Tax planning and dual citizenship

By Terry F. Ritchie | April 1, 2011 | Last updated on September 15, 2023
6 min read

If you work with dual citizens of Canada and the United States, it’s important to be aware of the unique financial, tax and estate planning issues these clients face. Given the recent tax changes in the United States, these clients and their advisors will need to be ahead of the curve.

American citizens are deemed to be residents of the U.S. for income, gift and estate tax purposes. A U.S. citizen who is also a resident of Canada would be deemed to be a Canadian tax resident and also subject to tax on their worldwide income. Many presume this type of person would be subject to two levels of tax: on their worldwide income in both Canada and the States.

However, the foreign-earned income exclusion presently exempts US$92,900 of Canadian-source employment income. After the application of the exclusion and the application of foreign tax credits, most American citizens in Canada pay no additional U.S. income tax. However, there are still substantial U.S. income tax filing and compliance issues as well as planning requirements.

Dual citizenship not always convenient

The U.S. government acknowledges dual nationality exists but does not encourage it because of the problems it may cause. For example, dual citizens crossing into the States should not present both passports or indicate they are dual citizens. Doing so will likely delay re-entry. From a U.S. perspective, these people are simply American citizens.

If a U.S. citizen becomes a Canadian citizen, in most cases he does not automatically lose his American citizenship. Use of a Canadian passport or becoming a Canadian citizen does not put into jeopardy an American passport or citizenship status. Regardless, using a Canadian passport as a U.S. citizen will likely mean a secondary screening. According to the American Embassy in Canada, people can hold both U.S. and Canadian citizenships but must always enter the States as an American. U.S. citizens who are resident in Canada are required to file IRS Form 1040 annually on their worldwide income. This form is required to be filed by April 15 (April 18, 2011) if an American citizen owes U.S. tax. If no U.S. tax is due on the filing date, an automatic extension to June 15 is available for American citizens resident in Canada.

Despite the fact an extension for filing a U.S. tax return is available to Americans in Canada, it’s important the taxpayer’s Canadian return is coordinated with the U.S. income tax return. We generally recommend a dual-citizen-taxpayer return be prepared by a tax preparer familiar with both Canadian and American tax matters. A preparer with knowledge of both systems will likely source income and deductions properly and understand foreign tax credits, carryovers and additional compliance requirements.

Unfortunately, you can’t escape the clutches of the IRS by renouncing your U.S. citizenship, as this causes further complications (see AE September 2010, “Americans In Canada” ).

Mutual fund earnings

What about U.S. citizens who own Canadian mutual funds? Last year, the IRS changed its view of the U.S. tax treatment of foreign mutual funds. Starting in 1986, many Americans used foreign mutual funds to gain tax deferral on income that wasn’t distributed to them. Thanks to the lobbying efforts of the mutual fund industry, the government enacted a new set of complex rules regarding Passive Foreign Investment Companies. A PFIC exists when 75% or more of its gross income for the taxable year consists of passive income or 50% or more of the average fair market value of its assets consists of assets that produce or are held for the production of passive income.

Passive income includes dividends, interest and its equivalents, passive rents and royalties, annuities, gains from the disposition of stocks and securities and other assets, certain gains from commodity trading, and certain foreign currency exchange gains.

As a result of the 2010 IRS policy review, the IRS issued Chief Counsel Advice 201003013, stating Canadian mutual funds should be classified as corporations for U.S. tax purposes. Therefore, if an American citizen receives income from a PFIC or sells a Canadian mutual fund that is a PFIC, U.S. tax and interest penalties could apply.

Such a taxpayer is required to file IRS Form 8621 (Return by a Shareholder of a Passive Foreign Investment Company or Qualifying Electing Fund) and can take one of two elections. The first election is called the Qualified Electing Fund (QEF) and the second is called the Mark-to-Market Election. If a taxpayer uses the QEF, he must, on an annual basis, include in his U.S. gross income his pro rata share of the mutual fund’s ordinary earnings as ordinary income, and any net capital gain as a long-term capital gain. He has to contact the Canadian mutual fund company to request a statement that details this information. Luckily, some fund companies in Canada are becoming more accommodating and are providing this information to their American investment clients.

The taxpayer could also take the Mark-to-Market election. In this case, the taxpayer would recognize the annual gain or loss of the shares as if they had sold them by the end of the year. For U.S. tax purposes, this is treated as ordinary income and not a long-term capital gain.

If he takes neither election, he would be subject to an excess distribution. In this case, the excess distribution is the part of the distribution received in the current tax year that is greater than 125% of the average distributions received during the previous three years. This amount would be considered ordinary income in the tax year.

Unfortunately, the amounts allocated to the previous three years will be subject to tax at the highest marginal rate and subject to an interest charge. Therefore, it is critical for U.S. citizens who hold Canadian mutual funds to make the appropriate election for their investment holdings. Although these rules have been in place for some time, with the passing of the Hiring Incentives to Restore Employment (HIRE) Act, taxpayers will have to comply.

Cross-border monitoring

Under HIRE, American taxpayers with foreign assets will have nowhere to hide. In fact, as of January 1, 2013, Canadian banks or investment firms doing business with Americans have to ask if they’re U.S. citizens or residents. If the client is an American citizen (or resident under U.S. tax rules), the bank will be required to report information related to the account to the IRS. If an account holder refuses to answer, the bank or investment firm will withhold 30% of any investment earnings and remit that to the IRS. Advisors should encourage American clients who haven’t been filing annual U.S. returns to meet the compliance requirements of the IRS prior to this legislation coming into force.

The IRS requires such taxpayers to file the previous six years’ returns, even if no additional U.S. tax is payable. But it can be a lot of work and require additional IRS compliance forms (Forms 8891, 3520, FBAR, etc.). Even though the HIRE Act doesn’t come into full force until 2013, the IRS has created a draft of Form 8938 (Statement of Foreign Financial Assets), which is required to be filed with next year’s U.S. income tax return if the American citizen has $50,000 or more in foreign financial assets.

The IRS has not yet released instructions for this form, but it appears taxpayers have to file the form along with the myriad of other U.S. compliance tax forms, including the TDF 90-22.1 (Foreign Bank Account Reporting), even though much of the information appears to be similar. The new form will significantly increase the amount of data U.S. citizens need to report if they hold foreign assets. Foreign assets include Canadian rental property but not raw land or homes used personally.

As a means to encourage U.S. taxpayers to become compliant, on February 8, 2011, the IRS announced the 2011 Voluntary Offshore Disclosure Program, available through the end of August 2011. This program will require individuals to pay a penalty of 25% of the amount in the foreign accounts in the year with the highest aggregate account balance covering the 2003-to-2010 time period. Some taxpayers will be eligible for 5% or 12.5% penalties. Participants also must pay back taxes and interest for the eight years as well as accuracy-related and delinquency penalties. Taxpayers participating in the initiative must file all original and amended tax returns and include payment for taxes, interest and accuracy-related penalties by August 31.

In conclusion, with these recent changes to American tax law, you must be prepared to advise clients who have not been filing U.S. tax returns or disclosing their foreign income or accounts.

  • Terry F. Ritchie is a Calgary-based cross-border financial planner with expertise in both American and Canadian tax regimes.

    Terry F. Ritchie