Now that the OVDI Program is over and the IRS has released its Fact Sheet on US citizens or dual citizens residing outside of the US, this is a good time to reflect on some common circumstances when US citizens resident in Canada may have additional US tax to pay.
One of the common rebuttals that we hear from US citizens residing in Canada who are not compliant with their US tax affairs is “we haven’t filed our US tax returns because the Canadian tax liability is higher than the US tax liability and therefore there is no need to file.” In many cases, it may be true that the Canadian tax liability is higher than the US tax liability but one may never know until a thorough review of all of the facts and income sources has been completed. In addition, such individuals may also need to file other US reporting forms (even when there is no income tax payable) like Form 5471, FBAR, Form 3520/3520A, 8891, etc., but such filing requirements are beyond the scope of this blog. Some common circumstances where US tax may be payable are as follows:
Deferral of income accruing in an RRSP
The RRSP rules in Canada are conceptually straight forward… a Canadian resident individual obtains a deduction when computing taxable income for contributions to a RRSP (subject to certain limits) and any earnings accumulated inside the RRSP are automatically tax deferred. Canada does not require a taxpayer to file additional forms or schedules to obtain a deferral of income accruing in an RRSP.
However, a US citizen must properly and timely file a Form 8891 to obtain such a deferral from his/her US taxable income. Otherwise, RRSP income is included in the US citizen’s taxable income for the current year. In addition, a Form 8833 must be filed to claim the benefits of the Canada-US Tax Treaty to deduct the current year RRSP contribution from the calculation of US taxable income. If a return was not filed or if it was filed late, the taxpayer must follow certain procedures to defer the income generated by the account. Simply filing the forms is not sufficient. If these procedures are not followed the taxpayer will likely owe US tax.
Capital dividends received by a US citizen
Capital dividends, overly simplified, are tax free dividends paid from Canadian private corporations to the extent that the corporation has a “capital dividend account”. Very generally, the capital dividend account of a Canadian private corporation is a surplus account that accumulates tax free amounts (such as the tax free portion of a realized capital gain or life insurance proceeds) that can ultimately be paid out to the shareholders of the corporation tax free.
The US does not recognize the concept of a “capital dividend”. Corporate distributions to its shareholders are subject to ordering rules which prescribe the characterization of such income. A “dividend” is generally defined to mean any distribution of property made by a corporation to its shareholders out of its earnings and profits.1 If a corporation does not have earnings and profits, a corporate distribution to its shareholders is treated as (1) a return of capital and (2) capital gain to the extent the distribution exceeds earnings and profits and the shareholder’s basis. Accordingly, capital dividends are usually fully taxable as dividends for US purposes.
Canadian “estate freeze” transactions
A common strategy used by shareholders of Canadian private corporations is to “freeze” their interest in the corporation and transfer the future growth to some other party. To accomplish an estate freeze, one must usually exchange their existing shares for new shares on a tax-deferred basis in Canada.
An in depth discussion of the complexities of an estate freeze that involves a US person is well beyond the scope of this blog. Simply stated, an estate freeze may result in both US gift and income tax consequences from the transfer and issuance of shares. Additional complexities and potentially harsh tax results may flow by the use of a Canadian trust in the freeze.
Canada generally has a preferential system to deal with the taxation of stock option benefits. In many cases, the resulting benefit is only half taxable pursuant to section 7 and paragraph 110(1)(d) of the Income Tax Act. In some cases, there may be (or may have been) opportunities available to defer recognition of the resulting stock option benefit to the year of disposition of the stock.
For US citizens, stock options may trigger taxable compensation as well as a gain on the sale of the acquired shares. Depending on whether the options are publicly traded and other factors, the US will determine compensation as arising on either the date of grant, vest, or exercise. Subsequent tax will arise on the date of sale. Both the timing and characterization of income may result in a disparity in the foreign tax credits available to offset the US income inclusion.
Use of the $750,000 capital gains deduction
Astute readers of our blogs will know that Canadian residents who hold shares of a qualified small business corporation may be able to benefit (to the extent that very detailed tests are met) from the $750,000 capital gains deduction upon the disposition of such shares.
Generally, gain from the sale of stock is treated as capital gain in the US. The US does not recognize the capital gains deduction claimed by a Canadian resident US citizen. Accordingly, any such gain would be fully taxable in the US in the year of sale. The capital gains deduction claim and reduced tax in Canada may result in insufficient Canadian tax available to offset US tax payable.
Flow-through share deductions
A common tax deduction for high income earning Canadian residents is flow-through share deductions. Overly simplified, a flow-through share deduction is available as a result of an investment in an oil and gas corporation (or partnership) which will renounce their ability to claim deductions on Canadian Exploration Expenses or Canadian Development Expenses in favour of the investor. This can often times reduce Canadian income tax (subject to possible alternative minimum tax).
From a US tax perspective, deductions and credits available to a corporation cannot be shifted to its shareholders. These deductions/credits comprise a portion of the tax attributes of the corporation. If flow-through share deductions are used by a US citizen to offset his or her Canadian taxable income, he or she may lack sufficient Canadian tax payable to offset US tax payable.
Principal residence exemption
As many people know, Canadian residents are generally exempt from capital gains taxation on realized gains from their “principal residence.” The discussion of a principal residence is beyond the scope of this blog but generally includes a property where a person ordinarily and habitually lives.
The US allows an individual to exclude up to US$250,000 from the sale or exchange of his or her principal residence from gross income.2 To qualify for the exemption, the property for which such exclusion is being claimed must have been used by the person two of the previous five years. In order to calculate the gain, a US citizen must convert the purchase and sale price into US dollars using the exchange rate in effect on the respective dates. With the rise in the value of the loonie against the US dollar, a US citizen selling his home in Canada may experience an unexpectedly large US taxable gain.
Canada has a preferential tax system for donations of “listed securities” directly to charity. To the extent that certain conditions are met, the capital gains inclusion rate on a direct donation of listed securities to charity will be zero thereby avoiding any capital gains tax that would otherwise apply. In addition, when calculating allowable charitable donations as a tax credit, Canada limits the amount of charitable donations (that are subject to the credit) in the taxation year to 75 percent of the taxpayer’s net income plus 25 percent of taxable capital gains realized on the disposition of property donated to charity and other amounts beyond the scope of this blog. Also, Canada and it provinces provide a generous tax credit equal to the highest marginal tax rate for donations over $200, which can further reduce Canadian tax paid for large donation amounts claimed.
The calculation of the tax benefit for charitable donations generally yields more favourable results in Canada than the US. In general, the deduction for charitable donations is limited to 20 percent, 30 percent, or 50 percent of a taxpayer’s gross income depending on the property contributed and the classification of the charity.3 A US tax filer must report charitable donations as an itemized deduction4 on Schedule A of the Form 1040. Itemized deductions are restricted in two important ways (1) they are subject to a reduction for high income earning taxpayers and (2) if claimed, must be used in lieu of the standard deduction to which the taxpayer is otherwise entitled. In 2011, the standard deduction available to a US taxpayer is $5,700. In other words, a taxpayer only realizes benefits from itemized deductions to the extent he/she can claim an amount in excess of $5,700. Thus in certain circumstances, a US taxpayer may receive little or no tax benefit for charitable contributions.
Pension income splitting
In 2007, the Canadian Government introduced pension income splitting legislation which enables optional pension income splitting with a spouse. In some cases, this can result in significant tax savings amongst spouses.
However, pension income earned by a US citizen is attributable and taxable to the person who earned it for US purposes. Although US citizens filing a joint return may realize a similar result, splitting pension income is simply not allowed in the US. As a result, the entire amount of pension income will be recognized by the recipient with only a portion of the tax that would otherwise have been creditable to offset the US taxable income to the extent that Canadian pension splitting is utilized.
Allowable business investment losses (ABILs)
ABILs are a special type of capital loss that, if certain conditions are met, will result in the allowable loss (which is one half of the realized loss) to be utilized to reduce all other sources of Canadian taxable income. This can be beneficial given that capital losses are only deductible against capital gains.
Unfortunately, ABILs do not have similar treatment in the US. In general, a loss from the sale of stock is treated as a capital loss. A US citizen may utilize up to $1,500 a year in capital losses to offset other types of income. However, any remaining capital loss can only be used to offset capital gains or be carried forward to another tax year.
Canada has a comprehensive medical expense tax credit regime whereby only certain medical expenses are creditable.
When calculating US taxable income, medical expenses are deductible as an itemized deduction (as described above in discussing the deduction available for charitable donations). However, the ability to use such expenses to offset US taxable income is even more limited. Medical expenses are only available as an itemized deduction to the extent they exceed 7.5% of an individual’s adjusted gross income. Again, many US citizens may receive little or no tax benefit from incurring medical expenses.
Canadian lottery/gambling winnings
In Canada, lottery/gambling winnings are generally tax free.
In the hands of a US citizen, lottery winnings are fully taxable as ordinary income. A taxpayer’s winnings can be offset by substantiated lottery losses. However, the taxpayer must claim these losses as an itemized deduction subject to the overall limit on itemized deductions and the loss of the standard deduction.
While the above list is not exhaustive, it should give you a flavour that the two taxation systems – Canada’s and the US’ – are not entirely consistent. Although the Canada-US Income Tax Treaty does a very good job of trying to eliminate double taxation, the treaty does not resolve the two countries’ differing tax treatment on certain sources of income and availability of deductions/credits thereby causing different taxes payable. US citizens resident in Canada need to exercise great caution in assuming that their ultimate US income tax liability may not be nil notwithstanding the fact that their Canadian tax affairs are up-to-date. Seek professional help!
1. In general, earnings and profits is taxable income with certain adjustments.
2. A married couple filing jointly can elect to exclude up to $500,000.
3. If the contribution is capital gain property, the available deduction is limited to 30 percent of his/her adjusted gross income if the taxpayer elects to claim the fair market value as the deductible amount, or up to 50 percent if he/she claims the adjusted basis as the deductible amount.
4. Itemized deductions include home mortgage interest, tax preparation fees, medical expenses and sales taxes.