The reality of being a “DUAL” Canada U.S. tax filer is that you are a “DUEL” tax filer

“It’s not the taxes they take from you. It’s that the U.S. tax system leaves you with few opportunities for financial planning”

I was recently asked “what exactly are the issues facing “Canada U.S. dual tax filers?” This is my attempt to condense this topic into a short answer. There are a number of “obvious issues facing U.S. citizens living in Canada.” There are a number of issues that are less obvious. Here goes …

There are (at least) five obvious issues facing “dual Canada U.S. tax filers in Canada”.

1. The Requirement To Pay Taxes To Both The U.S. And Canada

– Double Taxation: for example, the 3.8% Obamacare surtax on Investment Income

– U.S. taxation on things that are NOT taxed in Canada (example: sale of principal residence and investment income earned inside Canadian Controlled Private Corporations) and phantom capital gains caused only by exchange rate fluctuations

– U.S. punishment/deferral penalties (Interest on tax deferral) on Canadian mutual funds – have you ever heard of a PFIC?

In many cases, the “foreign tax credit rules” will mitigate the impact of potential double taxation. That said, it is very common for “dual filers” living in Canada to be required to pay taxes to the United States. Furthermore, double taxation (because of the “savings clause“) is generally NOT eliminated by the Canada U.S. Tax Treaty. U.S. citizens are NOT generally allowed to benefit from the treaty.

2. The Reporting Requirements

The United States requires its “citizens” to file detailed reports disclosing financial assets. While a “dual filer” living in Canada is required to report very little information to the Government of Canada, the USA requires a massive amount of information about Canadian assets to be reported to the IRS on an annual basis. There are severe penalties for the failure to report on these assets. You may have heard of FBAR, FATCA form 8398, Form 8621, Form 3520 and 3520A and more. Those who have a Canadian Controlled Private Corporation are required to file Form 5471 (a form that requires more disclosure about their Canadian Controlled Private corporation than is required on A CANADIAN tax return!). Note also that there are circumstances where income earned by the company is attributed to the U.S. citizen individual (and must be reported as income on the U.S. return)!

By the way, forms 8621 and Form 5471 have to be filed even if a tax return is not otherwise required!

U.S. citizens have ZERO financial privacy!

3. The Direct Costs Of U.S. Tax Compliance

U.S. tax returns (including satisfying the “reporting requirements”) can easily exceed 100 pages and can cost thousands of dollars to prepare. Of course, the costs are significantly less for those who have “simple lives” and few assets. U.S. tax returns are NOT simply an extension of a Canadian tax return. Those who complete their U.S. tax returns based ONLY on their Canadian tax returns are making a mistake. U.S. tax returns need to be considered separately and must take into account items that are “taxable or reportable events” in the USA but are not reportable or taxable in Canada.

4. U.S. Tax Rules That Directly Impact The Marriage Between A U.S. Citizen And Non-Citizen

With a bit of advance planning you can “work around” these areas. That said, a “non-U.S. citizen spouse” is considered to be an “alien” and an opportunity for income and assets to slip away from the U.S. tax system. It is common for U.S. citizens living in Canada to use the “married filing separately” category which is extremely punitive. Interestingly, this is a “built in tax” on the marriage between a U.S. citizen and an “alien”.

5. The Opportunity Cost – By Far The Biggest Cost

U.S. citizens resident, are deprived of many of the “normal” financial and retirement planning opportunities available to other Canadians. This is NOT immediately obvious. That said: it is the single biggest cost of being a “dual Canada/U.S.filer”.

Why Is This So – Let Me Explain …

Canada is a country with very high tax rates. It’s very hard to “save and get ahead” in a country with a high marginal tax rate that “kicks in” at a relatively low level of income. Canada has a brutally efficient system of tax collection. In addition to paying taxes on income that are (in general) higher than in the United States, Canada has a VAT (which is NOT recognized for purposes of the U.S. “Foreign Tax Credit” rules). Furthermore, Canada does NOT have generous “Social Security Type” programs. Canada Pension Plan and Old Age Security are NOT income replacements but are supplements to income. Therefore, (and financial literacy should be a required skill) it is ESSENTIAL that Canadian residents engage in intelligent, purposeful and effective retirement planning. Much of financial planning is based on the tax consequences of various transactions.

Intelligent, Purposeful And Effective Retirement Planning For Canadian Residents

At the risk of oversimplification most Canadians employ some or all of the following …

Employee Pension Plans:

Examples include the pension plans offered by teachers, public employees, etc. Fewer and fewer Canadians have access to these kinds of plans. Fewer and fewer Canadians have access to these lucrative arrangements.

Availability To U.S. Citizens In Canada: The U.S./Canada tax treaty does allow for favorable treatment of Company pension plans for U.S. citizens in Canada. The U.S. Canada tax treaty is particularly favorable in this regard. In contrast, consider the U.S. Australia tax treaty which does NOT afford similar U.S. tax treatment to Australian pensions.

Individual Tax Deferral Opportunities In Government Registered Plans:

Examples include: RRSP, TFSA, RESP, etc.

Availability To U.S. citizens In Canada:

RRSP – yes
TFSA – no tax deferral and fully taxable
RESP – no tax deferral and fully taxable

The income earned inside the TFSA and RESP will be taxed directly to the U.S. citizen. There may also be additional (expensive) “reporting requirements” with respect to these investments.

The Use of A Canadian Controlled Private Corporation 

Availability To U.S. citizens In Canada:

1. Clearly No. The growth of investment income inside the corporation is attributed to the shareholder and subjected to punitive taxation. This destroys the opportunity to use the Canadian Controlled Private Corporation as a retirement planning vehicle.
2. Clearly No. The “reporting requirements” reflected in Form 5471 are tremendously expensive and penalty laden.
3. Clearly No. U.S. citizen shareholders of Canadian Controlled Private Corporations are NOT entitled to the Canadian “lifetime” capital gains exemption on the sale of the shares of the CCPC.
4. Possibly No. Canadian tax planners plan the payment of dividends to shareholders in a way that results in minimization of taxes paid at the Shareholder level. This is the direct result of Canada’s system of giving shareholders tax credits for certain taxes paid by the corporation. The dividends are subject to full U.S. taxation on the U.S. return.
5. Possibly No. In theory dividends from a Canadian Controlled Private Corporation are possibly (depending on your interpretation of the Canada U.S. tax treaty) subject to the 3.8% Obamacare surtax.

There is no “Clearly Yes”. It’s complicated! I have seen very knowledgeable and competent advisors argue over whether U.S. citizens in Canada should make use of Canadian Controlled Private Corporations.

Individual Stock And Investment Portfolios:

Generally, this would include individual “debt” (think GICs) and “equity” (think individual stocks).

Availability To U.S. Citizens In Canada:

Yes absolutely available. The dividends, interest and capital gains are subject to “normal U.S. taxation”. The U.S. tax owed will be reduced by the tax paid in Canada.

Canadian Pooled stock And Investment Portfolios:

In general, this means “Canadian mutual funds”.

Availability To U.S. Citizens In Canada:

No. Canadian Mutual funds are considered to be PFICs under U.S. law and are subject to taxation at rates that can approach 100%.

Principal residence AKA The tax free sale on a principal residence (very popular in larger Canadian cities):

Availability To U.S. Citizens In Canada:

Yes and No. U.S. citizens in Canada are required to pay capital gains taxes on the sale of their principal residence. (There is currently a $250,000 USD exclusion).

Conclusion:

U.S. citizens in Canada are simply NOT able to take advantage of the retirement and planning opportunities available to their neighbors. The problem of the U.S. tax system for U.S living in Canada should be characterized as:

“It’s not the taxes they take from you. It’s that the U.S. tax system leaves you with few opportunities for financial planning”                                                             

Have a tax question? Contact John Richardson.