According to recent population studies, the number of US citizens living in Canada has increased to at least a million, with some estimates closer to 2 million. For US citizens working in Canada, US taxes are clearly an important implication of income generation, even if such income is earned entirely in Canada.
In this blog, we offer 5 basic tips for US citizens working in Canada, which elaborate on the obligation to file annually with the IRS, as well as other key insights.
TIP #1 – THE TAX OBLIGATIONS OF US CITIZENS WORKING IN CANADA ENDURE
Often, expats mistakenly believe that moving abroad means that their US tax obligations end. This is a fundamental error in understanding the US tax system.
US citizens, even those residing outside the United States, are considered to be US residents for tax purposes and are therefore subject to US tax reporting on their worldwide income. As such, US citizens working in Canada must annually report all of their income to the IRS, whether the income is US sourced or Canada sourced, or sourced to any other country.
TIP #2 – INFORMATION REPORTING TO THE IRS
US citizens working in Canada who hold non-US accounts or other non-US assets are subject to a number of specific filing requirements in the form of informational forms. Some of these forms are submitted to the IRS as attachments to the personal income tax return (Form 1040), while others are submitted to other governmental departments, including the US Treasury Department. The failure to file any of these forms can result in large penalties, such as a $10,000 penalty per form per year, or even have criminal consequences, if fraud is involved.
Some of the more common forms include:
- Foreign Bank and Financial Account Report (FBAR)
- Form 8938, Statement of Specified Foreign Financial Assets (FATCA Reporting)
- Form 3520, Foreign Trust/Pension and Gifts
- Form 5471, Foreign Corporation Ownership Reporting
TIP #3 – ACTIVITIES IN CANADA WITH US TAX IMPLICATIONS
With each item of income that an expat earns and with each foreign asset that is owned or acquired, special considerations need to be addressed. This is especially true for US citizens working in Canada. Here are a couple of notable examples:
Canadian Pension Plans
Foreign pension plans, including Canadian retirement savings plans, generally do not qualify for the beneficial tax-deferral treatment afforded to certain U.S. pension plans under Section 401 of the U.S. Internal Revenue Code (e.g., a 401(k) plan). As such, employer contributions and plan earnings may be subject to U.S. tax on a current basis and required to be reported on the individual’s U.S. income tax return, even though these items may not be currently subject to Canadian tax.
Fortunately for U.S. citizens in Canada, the U.S.-Canada tax treaty provides tax relief with respect to certain retirement savings plans. Under Article XVIII(7) of the treaty, a U.S. citizen who is a beneficiary of certain retirements plan in Canada can also enjoy tax deferral treatment in the U.S. with respect to the plan’s earnings. Examples of such plans include the registered retirement savings plan (“RRSP”) and the registered retirement income fund (“RRIF”).
Under current rules, the treaty relief is automatic (no election is required). Also, individuals with interests in treaty qualifying Canadian plans do not need to report these interests on Form 3520 (relating to foreign trusts), although they may be required to report on the FBAR or FATCA Form 8938.
Canadian plans that do not qualify under the treaty, such as the Canadian registered Tax-Free Savings Account (“TFSA”) and Registered Education Savings Plans (“RESP”), may still be subject to current U.S. income taxation on accrued, but undistributed, income and may be reportable as so-called “foreign grantor trusts” (an entity status that basically treats the plan owner as the direct owner of the plan’s assets) on Form 3520 and Form 3520-A, in addition to possible reporting on the FBAR and Form 8938.
To add another layer of tax complexity, a Canadian mutual fund held in a TFSA may be considered by the IRS to be a direct investment by the plan owner in a passive foreign investment company (“PFIC”), which must be reported as such on form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company). PFICs can be very tax disadvantageous as, absent certain elections, “excess” distributions and dispositions of PFICs are taxed at the highest marginal rate with an additional interest charge.
The Canadian Mutual Fund Trust
The Canadian mutual fund trust is a very common Canadian investment structure. For all the advantages that the trust entity offers under Canadian law, the U.S. expat should be aware that utilization of this type of entity may not necessarily be sound planning from a U.S. tax perspective. For instance, an entity that is characterized as a trust for Canadian tax purposes can be classified as a business entity for U.S. tax purposes that is akin to a corporation if the trust operates a business.
Such characterization under US tax law may trigger the US anti-deferral regimes, such as the controlled foreign corporations (“CFC”) regime. CFC classification that can potentially have significant US tax implications. For instance, a 10% or more US shareholder of a CFC must include currently in his or her gross income the CFC’s so-called “subpart F income,” which generally includes passive-type income, such as interest, dividends and rental income (meaning, for tax purposes, a CFC’s subpart F income is considered to be earned directly by the shareholder prior to an actual distribution to the shareholder). Under the CFC regime, company loans to an expat owner can trigger a so-called “Section 956 inclusion,” i.e., current inclusion of the loan amount in a 10% or more US shareholder’s gross income. Starting with the 2018 tax year, certain non-subpart F income will also be required to be included currently at the shareholder level under the new so-called “GILTI” rules.
TIP #4 – US TAX BENEFITS ARE AVAILABLE TO US CITIZENS WORKING IN CANADA
The good news for expats living in Canada is that both US domestic tax law and US-Canada bilateral agreements contain a number of provisions that are designed to prevent “double taxation,” or taxation on the same income in both countries. These include the foreign earned income exclusion (“FEIE”), foreign housing exclusion (“FHE”), and foreign tax credit (“FTC”).
These provisions, in many cases, can reduce or even eliminate the US federal income tax that would otherwise be due by the expat taxpayer. Keep in mind, however, that even if no US tax is owed, a US tax return still generally must be filed and the failure to do so can result in severe penalties.
TIP #5 – FATCA HAS EXPANDED THE REACH OF THE IRS
FATCA stands for the “Foreign Account Tax Compliance Act.” FATCA is a relatively new designed to combat offshore tax evasion by requiring US citizens to report their holdings in foreign financial accounts and their foreign assets on an annual basis to the IRS. As part of the implementation of FATCA, starting with the 2011 tax season, the IRS requires certain US citizens to report (on Form 8938) the total value of their “foreign financial assets.”
In order to further enforce FATCA reporting, starting on January 1, 2014, foreign financial institutions (“FFIs”) (which include just about every foreign bank, investment house and even some foreign insurance companies) became required to report the balances in the accounts held by customers who are US citizens. To date, we have seen several large foreign banks require that all US citizens who maintain accounts with them provide a Form W-9 (declaring their status as US citizens) and sign a waiver of confidentiality agreement whereby they allow the bank to provide information about their account to the IRS. In some cases, foreign banks have closed the accounts of US expats who refuse to cooperate with these requests.
If you are a US citizen working in Canada, it is essential that you remain compliant with your continuing US tax obligations. For late filers living in Canada, it’s important to note that you may encounter unique challenges in qualifying for the U.S. tax amnesty programs if you visit the US too often during the year.
Our experts at Expat Tax Professionals are available to help you understand your US tax filing requirements whether you are current in your filings or are filing late with the IRS. Please feel free to contact us for more information.