United States citizens and Green Card holders are both considered U.S. persons, regardless of where they live. U.S. persons living outside the U.S. (such as in Canada) must continue to file U.S. tax returns annually, even if they have no income from the United States. For such individuals, there are mechanisms to avoid or reduce U.S. tax exposure and, in many cases, end up owing no U.S. tax at all. Still, failure to file returns, related forms and certain foreign information reporting can result in significant penalties.
U.S. tax return complexity is dependent on various factors and decisions a U.S. person makes while residing outside of the U.S. Here, we review some of these with the aim of clarifying why a U.S. tax return can be so complicated, even for those with seemingly straightforward circumstances.
Let’s begin with a simple bank account. If a U.S. person holds chequing and savings accounts in Canada and the total of the highest balances in those accounts, at any time during the year, exceeds the threshold of $10,000 US, the individual has a reporting requirement, officially known as a Report of Foreign Bank and Financial Accounts (FBAR), Form 114.
This form must be filed annually and electronically (there is no paper option) with the U.S. Treasury. It reports all financial accounts, including bank accounts, investment accounts, RRSPs, certain life insurance policies, joint accounts and even accounts where one has signing authority but no financial interest. Failure to comply can result in a penalty starting at $10,000 US per financial account.
An additional reporting form, Form 8938, may be required when a specified individual’s1 financial assets exceed somewhat higher thresholds.2 This form includes not only most of the same information required by the FBAR, but also additional information, such as stocks held personally or debt owed to a foreign (non‑U.S.) entity. The penalty for failure to file Form 8938, filing it incompletely or filing it late is $10,000 US.
Also included among these financial accounts are the Tax‑Free Savings Account (TFSA) and Registered Education Savings Plan (RESP). However, these accounts add more complexity to the U.S. tax return. Unlike Canada, the Internal Revenue Service (IRS) does not recognize these accounts as tax‑deferred vehicles. This means income in those accounts must be reported on one’s U.S. tax return annually, even though it is not reported on a Canadian tax return. Likewise, grants received and income earned in a RESP account must be included on the U.S. tax return in the year they are credited to the account.
Even the type of investments a U.S. person holds may trigger additional reporting requirements on a U.S. tax return. For example, the U.S. has rules regarding Passive Foreign Investment Companies (PFIC), requiring complex reporting and elections on Form 8621. Before any U.S. person invests in a Canadian mutual fund (including exchange‑traded funds), they should consult their broker and U.S. cross‑border tax specialist. They must confirm whether the mutual fund is a PFIC and, if it is, does the particular fund provide PFIC reporting. If it is a PFIC, an election can be made in the first year, allowing favourable tax reporting in certain circumstances. A U.S. cross‑border tax specialist can advise if this is beneficial. Even with the election, PFIC reporting can be complex. Income values must be calculated based on the daily amount of units within the fund. Each mutual fund held must be reported on a separate Form 8621, with income calculated on a fund‑by‑fund basis.
Increasingly, Canadian financial institutions are providing the information needed to make PFIC calculations, but there are usually additional calculations required – to be made by a U.S. cross‑border tax specialist – to determine daily units and daily income inclusions. Keep in mind it is not the same income as reported on the Canadian tax return that would be reported on the U.S. tax return. Instead, it is the income calculated under U.S. rules and included on the PFIC reporting statements that would be reported on the U.S. tax return.
Having a broker who understands U.S. tax rules is also critical, not only for rules like PFICs, TFSAs and RESPs, but also for buying and selling regular stocks. U.S. tax is applied to capital gains differently than in Canada. Canada only taxes 50 per cent of capital gains, while the U.S. taxes 100 per cent of the capital gain, but at different tax rates, depending on whether the gain is short- or long‑term:
- A short‑term capital gain, which applies to a property held for less than a year, is taxed at regular U.S. tax rates. Since Canada only taxes half of the gain, the U.S. tax could exceed the Canadian tax, potentially causing issues for claiming the foreign tax credit, as we will discuss later.
- A long‑term capital gain, applicable to a property held for more than a year, is taxed at reduced tax rates. This reduced rate is more in line with Canada’s tax rates being applied to only 50 per cent of the capital gain.
There are other capital gain issues to be aware of. The statements a Canadian broker supplies for Canadian tax purposes are calculated using the average cost of the property, but the U.S. calculates the cost on a first‑in, first‑out basis. The capital gains are then converted to U.S. dollars at the exchange rate at the date of purchase for the cost and the date of sale for the proceeds. The more transactions in a year, the more complex the U.S. tax return becomes.
Lottery and gambling
Canadian taxpayers normally do not think twice about lottery and gambling winnings. Prizes won on lottery tickets, slot machines, raffles or other contests are not taxable in Canada. However, these are all taxable on the U.S. tax return. If a U.S. person has a non‑U.S. spouse, one strategy is to have the spouse purchase any lottery tickets to avoid losing a portion of winnings to U.S. tax.3
Business in Canada
Another complexity arises when a U.S. person starts a business in Canada. They may start this business as a sole proprietor, partnership or Canadian corporation. Each option has a specific impact on the U.S. tax return. A proprietorship, for example, is reported on both Canadian and U.S. tax returns. However, the rules for each country must be considered in determining how income and expenses are calculated. For example, depreciation is calculated far differently in the U.S. than in Canada. An additional form, Form 8858, may be required. Likewise, a partnership is reported on both Canadian and U.S. tax returns. Again, different rules may apply in each country. Another form, Form 8865, may also be required.
The greatest challenge by far is when a business is operated as a Canadian corporation. Here, it is important to know how many shares one owns, who the other shareholders are and if any of them are U.S. persons. Typically, the U.S. government does not look favourably on a business operated as a foreign corporation (Canadian in this case). The IRS maintains a complex set of rules to ensure any U.S. person does not avoid or delay U.S. tax by having their business in a Canadian corporation. Terms such as Global Intangible Low‑Taxed Income (GILTI), Subpart F and even PFIC may come into play to bring the corporation’s income into the U.S. person’s U.S. tax return annually. Here, Form 5471 may be required; either late filing or failure to file may trigger a $10,000 US penalty.
Foreign tax credit
While all this seems harsh, mechanisms do exist to help mitigate the negative impact of U.S. tax. The foreign tax credit is one such mechanism. Again, computation of the foreign tax credit can be complex. The U.S. has divided the foreign tax credit system into “baskets,” which divide income into specific categories. Generally, investment income goes into the passive basket, employment income and other income goes into the general basket, and proprietorship income goes into the foreign branch basket.4 The Canadian tax is then divided into the appropriate baskets and may be applied against the U.S. tax calculated on Canadian income allocated to that particular basket. The theory is you should be able to take a credit for the Canadian tax to help reduce or eliminate U.S. tax, if that income was earned outside the U.S. However, what if all the U.S. person’s investment income is earned via Canadian TFSA? In this case, there would be no Canadian tax in the passive income basket, but the U.S. person must pay U.S. tax on income otherwise tax‑free in Canada.
Net Investment Income Tax
Compounding matters, the U.S. also has something called Net Investment Income Tax (NIIT). This is an additional 3.8 per cent tax on investment income which kicks in once one’s income exceeds a particular threshold – depending on U.S. tax filing status. The IRS and U.S. tax courts5 have stated the foreign tax credit cannot be applied against the NIIT.
Foreign Earned Income Exclusion
Another mechanism to help avoid or reduce a U.S. person’s U.S. tax liability is the Foreign Earned Income Exclusion (FEIE). This can be applied to reduce income from wages or certain personal service self‑employed income. It allows a U.S. person living outside the U.S. to exclude a portion of earned income from their U.S. tax return up to a maximum amount. For 2022, this amount is $112,000 US ($120,000 US for 2023). In 2022, a U.S. person can exclude up to $112,000 of their Canadian T4 income converted to U.S. currency. This is very beneficial in certain circumstances, but should be evaluated carefully to ensure certain refundable credits are not disallowed.
Yet another advantageous mechanism is the standard deduction. U.S. persons may use either the standard deduction or itemized deductions. For 2022, the basic standard deduction is $12,950 if filing status is “single” or “married filing separate,” and $25,900 if filing status is “married filing joint.” It should be noted U.S. persons may file their tax returns together if they are both U.S. persons or elect to be treated as such. Using the standard deduction together with the FEIE can exclude a significant portion of income from U.S. taxation. Itemized deductions have been used less frequently since the standard deduction was increased and the types of allowable itemized deductions were reduced. Itemized deductions still allowed include mortgage interest, U.S. property taxes, state taxes and charitable donations. Medical expenses may also be included as itemized deductions but since they must be reduced by 7.5 per cent of your income, they need to be significant before they can be used.
Estate and gift taxes
The U.S. also has estate tax, applicable upon one’s death, and a gift tax, applicable when one gifts their assets. U.S. citizens living in Canada are subject to the U.S. estate tax on their worldwide assets. Currently, for 2022, there is an exemption of $12.06 million US, meaning if one’s worldwide assets are less than this amount, they will not have to pay any U.S. estate tax. Connected to estate tax is gift tax. Here, the principle is the IRS does not want U.S. persons gifting away their assets to avoid estate tax. A gift tax return is required if a U.S. person gives someone, other than their spouse, more than $16,000 US (2022 level) in a year. While the gift can be offset by the estate tax exemption amount, this reduces the estate tax exemption for future use. If a U.S. person’s spouse is not a U.S. person, the spouse can be gifted up to $164,000 US (2022 level) before a gift tax return must be filed. If the spouse is also a U.S. citizen, the spouse can be gifted any amount without filing a U.S. gift tax return. As a word of caution, be aware of Canadian rules to determine if Canadian tax consequences on gifts may apply.
U.S. cross‑border tax specialists
Normally, most U.S. persons who live in the United States and hold no foreign investments do not need to deal with the complexities a U.S. person living abroad does. Many U.S. persons living in Canada may not even fully know or understand the rules applicable to them. This is why a knowledgeable U.S. cross‑border tax specialist is so vital. Baker Tilly Canada has U.S. cross‑border tax specialists across Canada who can help you navigate the intricate rules.
- You are a specified individual if you are one of the following: U.S. citizen; a resident alien of the U.S. for any part of the tax year; a non‑resident alien who makes an election to be treated as a resident alien for purposes of filing a joint income tax return; a non‑resident alien who is a bona fide resident of American Samoa or Puerto Rico.
- Filing threshold is dependent on various factors: living inside or outside the U.S., filing a U.S. tax return as unmarried, married filing separately, or married filing jointly; and value of assets during the year vs. end of year.
- Withholding taxes still apply.
- Although these are the three most commonly used baskets, there are actually seven different baskets: section 951A, foreign branch, passive, general, section 901(j), certain income resourced by treaty and lump‑sum distributions.
- Catherine Toulouse v Commissioner 157 tc No 4, No 19076‑19L