Much has been written about the planning issues of Canadians moving to the U.S. But how many advisors are aware of the issues Americans face when they move to Canada or already reside here?

Many U.S. citizens move to Canada and stop filing U.S. tax returns because they’re unaware it’s still required of them. But these individuals will face a rude awakening once the HIRE Act comes into effect January 1, 2013 and they’re slapped with 30% withholding charges on investment earnings for remission to the IRS.

U.S. citizens are currently required by law to file a U.S. tax return annually and declare their worldwide income, including any Canadian-source income, investment income and capital gains, adjusted for U.S. dollars – despite the fact they no longer physically live in the U.S. or earn any income there.

Residency rules

Canada, on the other hand, doesn’t impose income tax based on citizenship. The term “resident” is not defined in the Canadian Income Tax Act. As a result, the basis for confirming a person’s residence has been established through the courts, certain statutory rules and the CRA’s interpretations.

The determination of one’s residence is generally a question of fact. According to case law, an individual is a resident of Canada for tax purposes if Canada is the place where the individual, in the settled routine of his or her life, regularly, normally or customarily lives. According to CRA Interpretation Bulletin IT-221R3, where an individual enters Canada, other than as a sojourner (a temporary resident), and establishes residential ties within Canada, that person will generally be considered to have become a resident of Canada for tax purposes on the date he or she entered Canada.

The primary residential ties of an individual are a dwelling, dependants, personal property and social ties. So when an American moves to Canada for employment or retirement purposes with his or her family and acquires a new primary residence, it’s very likely the income tax residency for Canadian purposes will be determined to have occurred as of the day he or she entered Canada.

Once income tax residency is established in Canada, these individuals will be deemed to have disposed of, immediately beforehand, all of their property, with some exceptions, for proceeds equal to the fair market value of the property at that time. They are then deemed to have acquired at the particular time such property at a cost equal to such fair market value.

In effect, at the date of establishing Canadian residency, they are entitled to a step-up in the tax cost of all property owned for purposes of determining the ultimate capital gain or tax loss implications upon a future sale, the settling of a trust, or at death in Canada. So it’s important for clients who move to Canada to establish fair market values of all property as of the date they determined

Canadian income tax residency

When residency in Canada is established, individuals are considered by the United States to be not only residents of Canada, but also of the U.S. for income tax purposes. This could lead to the presumption that they are subject to double taxation on their worldwide income. But in most cases, such exposure can generally be eliminated or reduced through the use of the U.S. foreign-earned income exclusion (FEI) and/or the use of foreign tax credits.

The FEI, in effect, eliminates up to US$91,500 (for 2010) of Canadian-source employment income from U.S. income tax as long as the U.S. resident taxpayer meets one of two tests, which apply if the taxpayer is out of the U.S. for one year or more. (Note: this relates only to employment income, and doesn’t include other forms of worldwide income such as investment income or capital gains.) Also, given that net income tax rates are generally higher in Canada, U.S. taxpayers who are resident in Canada for tax purposes are entitled to reduce or eliminate exposure to U.S. tax through the use of foreign tax credits.

Advisors in Canada focus a lot of attention on the reduction of Canadian tax for these types of clients (through the use of flow-through shares, large RRSP contributions, etc.), but they often don’t recognize the net U.S. tax results of some of this type of planning. Flow-through shares, for example, will not provide any U.S. tax relief and often create additional U.S. tax and other compliance headaches. So it’s important to tax-plan with both jurisdictions in mind.

Additional reporting requirements

In addition to reporting world income on their U.S. tax return, advisors should also be aware of their American clients’ requirement to file U.S. Department of Treasury Form TD F 90-22.1 – Report on Foreign Bank and Financial Accounts, similar to Canadian Form T1135. On this form, U.S. citizens must disclose their interest in financial accounts outside of the U.S. Failure to do so could lead to criminal prosecution with penalties as high as US$500,000 and ten years in jail.

Americans in Canada must also be careful about the establishment of a Canadian trust or the ownership of certain kinds of Canadian investments, including mutual funds, income trusts and registered plans (including RESPs and TFSAs). These may require the filing of Form 3520 – Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts and Form 3520A – Annual Information Return of Foreign Trust with a US Owner.

In this case, the penalties can be as high as 5% of the value of the investments and up to 35% of any distributions from Canadian investments, trusts, registered plans and TFSAs. If clients were ever to establish an RRSP, they would also need to file Form 8891 – US Information Return for Beneficiaries of Certain Canadian Registered Retirement Savings Plans.

Finally, if U.S. citizens in Canada establish a Canadian company or take an equity interest in a Canadian company, they might need to file Form 5471 – Information Return of US Persons With Respect To Foreign Corporations, and another whole myriad of IRS filing requirements and penalties would be imposed.

The HIRE Act

On March 18, 2010, President Obama passed into law the HIRE Act, the primary purpose of which was to extend unemployment benefits for those entitled to them. However, buried within the new law is some rather alarming legislation aimed at non-compliant American taxpayers in Canada and around the world.

No longer will American taxpayers be able to escape the clutches of the IRS. In fact, your friendly Canadian financial institution will be helping the IRS out. Starting on January 1, 2013, Canadian banks or investment firms, if they intend to do business with any U.S. persons, will have to ask every account holder whether they are a U.S. citizen or resident.

If so, the bank will be required to report information related to the account to the IRS. If an account holder refuses to answer (what will be referred to as a recalcitrant account holder), the bank or investment firm will withhold 30% of any investment earnings and remit that to the IRS. Advisors should therefore encourage their U.S.-citizen clients who haven’t been filing U.S. returns annually to meet the compliance requirements of the IRS prior to this legislation coming into full force.

Generally, the IRS requires such taxpayers to file the previous six years’ returns. In most cases, after the application of the FEI and foreign tax credits, no additional U.S. tax will likely be required. But it can be a lot of work and the additional IRS compliance forms (Forms 8891, 3520, etc.) will be required.

Exit taxes

In light of this new legislation, should Americans in Canada consider giving up their U.S. citizenship?

Unfortunately, this route is not an easy solution. By law, the U.S. can now impose a deemed exit tax on the worldwide assets (including assets in Canada) against those individuals who choose to give up their U.S. citizenship.

U.S. and Canadian retirement and other deferred plans can also be hit with a 30% withholding tax at the time of expatriation.

Further, if a client hasn’t filed U.S. tax returns in the past, they’ll be forced to file returns for the last five years and have them certified in order to be able to expatriate. They’ll also have to provide full financial disclosure on worldwide assets.For some clients, this might be a viable option, but it’s important for advisors to fully understand the implication of this option, as transfers from a “covered expatriate” to a U.S. citizen or resident (family member, etc.) would subject the recipient of the transfer to a gift tax (after the annual gift tax exclusion) of 45%!

Other considerations

As many advisors may be aware, there is currently no U.S. estate tax. But after so many high-profile billionaire deaths this year, including Mary Cargill of Cargill Inc. ($1.7 billion), Dan Duncan of Enterprise Energy ($9 billion), Walter Shorenstein ($1.1 billion) and more recently, George Steinbrenner of the NY Yankees ($1.1 billion), the likelihood of a retroactive U.S. estate tax becomes more probable.

Unless Congress does something this year, the U.S. estate tax comes back into full force on January 1, 2011, with an exemption of $1 million and a maximum rate of 55%. But with U.S. mid-term elections in November 2010 and the potential for Republican control of the U.S. House and Senate, anything’s possible.

As with income tax residency, U.S. citizens residing in Canada will be considered residents of the U.S. for estate and gift tax purposes. Therefore, it’s critical that advisors plan for any U.S. estate tax exposure.

This planning can be achieved through the proper drafting of Canadian wills with appropriate U.S. estate planning language and through Spousal Rollover or Qualified Domestic Trusts (if married).

The role of life insurance (held through an Irrevocable Life Insurance Trust), charitable bequests at death and irrevocable trusts for U.S. beneficiaries should also be considered.

  • Terry Ritchie, CFP (U.S.), RFP (Canada), TEP, EA, a Calgary-based cross-border financial planner with expertise in both American and Canadian tax regimes, and co-author of The Canadian Snowbird in America, The Canadian in America, and The American in Canada