Living in Canada and Filing Your Canadian Income Tax Return
Due to its contiguity with the United States, Canada has always been a popular destination for U.S. expats. This, however, is only one of several factors that motivate Americans to move to Canada. Others include the health care system, education, and general quality of life considerations. According to some estimations, there are more than a million American citizens currently living in Canada.
The Canadian income tax system is fundamentally similar to the U.S. federal income tax system although there are notable differences. For instance, similar to the U.S. system, Canada taxes its residents on their worldwide income (i.e., whether the income is earned within our without Canada). However, unlike the U.S., Canada does not have citizenship-based taxation. This means that unlike the U.S., Canadian citizens living outside of Canada are generally not considered tax resident in Canada.
Like the U.S., Canada employs a marginal federal tax rate based on a progressive tax system, where tax rates for an individual increase as income rises. Provincial taxes, like U.S. state taxes, are also imposed in additional to federal taxes. As a general matter, the U.S. has a higher federal maximum income tax rate, while Canada has higher local tax rates.
Also similar to the U.S., Canadian taxpayers are required to file an income tax return annually. The filing deadlines are relatively similar (April 15 in the U.S. versus April 30 in Canada).
In contrast to the U.S., Canada does not have an estate tax. Instead, a tax is triggered on any unrealized gains immediately prior to death (although some exemptions and deferrals may apply). The U.S. estate tax and the Canadian tax on unrealized gains have the potential to cause serious tax issues for a U.S. citizen who is resident in Canada upon his or death. Careful planning should be in place in order to mitigate the adverse tax consequences under these circumstances.
Principle #1 - Your Obligation Endures
Your U.S. Tax Filing Obligation Endures Even After Moving Abroad
Our first principle is of particular importance because U.S. expats so often mistakenly believe that once they have moved abroad their U.S. tax obligations cease to exist.
In fact, as a basic rule, U.S. citizens, even those residing outside the United States, are considered to be U.S. residents for tax purposes and are therefore subject to U.S. tax reporting on their worldwide income. Expats must annually report all of their income to the IRS, just as they did prior to moving to abroad, whether the income is U.S. source or foreign source, and whether that foreign source is Canada (e.g., employment in Canada) or any other foreign country.
Principle #2 - New Filing Obligations
You’re Likely Subject to New Information Reporting Obligations
U.S. expats who hold accounts or other assets overseas 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. The failure to file any of these forms can result in severe civil penalties, such as a $10,000 penalty per form per year. Additionally, in certain extreme cases, criminal penalties, including fines and incarceration, may apply if the reporting delinquency is shown to be willful.
Some of the more common forms include:
- Foreign Bank and Financial Account Report (FBAR)
The FBAR is not a tax form and it is not filed with the IRS. Instead, it is an informational form that is submitted with the U.S. Treasury Department. A U.S. account holder (person or entity) with a financial interest in or signature authority over one or more foreign financial accounts, with more than $10,000 in aggregate value in a calendar year, must file the FBAR annually with the Treasury Department.
- Form 8938, Statement of Specified Foreign Financial Assets (FATCA Reporting)
If you reside outside the U.S. and have a bank account or investment account in a foreign financial institution, you are generally required to include Form 8938 with your U.S. federal income tax return if you meet certain monetary thresholds.
Principle #3 - New US Tax Considerations
Your Activities in Canada Have Important U.S. 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. The following are examples of common activities in Canada and their potential U.S. tax implications.
Canadian Retirement Savings 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”), 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” 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 U.S. tax law may trigger the U.S. anti-deferral regimes, such as the “controlled foreign corporation” regime, the new “global intangible low-taxed income” regime, or the “passive foreign investment company” regime, all of which are generally designed to prevent taxpayers from deferring U.S. tax by shifting income to foreign entities. Careful planning is often needed to ensure that these regimes do not subject your income to highly punitive U.S. federal tax rates.
U.S. Tax Reporting Considerations
It is important to keep in mind that in addition to the U.S. tax implications associated with the above activities, additional tax reporting obligations may also arise as a result of other activities in Canada. In addition to the Forms 3520 and 8621 discussed above with respect to foreign trusts and PFICs, some of the other common forms associated with the investment or other financial activities abroad include:
- Form 5471: must be filed by certain shareholders of foreign corporations
- Form 8865: must be filed for each controlled foreign partnership in which the taxpayer is a 10% or more partner
- Form 8858: must be filed for each wholly owned foreign entity that is disregarded for tax purposes (often by way of a “check the box” election)
Principle #4 - US Tax Benefits
U.S. Tax Benefits Are Available to You
The good news for expats living in Canada is that both U.S. domestic tax law and U.S.-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 provisions, in many cases, can reduce or even eliminate the U.S. federal income tax that would otherwise be due by the expat taxpayer. Keep in mind, however, that even if no U.S. tax is owed, a U.S. tax return still generally must be filed and the failure to do so can result in severe penalties.
Domestic law provisions, such as the foreign earned income exclusion (“FEIE”), foreign housing exclusion (“FHE”), and foreign tax credit (“FTC”) are designed specifically for taxpayers living abroad.
Foreign Earned Income Exclusion
Provided an individual is able to establish that his tax home is outside the U.S. (by satisfying either the “bona fide residence” test or the “physical presence” test), such individual can exclude from income a portion of their income earned overseas. The FEIE amount is adjusted annually for inflation. For tax year 2020, the maximum foreign earned income exclusion is $107,600 ($215,200 for a married expat couple).
In order to claim this exclusion, an individual must file a U.S. federal income tax return (Form 1040). To claim the FEIE, an individual must file Form 2555 with their U.S. federal income tax return.
Foreign Housing Exclusion/Deduction
In addition to the FEIE, a U.S. expat can also exclude or deduct from their gross income their housing cost amount in a foreign country provided they qualify under the bona fide residence or physical presence tests. The exclusion is applicable whenever an individual has wages. The deduction is applicable whenever the individual is self-employed. In order to claim the foreign house exclusion/deduction, an individual must file Form 2555.
However, the housing cost amount is subject to certain limitations that are adjusted based on geographical location. Without any adjustments to the limitations, the maximum foreign housing exclusion for 2020 is $15,064. Adjustments vary from city to city and are based on the cost of living in each city. Such adjustments apply specifically to the following Canadian cities: Calgary, Edmonton, Halifax, Montreal, Ottawa, Toronto, and Vancouver.
Foreign Tax Credits
As an alternative to (and for higher income earners, in complement to) the FEIE and foreign housing exclusion/deduction, a U.S. expat can claim a foreign tax credit (“FTC”) for foreign income taxes paid. The amount of foreign tax credits that may be taken is limited to the amount of foreign source taxable income and cannot be used to offset U.S. source income.
If the Canadian tax rate on an expat’s income is higher than the U.S. tax rate, then there should be no residual income tax to pay in the U.S. after claiming a foreign tax credit for the Canadian tax paid. However, a foreign tax credit cannot be used to reduce the U.S net investment income tax and, as such, residual U.S. tax may result even if the foreign tax credit can otherwise be fully utilized against the earned income tax. The foreign tax credit rules are particularly complex and, as such, require a thorough analysis by a tax expert.
Aside from specific situations, in order to claim a foreign tax credit, an individual must file Form 1116 with their U.S. federal income tax return.
Many countries have signed treaties and other international agreements with the U.S. whereby certain benefits are available to U.S. expats residing in a particular foreign country, for instance in order to protect them from double taxation, both in the U.S. and in their country of residence. U.S.-Canada agreements include:
- U.S.-Canada Income Tax Treaty – This treaty is designed to mitigate the effects of double income taxation. Generally, under an income tax treaty with the U.S., U.S. expats may be entitled to certain credits, deductions, exemptions and reductions in the rate of income taxes of the foreign country in which they reside.
- U.S.-Canada Totalization Agreement – This agreement affects tax payments and benefits under the respective social security systems. It is designed to eliminate dual social security taxation, the situation that occurs when a worker from one country works in another country and is required to pay social security taxes to both countries on the same earnings. It also helps fill gaps in benefit protection for workers who have divided their careers between the United States and Canada.
Principle #5 - Reach of US Government
Due to FATCA and its Supporting International Agreements, the U.S. Income Tax Reach Has Become Wider Than Ever Before
FATCA stands for the “Foreign Account Tax Compliance Act.” FATCA is a relatively new law that was enacted in 2010 as part of the HIRE Act. The objective behind FATCA is to combat offshore tax evasion by requiring U.S. 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 U.S. 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 U.S. citizens. To date, we have seen several large foreign banks require that all U.S. citizens who maintain accounts with them provide a Form W-9 (declaring their status as U.S. 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 U.S. expats who refuse to cooperate with these requests.
To this end, a FATCA agreement was signed between the United States and Canada on February 5, 2014 for the purpose of advancing account information exchanges between the countries. While Most FFIs provide the required U.S. account information directly to the IRS, under Canada’s FATCA agreement, Canadian FFIs instead provide the information to the CRA, which then provides it to the IRS.
If you are a U.S. expat living in Canada, it is essential that you remain compliant with your continuing U.S. tax obligations. Our experts at Expat Tax Professionals are available to help you understand your U.S. tax filing requirements and to assist you with all of your U.S. tax compliance needs.