|Although you are a Canadian resident, as a U.S. citizen or Green Card holder you continue to have U.S. tax obligations. In most instances it only involves filing a U.S. tax return and possibly a state return with no actual tax owing based on the exclusions and credits for which you could be eligible.
By Wojciech Kupny,
Edited By Wayne Bewick CA, CFP, CPA, Arun (Ernie) Nagratha, CA, CPA
U.S. citizens must file tax returns on an annual basis irrespective of how long they have been out of the U.S. In fact, even in situations where individuals are U.S. citizens at birth due to their ancestry and have never lived in the U.S. they are still required to file tax returns on an annual basis. Note that these obligations also apply to “Green Card” holders who are treated like U.S. citizens for U.S. tax purposes. This article outlines various U.S. tax obligations that these U.S. persons need to be aware of, even while living in Canada. In addition, it will discuss situations where a Canadian citizen or resident for income tax purposes will have a filing obligation even if they are not a U.S. citizen or green card holder.
U.S. Income Tax Requirements
Liability for U.S. income tax is based on citizenship, as well as residence. As a U.S. citizen, you must file annual U.S. income tax returns regardless of where you live or how long you have been away from the U.S. For U.S. tax purposes, you must report your worldwide income from all sources. However, to relieve double taxation the IRS allows you to claim a credit against your U.S. tax liability for taxes you pay in Canada or wherever the income is earned. In the case of U.S. citizens residing in Canada, the credit will be enough to eliminate any U.S. tax liability since Canadian taxes are generally higher. In addition, the U.S. allows expatriates to exclude up to US$85,700 (for 2007) of foreign earned income when computing their taxable income. The foreign earned income exclusion will be discussed in more detail later in this article.
Alternative Minimum Tax (AMT). U.S. tax laws give preferential treatment to certain types of income, deductions (such as a deduction for mortgage interest and property taxes) and credits and the AMT attempts to ensure that anyone who benefits from this treatment pays a minimum amount of tax. Prior to December 31, 2004 the U.S. had a 90% foreign tax credit limitation for AMT purposes. The result was that many Americans were being double taxed as the AMT was typically not creditable on the Canadian income tax return. However, for taxable years beginning after December 31, 2004, the U.S. AMT rules have changed and eliminated the 90% foreign tax credit limitations so that many U.S. persons resident in Canada will not be subject to the additional AMT.
Normally you must file your U.S. return for a particular year no later than April 15th of the year following the year in issue. However, there is an automatic extension to June 15th if you are resident outside the U.S. on April 15th. For example, if you are a U.S. person and are resident in Canada on April 15, 2008, you must file your 2007 U.S. tax return by June 15, 2008. It is important to note that this does not give you an extension to pay your U.S. taxes should you have a liability to be paid with your return. The payment must still be made on or before April 15th or you will be susceptible to late payment interest and penalties.
Foreign Earned Income Exclusion
As discussed, U.S. citizens and permanent residents (green card holders) are required to file U.S. tax returns and report their worldwide income, even when they work outside of the U.S. The foreign earned income exclusion allows qualified individuals to exclude a portion of their foreign sourced and foreign earned income from U.S. taxation. The exclusion is limited to the lesser of $85,700 (for 2007) or the foreign earned income. To qualify for the exclusion an individual must meet either the (i) Bonafide residence Test (BFR) or (ii) Physical Presence Test (PPT). Once an individual meets the requirements of either the tests they must file a Form 2555 with their U.S. income tax filing. A taxpayer cannot file the Form 2555 until they qualify, therefore in most instances an individual will need to extend the due date of their return beyond the automatic June 15th filing deadline. For additional information on how to meet the BFR or PPT tests please visit the IRS website at www.irs.gov.
Prior to January 1, 2006, individuals who claimed the foreign earned income exclusion benefited from a lower effective tax rate on other sources of income. The reason being was that the IRS levied taxes based on taxable income and the foreign earned income exclusion was a direct deduction from taxable income. For example, if you earned $100,000 and excluded $85,700 from income you would be taxed as if you only earned $14,300 ($100,000 - $85,700) which would put you in the lowest tax bracket. However, the IRS introduced a new rule referred to as the “stacking calculation” to ensure that taxpayers living internationally are paying similar taxes on other sources of income as taxpayers with similar income who were living in the U.S.
The stacking rule requires the taxpayer to first add back the amount of the foreign earned income exclusion to taxable income, and then calculate his or her U.S. tax on that combined amount. Then, the taxpayer must figure the amount of tax that would be due if the amount of the foreign earned income exclusion alone were their taxable income. For example, the $14,300 as discussed above would be taxed as if your taxable income was $100,000 so that you would be in the 28% tax bracket for single filers instead of in the lowest tax bracket. The difference between these two amounts, if any, represents the taxpayer’s tax liability. The new “stacking calculation” does not typically affect U.S. citizens or green card holders working in Canada since the overall tax rate in Canada is higher than the U.S. tax rate. However, in arrival and departure situations additional tax analysis is required as the foreign earned income exclusion may not be as beneficial as using only foreign tax credits and an analysis should be done to see which method will produce the lowest amount of U.S. tax payable.
U.S. reporting rules for RRSPs and RRIFs
If you own a Canadian RRSP or RRIF, under U.S. domestic law, you are required to include income and gains earned inside your RRSP or RRIF in your taxable income for U.S. tax purposes on a current year basis, rather than when this income is withdrawn (which is the case for Canadian tax purposes). In essence, U.S. domestic law treats RRSPs and RRIFs as if they are simply normal investment accounts. Due to this timing mismatch, double taxation can result. However, there is relief under the Canada-U.S. tax treaty, which allows a U.S. person to elect to defer recognition of the income and gains from their U.S. taxable income until such time as the income is withdrawn from their RRSP or RRIF. Where this election is made, the timing of the taxation of the accrued RRSP or RRIF income will be the same in Canada and the U.S. Please note that some U.S. States do not recognize the Canada-U.S. tax treaty and tax you on a current year basis (e.g. California) which will result in some double taxation.
Form 8891 is now used to make the election to defer RRSP and RRIF income not yet withdrawn. The form must be completed if you hold an interest in an RRSP or RRIF, and the form must be attached to your U.S. tax return.
There are three purposes of Form 8891, which are as follows:
To report distributions received from Canadian RRSPs and RRIFs
To report contributions and un-distributed earnings
To make the election to defer U.S. income tax on income in an RRSP or a RRIF that has accrued, but has not been distributed
A separate Form 8891 must be filed for each RRSP or RRIF for which there is a filing requirement. In the situation where you and your spouse file jointly, Form 8891 must be filed for each spouse.
Form TD F 90-22.1
Each United States person, who has a financial interest in or signature authority, or other authority over any financial accounts, including bank, securities, RRSP or other types of financial accounts in a foreign country, if the aggregate value of these financial accounts exceeds US$10,000 at any time during the calendar year, must report that relationship each calendar year by filing TD F 90-22.1 with the Department of the Treasury on or before June 30, of the succeeding year. Please note that failure to file or late filing of these forms can carry a minimum penalty of $10,000.
U.S. persons living in Canada can invest in RESPs. However, this can pose adverse tax consequences as the U.S. does not allow a tax free deferral of income accrued within a RESP similar to RRSP. Therefore, the contributor to the RESP (typically the parent) is taxable on the annual earnings within the plan excluding unrealized gains and losses. Therefore, double taxation can potentially exist as the income is taxed in the hands of the contributor on a yearly basis for U.S. purposes, and then taxed again for Canadian purposes in the hands of the beneficiary (the child for whom the RESP was set up) when the income is withdrawn from the RESP. In addition, the RESP is regarded as a foreign trust for U.S. tax purposes and requires separate trust returns to be filed on an annual basis. Before investing in an RESP a U.S. citizen should seek professional advice to determine if there are ways to mitigate the negative tax consequences.
Relinquishing of U.S. citizenship or Green Card
Given the onerous reporting requirements the U.S. imposes on its citizens and green card holders regardless of where they reside, some U.S. citizens living permanently in Canada may wonder whether it is advantageous (for tax purposes) to relinquish their U.S. citizenship or green card. Generally, if you relinquish your citizenship or green card you will become a non-resident of the United States for income tax purposes as of the last day of the calendar year. However, if your tax home has shifted to Canada and your ties are significantly closer toCanada your residency termination date will be the date you relinquished your citizenship or green card.
Special expatriate rules apply to individuals who have been long-term residents of the United States and subsequently relinquish their U.S. citizenship or green card. You are considered a long-term resident if you were a U.S. citizen or green card holder for at least 8 of the prior 15 taxable years prior to the termination of your residency. These rules have been enacted to ensure individuals are not relinquishing their citizenship or green cards strictly for tax avoidance purposes. You will be subject to U.S. taxation under Section 877 if you are a former U.S. citizen or green card holder and if you meet any one of the following conditions:
If you are subject to tax under section 877, you are no longer taxed as a citizen or resident on your worldwide income. However, you must compute your tax as a non-resident in accordance with the special rules of section 877.
- Your average annual net income tax liability for the 5 years ending before the date of your termination of residency is more than a set amount ($136,000 for 2007)
- Your net worth is $2 million or more on the date you terminated your U.S. residency
- You fail to certify on Form 8854 that you have complied with all your U.S. federal tax obligations for the 5 years preceding the date of your expatriation
If, for any tax year during the 10-year period in which you are otherwise subject to section 877, and you are present in the United States for more than 30 days in a calendar year ending in such tax year, you will be treated as a U.S. citizen or resident for that tax year. You will be subject to U.S. tax on your worldwide income. There are some exceptions to this rule but they are beyond the scope of this article.
In addition to personal income tax obligations, individuals should be made aware of potential estate tax liabilities in the U.S. upon death. U.S. citizens and residents are subject to estate tax on their worldwide assets. It is important to note that residence for estate tax purposes is separate from income tax and is based on domicile (physical presence and intention to remain indefinitely.) Therefore, individuals on short-term assignment may be filing a U.S. resident income tax return, but will still be considered non-resident for estate tax purposes. Non-residents are only subject to U.S. estate tax on U.S. situs property which typically includes U.S. real estate property, U.S. pensions, and shares and options of U.S corporations.
Non-residents are exempt from estate tax if their U.S. situs properties are less than US$60,000 in value.
Citizens and residents are exempt from estate tax if the value of their worldwide assets is less than US$2,000,000 for the 2008 taxation year. This limit will increase in 2009 to US$3,500,000 and then the system will revert to the old rules with a maximum exemption limit of US$1,000,000. Therefore, unless further action is taken, the repeal of estate tax will only last for the 2010 tax year. Unfortunately, it is difficult to predict whether further steps will be taken to make this repeal permanent, or to perhaps continue the rules as they apply for 2009.
Estate tax is computed at graduated rates with the top rate currently being 45%. After 2010 the top rate will go back up to 55%.
Typically, when a U.S. individual passes away the assets rollover to the U.S citizen’s spouse tax free. The assets will then be taxed upon the eventual death of the spouse.
The Canada-U.S. tax treaty does have a provision that deals with estate tax to help alleviate the burden on non-residents with U.S. situs assets. The treaty allows non-residents to claim the same credits available to U.S. citizens on a prorated basis which is (U.S. situs assets/worldwide assets). The credits that are available to Canadians with U.S. situs assets are the Unified credit and the marital credit.
U.S. citizens and residents are subject to gift tax on gifts of all property while non-residents are subject to gift tax on gifts of tangible U.S. property. The gift tax rates are equal to estate tax rates. The current annual gift tax exclusions are as follows:
Unlimited gifts to U.S. citizen spouse
$125,000 per year to non-citizen spouse (2007)
$12,000 per year to all other recipients
In addition, there is a lifetime gift tax exemption of US$1,000,000 for U.S. citizens and residents. There is no exemption imposed on non-residents.
Gifts received by U.S. citizens/residents from a non-resident in excess of US$100,000 must file a Form 3520 to disclose this gift to the IRS.
Individual Taxpayer Identification Numbers (ITINs)
Any taxpayer filing a U.S. return must have either a social security number (SSN) or an individual tax-payer identification number (ITIN). In many instances an individual is not eligible for a SSN (i.e. Canadian with U.S. real property) and must therefore apply for an ITINto have their return assessed. In order to obtain an ITIN you must submit a Form W-7 along with your income tax filing. A separate form is required for each family member who requires an ITIN. In some instances it will also be beneficial to obtain ITINs for your children as you will get additional exemptions on your income tax filing.
In addition to the completed Form W-7, a valid application must include the following documents:
Certified or notarized copies of documents, that support the information provided on the W-7. A notarized or certified copy of a valid passport will suffice as full documentation for these purposes. Passports will be considered current if the date displayed on the document has not expired prior to the date Form W-7 is submitted. If such passport or copy is not included, you must submit at least two forms of identification as listed in the instructions to Form W-7.
The notary must see the original, valid and unaltered documents and must then verify that the copy conforms to the original. The notary must be a U.S. public notary legally authorized within his/her local jurisdiction. Your office may have a notary who can notarize your documents and you should check with your HR contact. Most banks and real estate offices also provide notary services, although the most cost effective way of getting a document notarized is often at the U.S. embassy if there happens to be one in the city in which you live. The notary should then place his seal on the document. The notary's original certificate with seal must be sent to the IRS along with your application.
Non-residents of the United States for income tax purposes
A non-resident of the United States is an individual who is neither a U.S. citizen nor green card holder or does not meet the Substantial Presence Test. To meet the Substantial Presence Test (SPT) an individual must exceed 183 days of presence in the United States in the current year or over a three year look back using the following formula [2007 days + (2006 days/3) + (2005 days/6)]. Once you meet the Substantial Presence Test you are considered a resident for U.S. income tax purposes under domestic law. However, under Article 4 of the Canada-U.S. tax treaty you can still be considered a non-resident of the United States for income tax purposes if your residential ties are stronger to Canada even if you meet SPT. In addition, days of physical presence are exempt from SPT if you are under a student visa (J or F visa).
Non-residents are taxed on U.S. source income only. Typically, U.S. non-resident returns are prepared for individuals who are on short-term employment assignments in the United States; own a rental property in the United States, dispose of real property in the United States or have Business or Partnership income from the United States.
If a Canadian employee is present in the U.S. for no more than 183 days during a tax year (now a 12 month period under the proposed changes to the Canada-U.S. treaty), and the remuneration is not borne by a U.S. employer or by a taxable branch (permanent establishment) of a foreign employer, this income is exempt from U.S. taxation, regardless of the amount of U.S. source compensation. Unfortunately, avoiding U.S. tax may provide little benefit if the employee remains subject to the higher Canadian resident tax rates, however, in most instances a U.S. non-resident treaty based return is still required so it does not alleviate the hassles of obtaining an ITIN and filing a U.S. income tax return.
Each state has its own rules and guidelines for determining residency status separate from IRS requirements. Every state has its own tax forms and they are typically due by April 15th of the following year. The U.S. return is mailed in separately from the individual state returns. It is important to note that some states (e.g. Texas and Florida) have no state tax while other states only tax certain types of income (e.g. Tennessee only taxes interest and dividends). Also, as mentioned earlier some states do not follow the Canada-U.S. tax treaty, therefore in some instances you can be a resident for state income tax purposes while a non-resident for Federal income tax purposes. As the rules are different for each state it is important that the state implications are considered.
We strongly encourage all individuals to comply with IRS filing requirements. It is important to remember that although you are a Canadian resident, as a U.S. citizen or Green Card holder, you continue to have U.S. tax obligations. In most instances it only involves filing a U.S. tax return and possibly a state return with no actual tax owing based on the exclusions and credits for which you could be eligible. It’s to your advantage to maintain yourself in good standing for future dealings with the U.S. authorities, particularly if you plan to return to the U.S. one day. Ensure that all your required U.S. filings are made on a timely basis and that you plan ahead for potential estate tax liabilities.
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