the US estate tax on the first US $5.12 million of value of the estate. This eliminates most, but not all, of US estates from the application of the estate tax. At its highest marginal rate, the US estate tax is presently at 35 percent.
Prior to 1972, Canada also had an estate tax. However, the Canadian estate tax was abolished effective January 1, 1972 and instead replaced with a system that forces the recognition of any unrealized gains immediately prior to death. Such gain recognition is subject to many exemptions and deferrals. Canada also taxes certain registered pension assets (such as Registered Retirement Savings Plans or Registered Retirement Income Funds) upon the death of the Canadian resident but, again, the taxation of such amounts are subject to certain exemptions and deferrals.
Accordingly, the US estate tax and the Canadian “deemed disposition” tax can cause significant issues for a US citizen who is resident in Canada upon death. Similarly, it can cause significant problems for a Canadian resident (who is a non-US person or not domiciled in the US) who owns US situs property on death. The Treaty has limited provisions that attempt to reduce the negative exposure of the application of the two “death tax” systems but such provisions usually result in minimal relief and therefore it is crucial for affected persons to plan carefully.
How corporations are taxed
The US has certain corporate entities that enable income to be earned by such entities but taxed at the “shareholder” level (this is often referred to as a “flow-through” vehicle). This can be very beneficial for US persons since it can often eliminate double taxation which can sometimes arise with the use of corporations. Canada does not have a similar regime. All income realized by a Canadian corporation is taxed at the corporate level. Any after-tax corporate amounts paid to a shareholder will normally be taxed as a dividend. This can lead to double taxation for the shareholder of Canadian corporations if not properly planned.
The US also has unique flow-through entity called a Limited Liability Company (“LLC”). Accordingly, it is very common for a US tax advisor to recommend the use of a LLC to a Canadian resident person when they are considering investing in the US. However, the use of a LLC for a Canadian resident investor is most often not a recommended entity since the LLC will not be a “flow-through” vehicle for Canadian tax purposes (but it may be for US purposes). This can cause significant tax problems that could result in double taxation.
Accordingly, it is critical for Canadians who wish to invest in the US to get proper tax and legal advice to ensure that double taxation will not result from the realization and repatriation of profits back to Canada. Similarly, it is crucial for US persons to get proper tax and legal advice to ensure that the ultimate tax burden is acceptable to the extent that they are investing in Canada.
Foreign reporting regime
Both Canada and the US have reporting regimes that they impose on their taxpayers to the extent that such persons hold assets or earn income outside of their country. In the US, the most common report is the so called “FBAR” (Form TD F 90-22.1). To the extent a US person has ownership in or signature authority over certain foreign accounts then the FBAR will need to be filed on a timely basis. Failure to file comes with a $10,000 penalty but if the failure to file is willful the penalty escalates to the greater of 50 percent of the highest account balance during the year or $100,000. Also, there is an additional foreign reporting requirement that is new for 2011 – Form 8938 – that must be filed by US persons who own “specified foreign financial assets” if the value of such assets exceeds certain thresholds which vary according to filing status.
For Canadian residents, to the extent that they hold specified foreign property with a cost of $100,000 or greater, prescribed form T1135 will need to be filed on a timely basis (we have written about this before and you can read about it here). The penalties for not filing are to a maximum of $2,500 but can be subject to an additional level of penalties which can escalate quickly. To the extent that Canadians have foreign affiliates, then a separate foreign reporting regime exists.
Taxation of the same source of income
Our firm has written on this subject in our blog of December 14, 2011. Rather than spill more ink on this subject, suffice to say that a US citizen resident in Canada must be very careful and aware of how the same source of income is taxed in Canada and in the US so as to potentially avoid nasty surprises.
Canadian departure tax versus US departure tax
Since Canada taxes on a residency basis, Canada will no longer have the right to tax that person to the extent they become a non-resident of Canada (with the exception of certain Canadian source income that such a person may receive). When a person becomes a non-resident of Canada, the Canadian tax rules impose a “departure tax” which, generally, will cause a deemed disposition of the person’s assets at fair market value thus triggering any accrued gains or losses on such properties. The deemed disposition rules are subject to many exceptions. In a worst case scenario, the Canadian departure tax can cause significant liquidity problems. Notwithstanding, the resulting tax liability must be paid or adequate security provided to the Government of Canada. Thus, careful planning must occur to the extent that the person is considering becoming a non-resident of Canada for income tax purposes.
The US also has a departure tax known commonly as the “expatriation tax.” The US expatriation tax applies to US citizens who renounce their citizenship and to certain long-term residents who lose US residency. Determining whether you are a long-term resident and whether you have lost US residency is complicated. But know that losing US residency for purposes of the expatriation tax is surprisingly easy. For example, failing to waive tax treaty benefits to which you are entitled may result in the US expatriation tax applying. If you have renounced your US citizenship or lost your long-term US residency, the expatriation tax will apply if any of the following are true:
- Your average annual net income tax for the last five years is more than US $151,000 (this amount is adjusted for inflation).Because of the foreign tax credit, it is somewhat uncommon for Canadians to owe this much in US tax.
- Your net worth is at least US $2 million.
- You are not in compliance with your US tax obligations.
When the expatriation tax applies, it works like this: Pretend that all of your assets are sold for their fair market values and you recognize a gain or loss on these sales. Add the gains and losses together. Then subtract $651,000 (an amount adjusted for inflation) from your net gains. If the number is positive, you will owe tax on the remaining amount. There are ways to defer paying this tax, but doing so involves posting a security bond with the Internal Revenue Service (“IRS”).
Paid tax preparers
In the US, only tax preparers who have a Preparer Tax Identification Number (“PTIN”) are able to prepare US income tax returns and charge a fee for such. In Canada, no such system exists although our firm has written recently that we believe Canada should have a similar system and are hopeful that Canada will shortly follow suit.
Accordingly, for US citizens who are resident in Canada, one of the challenges they face is finding a tax preparer who is capable of preparing both their Canadian and US tax returns and who has a US PTIN. There are not many Canadian firms who have professionals who hold valid US PTINs. In fact, according to the IRS there are only 2,392 such individuals in all of Canada, and only 274 in Alberta. At this time there is no easy way to determine whether an individual holds a valid PTIN but the IRS recently announced this information will be available on its website.
The above represents many, but certainly not all, of the fundamental differences between Canada and the US tax systems. As always, the devil is in the details, which are complex and can sometimes produce surprises and counter-intuitive results. We will continue to highlight the more common differences in our articles and blogs.