Americans in Canada: Time to Face the Paper Tiger

July 1, 2012 | Dental |

Are you among the one million or so Canadian residents who are also us citizens? if so, you may have american income tax filing and planning requirements that require immediate attention.

In fact, the next time you cross the border into the us you may be asked for your american passport and if you don’t have one, border guards may instruct you to secure one. if you present a Canadian passport that indicates the us as your place of birth, they may ask you
numerous questions.why? us authorities are now linking passport data with tax filing compliance.when you apply for a us passport, you will be required to inform the state department whether you have filed your us tax returns for the last three years.this information will then be forwarded to the internal Revenue service.

Since 2008 when the us budget deficit began to swell and certain financial institutions were found to be assisting wealthy Americans who were evading tax, the iRs has been stepping up enforcement of reporting rules for expatriates. it’s important for us citizens (and in some cases green card holders) who are residents in Canada to be aware of and meet their obligations because the iRs has made it clear that it will impose steep penalties for non-compliance. here’s what you need to know about filing the necessary documents to satisfy the “paper tiger”.

Most obligations relate to filing documents rather than paying taxes

No matter where they live,american citizens are subject to us income, gift and estate taxes.they are required to pay us tax on their worldwide income – not just income earned in the united states. however, a “foreign-earned income exclusion” exempts up to US$95,100 of Canadian-source employment and business income.  After applying this exclusion and foreign tax credits, most Americans residing in Canada pay no additional us income tax.

When it comes to tax strategies, however,americans living in Canada sometimes have to plan differently than Canadians since certain situations can create tax obligations. here are a few examples:

Canadian corporations and trusts: having a Canadian entity like a professional corporation (PC) or trust can create complications.

  • When you control a corporation such as a PC, investment income earned inside it is included in your us personal taxable income – even if the income is not distributed to you.the same may even apply to income earned from providing your own services. even if the income is distributed, us tax may be higher than Canadian tax.
  • When you (and other americans together) own only a minority of an investment company, income distributed out of it can be subject to onerous taxation – even up to 100% of the distribution.
  • Income earned by a trust can, in some cases, be attributedback to the person who funded the trust.alternatively, distributions received by you from a trust could be subject to tax similar to that for an investment company.
  • If you sell your incorporated dental practice, Canada often allows an effective tax exemption of up to C$750,000 of the gain. unlike a Canadian, however, you would be subject to us tax on the entire gain, usually at a rate of 15%.

Gift and estate taxes: should you die, your estate will be subject to a tax of 35% of its value over us$5.12 million.

US gift tax is integrated with estate tax, so lifetime transfers count against the same $5.12 million. once that threshold is passed, gift tax applies at the 35% rate. many common corporate reorganizations (such as integrating a pC into a trust for your children), which create no tax in Canada, can create us income or gift tax.

It’s important to carefully plan these types of transactions if you or your spouse is a us citizen.

US citizenship, not country of residence, is what counts

Each US citizen who makes more than a small amount of income, no matter where he or she lives, is required to file a tax return reporting worldwide income, regardless of whether the individual owes money to the iRs.this return must include reports for most closely-held foreign entities such as PCs.

If you have accounts in Canada totalling $10,000 or more during the year, for example, you must file an annual Report of Foreign Bank and Financial account (FBaR) listing every
foreign account in which you have a financial interest or signature authority. starting in 2014, foreign banks and investment firms will be required to report the accounts of US citizens.  Thus your Canadian institution will ask you if you are a us citizen and must report your account information to the IRS.  If you refuse to answer the question, the bank will decline your business.

US penalties for non-filers are similar to those of Canada – most are based on the amount of tax payable. since few Americans in Canada owe us tax, these penalties are rarely a significant issue.the more serious penalties arise from failing to file the supplementary reports required for corporations, partnerships, trusts and bank accounts held abroad.  The penalty for failing to file even one of these forms is typically $10,000, but total penalties can reach much higher.

Options to get into the system

Since many americans living in Canada have never filed US tax returns, the following are some options to consider:

File eight years of returns: the IRS is encouraging people to come forward voluntarily, promising those who file eight years of past tax returns and FBaRs they won’t go to jail or
be required to pay the $10,000+ supplementary filing penalties.  In return, you must provide all requested information and pay a fine of 5% of the value of non-us accounts (the highest amount during that eight-year span).

File six years of returns: this is a less expensive proposition but also offers less certainty the IRS will abate penalties. the IRS has indicated it is considering leniency if non-filers
take the initiative; unfortunately, the definition of “lenient” is unclear.

File this year’s return: this is the “hope and pray” approach. If the IRS selects your return, and asks for prior years’ returns, you may be penalized heavily – this approach does not lend itself to IRS sympathy.

Do nothing: Relying on the “I didn’t know I needed to file” excuse is a risky proposition.  If the IRS assesses tax, penalties and interest, you are at risk. if you were also a Canadian citizen for the tax year in question, the IRS will usually have no enforcement ability in Canada. however, if you have us assets, they are vulnerable to an IRS levy.  If you
do not pay, and you cross the border, you could be arrested.

Renounce your American citizenship: this is not an easy process either; even if you have filed your returns, you may be exposed to significant us tax and penalties.

These are only some of the options available to american citizens residing in Canada. and there are others for green card holders. ultimately, you don’t want a fight with the paper tiger.  If you haven’t been filing tax returns, it’s important to get into the system.  The good news is that most risks can be managed if you consult with advisors who have us tax
expertise to help you plan a strategy for your situation.

Bottom Line:This article offers tax considerations, in light of recent developments, for Americans living and/or working in Canada.