There are nearly 200 countries in the world and almost all of them implement a residency-based tax system. Put simply, this means that you’re only obligated to file a tax return where you live. There are, however, a small handful of countries that tax individuals not only on their residency, but also on their citizenship.
The most well-known of these nations is the United States of America. Citizens of the United States (or Green Card holders) who have expatriated will need to file two sets of tax returns; one to the Internal Revenue Agency (IRS) due to their American citizenship, and a second to the country where they reside.
As such, Americans living in Canada need to be aware of two sets of tax rules and how they interrelate. The traditional advice for a Canadian will not always apply to American-Canadians, and the tax rules that Americans may be accustomed to in the U.S. may not hold true in Canada.
Let’s take a closer look at a few of these issues.
Triggering capital gains
While it’s always difficult to determine the right time to sell an investment, in Canada it’s generally quite simple to estimate your tax payable on the sale of your shares. The difference between your purchase price and sale price is called a capital gain, and only half your capital gain is subject to tax. Therefore, if your marginal tax rate is 50%, you would expect to pay 25% tax on your capital gain.
As a U.S. citizen in Canada, you have additional factors that need to be considered.
First, exchange rates are significant. On your U.S. tax return, you have to report gains and losses in U.S. dollars. Just because you have a loss in one currency does not mean that will be the case in another currency. This mismatch could result in an unexpected tax bill. For example, consider a property that someone may have bought for $500,000 USD in 2011 when the USD and CAD were at par. Now, let’s assume that you sold that same property in early 2017 for $450,000 USD when the Canadian dollar was worth $0.65 USD. In the U.S. you have a loss, but on the Canadian return you have a gain of $192,000 ($450,000/0.65 = $692,308 – $500,000). In another scenario the reverse could also be true, where there is a loss in Canadian currency and a gain in U.S. currency.
Second, the U.S. classifies capital gains as either short term or long term. If the holding period was one year or less, it’s considered short term and is taxed as ordinary income. Conversely, if the holding period was greater than a year, the capital gain is subject to lower tax rates that would more closely resemble the tax-favoured capital gains treatment in Canada. Care must be taken and attention paid when triggering gains for this reason.
Lifetime capital gains exemption
Canadians who dispose of qualified small business shares can take advantage of a lifetime capital gains exemption. As of 2018, the exemption amount is $848,252 and it’s increased annually. Similarly, there is a $1,000,000 exemption on dispositions of qualified farming and fishing property. This is a great tax reward for many Canadians who sell their business.
Unfortunately, the IRS does not have the same exemptions. Therefore, the entire gain from the sale of small business shares, farm property, or fishing property, would be subject to U.S. tax for American citizens.
A fairly common year-end tax planning strategy is tax-loss selling. The concept is that you sell the investments you’ve lost money on to offset the gains that you’ve realized on your winners. You only pay tax on the net amount of gain. In Canada, if you have net losses you are allowed to carry them back to be applied against gains in any of the three previous tax years, or forward them indefinitely.
For U.S. citizens, exchange rates again need to be considered to make sure you’re not accidentally creating a gain in U.S. dollars. When creating capital losses, there are further intricacies to be considered from a U.S. perspective, with respect to short and long-term holding periods.
Short-term capital losses will offset short-term capital gains, and long-term capital losses will offset long-term capital gains. Short-term capital losses will only be applied against long-term capital gains once there are no remaining short-term gains to apply them against. Similarly, long-term capital losses will only be applied against short-term capital gains once there are no remaining long-term capital gains to apply them against. If you have a net capital loss, then the first $1,500 can be applied against ordinary income and the excess can be carried forward. For married filers submitting joint returns, the amount is doubled to $3,000. You are not allowed to carry back capital losses in the U.S.
Selling your home?
In Canada, you can sell your principal residence and the entire gain is tax free. It doesn’t matter if the gain is $5,000 or $5,000,000.
Americans need to be aware that the IRS only allows for a tax-free exemption of the first $250,000 USD in gain on your principal residence, and only if you have actually lived in that home for at least two of the past five years. If you’re married, this exemption can be doubled to $500,000 USD. This can create a significant and unexpected tax bill if you’ve remained in the same house for decades and your home has dramatically increased in value since your original purchase.
And with what has happened to real estate valuations over the last few years in markets such as Toronto and Vancouver, you may see a significant gain in a much shorter amount of time. For homes located outside of the U.S., currency fluctuations will again play a role in determining the $250,000/$500,000 exemption as the gain will be calculated in USD.
TFSA and RESP accounts
TFSA accounts are phenomenal savings vehicles for Canadians. Investment income within TFSA accounts is not taxable when earned, nor when eventually withdrawn and spent.
The IRS, however, does not allow any special tax-sheltering privileges for TFSA accounts, so this income is subject to taxation for Americans. Worse still, TFSA accounts may be considered a foreign trust, which means filing the onerous 3520 tax compliance forms. I say “may” because, to the frustration of many U.S. citizens in Canada, there has been no specific communication or guidance from the IRS on this matter, and different tax practitioners have different opinions on the status of a TFSA as a foreign trust.
Similarly, RESP accounts, while excellent education savings vehicles for Canadians, fall victim to the same traps as TFSA accounts for U.S. citizens. Worse still, the CESG grants that are received into the plan are considered income and, therefore, subject to taxation. If you have a Canadian spouse who has no ties to the U.S., you can still take full advantage of the benefits of an RESP account by ensuring that the Canadian-only spouse is the sole subscriber.
Canadian domiciled mutual funds
Canadian domiciled mutual funds can be fine investments for most Canadians, but for U.S. citizens the tax treatment can be very punitive when held within non-registered accounts, TFSAs, or RESPs. The U.S. considers several Canadian-based mutual funds to be Passive Foreign Investment Companies (PFICs). PFIC rules are quite complex and are outside of the scope of this article. If you are a U.S. citizen and are not aware of what a PFIC is or how they are taxed, I suggest you contact your advisory team to learn more.
From a year-end tax planning perspective, you would be wise to extricate yourself from your PFIC holdings in the above-mentioned accounts prior to the end of the year. Not only to avoid any further punitive tax treatment, but also to avoid having to make the onerous tax filings next year. If, for whatever reason, you still want to hold a PFIC you should talk to your mutual fund provider to determine if they can provide you with a PFIC Annual Information Statement (or QEF statement). This will allow you to treat the PFIC as a Qualified Electing Fund (QEF), which is taxed more favourably.
Unfortunately, many fund providers do not provide such statements, which means that you would have to take the default PFIC tax treatment or make a Mark-to-Market (MTM) election. The MTM election is preferred to the default method. Taking the MTM election means you will be taxed as though you hypothetically sold your fund holdings at the end of each election year.
The gain on the deemed disposition is taxed at ordinary rates instead of capital gains rates. The deemed disposition is, of course, fictional and there will be no corresponding income or tax payable to Canada. With income in the U.S. but not in Canada there would be no chance to claim a foreign tax credit, resulting in double taxation when the fund is eventually sold (for real) in Canada.
A reasonable solution to this problem would be to actually realize the gain each year in Canada by selling the fund on December 31, and then rebuying it. At least then your income in Canada and the U.S. will match and you’ll have a basis for claiming a foreign tax credit, but then, you would lose all the deferral inherent in an unrealized gain. Therefore, you may be better off just avoiding PFICs.
If you have a non-U.S. spouse, they could own the PFIC in an account that is in their name only. However, if all of the investments are currently in your name, you need to be careful about tax attribution rules in Canada. A family income-splitting loan could be combined with this strategy. Your spouse can take the loaned funds and invest in the desired PFIC in an account registered to them solely. Assuming your U.S. filing status is Married Filing Separately, all that you would need to report on your U.S. tax return would be the interest paid to you by your spouse on the loaned funds.
Large RRSP contributions
As a Canadian, a great option to invest tax-efficiently is within an RRSP. When you contribute, you get a deduction on your tax return which reduces your taxable income for the year by an amount equal to your contribution. For as long as the investment remains within the RRSP, all growth is tax free. When a withdrawal is eventually made from the RRSP, it is taxed as ordinary income.
The idea is that when you start to make withdrawals it will be after you have retired, when it is likely that you are in a lower tax bracket than you were in when you made the original RRSP contribution. If you do not make your maximum RRSP contribution in any given year, the ability to do so will be carried forward indefinitely. This carry-forward mechanism results in many Canadians accumulating very large RRSP deduction limits. In the event of a financial windfall (severance, stock option exercise, sale of property, inheritance), you may be inclined to make a lump-sum RRSP contribution to reduce your taxable income dramatically in that year.
This large RRSP contribution can cause issues if you are a U.S. citizen. While there are some exceptions, by default, the IRS does not recognize the RRSP contribution for deduction purposes on your U.S. tax return. This can result in a mismatch of taxable income in the two countries, and depending on the size of the RRSP deduction, you may find yourself with an unexpected amount owing to the IRS.
Other than the concern over deductions being matched, RRSPs generally work well for U.S. citizens in Canada. The income is tax deferred on both sides of the border, and there is no cause for concern with holding PFIC investments within RRSPs.
It’s easy to get frustrated by the complexities and seemingly unfair rules that apply to Americans living in Canada. What I try to remember (as an American citizen in Canada myself) is that there are many advantages that come with U.S. citizenship as well.
You can work, vote, and enjoy unrestricted travel in the States. On the contrary, Canadian snowbirds are restricted as to the number of days that they can spend stateside. Furthermore, the ability to retire in the U.S. after working in Canada could have lucrative tax advantages for individuals who have amassed large RRSPs or Canadian pensions.
In the meantime, paying attention to tax planning strategies – on both sides of the border – is important to consider so you don’t fall victim to double taxation. Layering multiple tax regimes with differing rules can become much more complex than dealing with a single tax jurisdiction. As such, it is recommended that you consult your team of trusted advisors as necessary.
Aaron Hector, Vice President & Consultant
Doherty & Bryant Financial Strategists, Calgary
A division of T.E. Financial Consultants Ltd.
This article was published in T.E. Wealth’s Strategies newsletter, March 2018 edition. Read the full edition here.