Given all the recent media attention it seems like those of us that are considered U.S. persons living in Canada have a target right in the middle of our forehead. The IRS has taken to task the lucrative activity of pursuing U.S. persons living outside of America to ensure that they are paying their fair share. The basic definition of a U.S. person according to the IRS is any citizen or resident of the United States, regardless of the amount of time that the individual actually lived in the United States. Included in this list are children of U.S. citizens and green card holders. As such U.S. persons living in Canada should be particularly diligent in ensuring that both the CRA and IRS are satisfied at tax time by following some simple rules:
FILE all necessary documentation
Filing is essential to ensuring that you will not suffer adverse consequences as a result of being a U.S. person. The penalties for not filing are large and currently the IRS has implemented a number of measures, such as the Offshore Voluntary Disclosure Program (OVDP), to make it less punitive for U.S. persons living in Canada who come forward voluntarily and bring their filings up to date. In addition to filing taxes, U.S. persons are required to report their holdings in foreign bank and financial accounts (FBAR) where the sum of those accounts is greater than $10,000. For investors with sufficiently large assets, a Statement of Foreign Assets must also be filed. Next year, Canadian financial
institutions will need to report U.S. persons holding foreign accounts directly to the IRS.
BEWARE of Passive Foreign Investments
Passive Foreign Investment Companies (PFIC) are companies that do not participate in an active business. Generally speaking, Canadian mutual funds and ETFs, although they are trusts in the CRA’s eyes, may fall into the category of companies for the IRS. As a consequence, many mutual funds and ETFs fall into the category of Passive Foreign Investments as they derive passive income in the form of interest, dividends and capital gains. When a fund is sold for a capital gain, the IRS has taken the tact to tax these gains at the highest level and apply an annual interest charge to the tax bill. Of course, this situation does not occur for investors that own individual stocks and bonds.
For example, suppose you purchased a mutual fund in 2008 for $10,000. This mutual fund did not distribute capital gains and was sold in 2012 for $20,000, including a $10,000 capital gain. The IRS would divide the gain over the number of years you held the fund and apply an interest charge to the tax payable for each year.
To put this into perspective, consider this example of the PFIC taxation provided
Jan 1, 2008: Purchased 10,000 units of a mutual fund for $100,000 Distributions of $8,000 were received annually and are be reported as non-qualifying income.
Dec. 31, 2010: All units sold for $400,000 resulting in a $300,000 capital gain.
If you include the tax paid on the regular distributions over the three years the total tax bill on this investment would be approximately $120,000! According to the article, this would compare to a total tax bill of approximately $45,000 for a U.S. resident purchasing a U.S. fund with the same characteristics!
There are methods to avoid this type of consequence by estimating annual income based on either a mark to market valuation or by attaining the distribution schedules of each fund company.
ENSURE that you Remain Qualified for Exemptions
The IRS isn’t all bad. There are a number of exemptions to make the tax process easier. Canadian tax paid can be used to offset U.S. tax due. There are elections available to defer the tax on RRSP and RRIF accounts so that the IRA taxes these plans in sync with the CRA.
All PLANS are not Considered Equal
As mentioned previously, RRSPs and RRIFs can be exempted from being taxed by the IRS until the income is actually taken out of the plan. However, this does not apply to all plans. TFSAs and RESPs are considered taxable annually.
U.S. Persons holding these types of plans need to consider if they will receive the same benefits that other Canadians enjoy.
In summary, this article only scratches the surface of U.S. tax legislation and should not be used as tax advice nor considered to be exhaustive. However, it points out a simple opportunity for advisors who have not yet sat down and had these discussions with investors who may be U.S. persons. Getting in front of U.S. tax rules at a time when there are some opportunities for forgiveness can provide tremendous added value for investors.