From Americans Living in Canada – Smile, The IRS is Watching You, by David A. Altro and Jonah Z. Spiegelman. Copyright © Altro Levy LLP, 2014. Reprinted with permission of Altro Levy LLP
The US is the only western country in the world that imposes tax on its citizens regardless of where they live and no matter where income is earned. Most countries require only residents to pay tax. If you exit Canada, for example, you don't have to file any more Canadian tax returns.
The US policy is different. Moving away from the homeland doesn't mean you are free from the Internal Revenue Service (IRS). You are required to file your US tax returns every year, report your worldwide income to the IRS and pay any tax imposed by the US tax laws.
Since Canadian residents report worldwide income to the Canada Revenue Agency, US citizens living in Canada have heavy compliance requirements in order to keep up with filings in both countries on income from every source.
US citizens must file personal income tax returns on Form 1040 each year. All worldwide employment income, interest, dividends and gains are reported. US tax rules, which often differ from Canadian rules, apply to determine whether US tax is payable in a given year.
Thankfully, there are a number of mechanisms available that prevent double taxation on most of these types of income. As discussed below, most US citizens living in Canada can stay compliant merely by filing correctly. Generally there is no excess tax payable in the US.
Foreign Earned Income Exclusion
The Foreign Earned Income Exclusion (FEIE) is available to exclude up to $99,200 (in 2014) of employment or business income earned outside the US. As long as you are actually living and working most of the time in Canada, the IRS will not tax even a very good wage. However, unearned income, such as interest, dividends and capital gains, cannot be excluded under the FEIE.
For those living a more cross-border lifestyle, the residency limitations of the FEIE could pose problems as well. The FEIE is only available if you meet the "bona fide foreign resident" (BFFR) test or the "physical presence test" (PPT).
To demonstrate status as a BFFR in Canada, an individual would most often have to file a Canadian tax return as a resident of Canada throughout the whole year. There are special relieving provisions for people who move to or from the US in a year.
The physical presence test requires the individual spend at least 330 days in a twelve-month period outside the United States.
To take the FEIE, an individual must have his or her "tax home" outside the United States throughout the year (for a BFFR), and for the 330-day period (under the PPT). A tax home is generally the main place that an individual works, if he or she works, and the main residence, otherwise.
Foreign Tax Credits (FTCs)
Where annual income is greater than the FEIE exclusion amount or non-wage income is received, FTCs are fundamental to ensuring that most kinds of income don't get taxed twice. Generally, taxes paid to a foreign country on income earned will generate a nonrefundable credit in the US, canceling out the US tax on that item of income.
Canadian personal tax rates are, for the overwhelming majority of people, higher than US rates, so the FTC regime will almost always ensure that Americans in Canada who have no US-source income pay no US tax.
Those who have US income will usually find that the Canadian FTC will offset the US tax, so there is no double taxation. In these cases, the total tax is the same as if all the income were earned in Canada; all one is doing is allocating how much goes to each revenue authority.
However, there are many complicated rules related to the source, timing and character of income that can limit the amount you can claim. Therefore, especially when entities such as companies or trusts are involved, careful planning is important to maximize the FTCs available.
The biggest problems arise when an item of income is taxed in one country and not in the other. A good example is when a US citizen sells their principal residence in Canada for a substantial gain. Under the Income Tax Act of Canada, the transaction is exempt from capital gains tax. The historic increase in property values, especially in big Canadian cities, means that baby boomers looking to downsize their homes will receive windfalls of tax-free cash.
However, under US law, each person can only claim $250,000 as a capital gains exemption for a principal residence, with any excess taxed by the IRS at rates up to 23.4 per cent. So, if Jane, a US citizen, sells her home for a $500,000 gain, she may have to write a cheque to the IRS for more than $57,000 of tax without credits in Canada. If Jane co-owned the home as a joint tenant with her husband, she would usually only claim her half of the gains, so that a total capital gain of $500,000 could occur without tax. This exclusion of capital gains tax only applies if Jane has owned the home and lived in it for at least two years in the past five year period. Again, there are exceptions to this rule, such as for people who are required to move for their work.
There are other instances where the mechanisms in place intended to prevent double taxation fall short. As discussed in later chapters, the tax treatment of certain types of entities can complicate tax planning for a US citizen living in Canada.
As well, fluctuations in the relative values of the Canadian and US dollar can result in disproportionately high capital gains in one country with tax owing as a consequence.
For the most part, maintaining compliance with US tax requirements is little more than paperwork. Nonetheless, as discussed in the next chapter, the paperwork can be quite burdensome all by itself. And then there is the estate planning that should be implemented to keep US tax exposure as low as legally possible.