Foreign Tax Credits – Sometimes Not Enough

As mentioned in my previous post, filing a U.S. income tax return for a Canadian resident might be nothing more than a paper pushing exercise.  I’ll give you an example.  If a U.S. citizen lives and works in Canada, he or she will have to pay Canadian income tax on the employment income he or she earns. As a U.S. citizen, this person would also be responsible for reporting his or her Canadian employment income on his or her U.S. tax return.  The first question that comes to mind is invariably “if I am reporting income on two tax returns (my Canadian return and my U.S. return), does that mean I am going to have to pay tax twice?”. The answer to this question is no. This is due to a double-tax prevention mechanism, commonly known as ‘foreign tax credits’.  A foreign tax credit is a virtual dollar-for-dollar reduction in tax that a taxpayer can claim if he or she has already paid income tax to another country on income taxable in a second country. In the example noted above, the taxpayer would pay income tax on their Canadian employment income to the government of Canada, and subsequently claim a credit on their U.S. tax return (against the U.S. tax levied on that same employment income).  Because the Canadian tax rates tend to exceed the U.S. tax rates on employment income (depending on what province and what state you are dealing with), this credit typically offsets an individual’s U.S. tax liability in its entirety.  Foreign tax credits are non-refundable.  In other words, they can only reduce your tax liability to zero (the U.S. government will not give you a refund for tax that you pay to Canada) – the IRS will however allow you to carry unused credits forward for a period of 10 years, in case you need to use them in a future year.

In other situations, an individual’s cross-border compliance obligation can cause frustration.  One of the more common situations where U.S. citizens who reside in Canada run into some financial peril is when they earn certain types of income on which the U.S. tax rates exceed the Canadian tax rates.  In this situation, a taxpayer would pay his or her Canadian tax, and bring a foreign tax credit onto his or her U.S. return; however, the credit would not be large enough to offset the U.S. income tax levied.  As I mentioned above, the Canadian tax rates levied on earned income (i.e. – employment income and unincorporated business income) tend to exceed the U.S. rates, and the foreign tax credit mechanism alleviates any U.S. liability and/or concern.  That said, the U.S. rates on several types of investment income (including dividends, capital gains, trust distributions, and/or income derived from non-U.S. mutual funds) can greatly exceed the Canadian rates. For example, Canada effectively taxes capital gains at a rate equal to one half on an individual’s marginal tax rate.  The U.S. taxes capital gains at different rates, depending on how long the capital property was held for. Short-term (i.e. – investments held for less than one year) capital gains are taxed at an individual’s marginal tax rate, and long-term capital gains (i.e. – investments held for more than one year) at a flat rate of 15% (or 20% for high-income earners).  As is clear, a situation could arise where a U.S. citizen (and Canadian resident) taxpayer triggers a capital gain, and the Canadian tax levied is less than the respective U.S. tax (i.e – a short term gain).  This particular taxpayer would owe some tax to Canada (the presumed country of source), and would subsequently need to pay a top-up to the United States, for a combined rate equal to the higher U.S. rate.

In my next blog entry, I will reiterate the importance of having a financial planner with knowledge of both Canadian and U.S. income tax law and investment markets.

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These articles are for general informational purposes only. Please obtain professional advice before taking any action based on this information. No endorsement or approval of any third parties or their advice, information, products or services should be implied by any references to third parties contained in any article. Trademarks cited in these articles are the respective properties of their owners.

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