The time is ripe for Americans living in Canada to come clean with U.S. authorities and start reporting their taxes, experts say.
There are roughly a million U.S. citizens in Canada, and by most estimates, a significant percentage of them don't file their taxes with the U.S. Internal Revenue Service, as required by U.S. law.
Staying in the shadows has been the preferred route for many, often for their entire working lives. Many were either unaware they had to file, assuming incorrectly that paying higher taxes exempted them from paying U.S. ones. Many accidental Americans may not have even been aware they were still U.S. citizens after living most of their lives in Canada.
The option of doing nothing is about to get much riskier, and potentially more costly as the U.S. cracks down, according to tax experts.
The 2011 tax year marks a pivotal decision point for expatriate Americans, according to Beth Webel, tax services partner at PricewaterhouseCoopers LLP in Hamilton.
"For people who don't owe anything, the general feeling is that now is the time to come clean," Ms. Webel argued.
That's because U.S. officials have promised to accommodate individuals who don't owe any taxes and were unaware of their reporting obligations. There's also a new amnesty program, which could be attractive for people who do owe money to the IRS.
And finally, onerous new reporting requirements kick in this year for Americans who have significant foreign financial accounts (at least $200,000 U.S. for individuals and $400,000 for couples). IRS Form 8938 – Statement of Specified Foreign Financial Assets – is the latest in a string of measures aimed at tightening the noose around Americans who are hiding money offshore.
A good place to start for "delinquent filers" is to figure out whether they owe U.S. taxes. Ms. Webel recommends going back at least six years and doing a draft U.S. return for the year that is most likely to be problematic.
A Canada-U.S. tax treaty is supposed to protect individuals from being taxed twice on the same income. But there are quirks in the two tax regimes that could leave Canadians exposed to U.S. taxes on items such as corporate income or proceeds of a house sale. As well, the U.S. doesn't recognize Canadian tax-free savings accounts, and could tax income you thought was sheltered.
"You need to assess what your exposure is," said Matt Smith, a senior manager at Deloitte & Touche LLP. "What many people find out is there's no tax to pay and [they have]some exposure on information reporting, but it's manageable. Before you get excited, find out what you're excited about and you may find it's not the issue that you think it is."
There are at least five options: the "just-cause" defence, amnesty, soft disclosure, do nothing or renounce your citizenship.
None of these options is very palatable, particularly for Canadians who've been dutifully reporting their income to the Canada Revenue Agency. And most options involve significant costs, potentially steep penalties ($10,000 per account per year) and even risk of criminal prosecution. Just hiring an accountant to file past returns and various other IRS reporting requirements can run into the thousands of dollars a year.
1. The just-cause defence: If you don't owe anything to the IRS, this may be the way to go. File six years of back taxes, along with Foreign Bank Account Reports (FBARs) plus the new 8938 form for 2011, and plead just-cause for not doing so earlier. The IRS is poised to release further details on this option. If the IRS accepts your mea culpa, the penalty is zero.
2. Amnesty: The IRS recently opened a new permanent Offshore Voluntary Disclosure Program. The program, which requires eight years of back filing, is aimed mainly at Americans "hiding" offshore accounts. It means paying mandatory penalties of up to 27.5 per cent, plus any taxes and interest owing. The good news is that if you live in Canada and can show you aren't hiding anything, the penalty could be as low as 5 per cent of assets held offshore.
3. Soft Disclosure: Just start filing, as if the years prior to 2011 didn't exist. This is a low-cost option, but it could come with significant risk. The IRS has warned that it won't look kindly on tax cheats who try to slip into the system this way.
4. Do nothing: This is the lowest-cost option, but it comes with unknown risks. Finance Minister Jim Flaherty has made it clear that Canada won't collect taxes for the IRS. But starting in 2014, the IRS will begin demanding that Canadian financial institutions start identifying their American clients or face steep penalties in the United States under the Foreign Account Tax Compliance Act.
5. Renounce your citizenship: This could be the most costly route of all. First you'll have to make peace with the IRS. And for some high-wealth individuals, there's an extra exit tax on all your worldwide assets. But once you're out, you're out – no more FBARs, no more IRS.
With files from reporter Sean Silcoff
THE TFSA TRAP
Americans living in Canada that have been swept up in the recent tax crackdown by the U.S. Internal Revenue Service shouldn't invest in tax-free savings accounts, an Ottawa tax specialist says.
Since 2009, Canadians adults have been able to contribute up to $5,000 a year to a TFSA and not pay tax on any investment income earned by those contributions.
But Martha Skeggs, director of taxation services with McLarty & Co., an Ottawa accounting services firm, says the IRS doesn't recognize TFSAs because there is nothing in the income tax treaty between Canada and the U.S. about them. As a result, the IRS treats TFSAs as foreign trusts, and American filers in Canada have to report income they have earned in the accounts to the IRS.
Ms. Skeggs notes that some people in this situation may not have to pay much tax to the IRS in the initial years of investing in a TFSA, but the amounts payable grow as the size of the amount in the account grows.
Then there's the paperwork. Filers have to fill out two IRS forms, about 10 pages in total, about the trusts; penalties for not doing so are significant, a minimum of $10,000 (U.S.) per form, per year. Hiring an accountant to handle the paperwork can cost several hundreds of dollars – eating up most or all of the profits earned inside the shelters – on top of the tax filings and reports on foreign financial accounts they are already required to file with the IRS. "It's a lot of work," Ms. Skeggs says.
As a result, she's been counselling most of her clients against investing in TFSAs, and roughly two dozen have followed suit. "It can be complicated and people think it's not worth it. For many of them, when you explain the rules, they're deciding to cash out of [their TFSAs] They're deciding it doesn't make sense to contribute to TFSAs at this point."