Tax traps for U.S. citizens living and working in Canada

In order to combat tax evasion, the United States has put in place many rules directed at US citizens investing outside the United States. While they might make sense to those who still live in the U.S., these are traps for many US citizens living in Canada, simply doing the sort of things that many Canadians normally do. While it is true that Canada is not a tax haven, these rules are often of general application and the Canada-United States Tax Treaty (which should grant tax relief) does not provide much relief due to the overreaching application of the “savings clause” (which specifies that most of the tax treaty is not applicable to US citizens).

1. What does a U.S. citizen in Canada need to know about Passive Foreign Investment Companies (PFIC)?

The rules in question may apply to income or profits derived by a U.S. taxpayer who owns shares in a passive foreign investment company (PFIC). The PFICs are non-U.S. corporations that derive at least 75% of their gross revenue from passive sources or at least 50% of which is used to generate passive income.

When a U.S. taxpayer owns a minority interest in a PFIC, the income derived from those (or the profit on the sale of his shares of the corporation) are subject to punitive taxation regimes. Without making a timely election, that regime would be the excess distribution regime.

Under this regime, the excess distribution is determined by first computing the average amount of PFIC distributions for the previous three years. Distributions greater than 125% of this average are defined as “excess distributions” which are then allocated to the entire holding period in which the taxpayer owned the shares. Any income credited to a previous year is taxed retroactively to the highest marginal rate, and interest and penalties are applied until the current tax year.

Many Canadian mutual funds might be PFICs – the IRS issued little guidance on the topic, but in order to be sure to be compliant (as is the case when renouncing U.S. citizenship) one should file forms 8621 and pay the PFIC tax if applicable. We, therefore, recommend that U.S. citizens living in Canada carefully consider the PFIC issue before investing. 

Check out our client Robin’s story here to learn more about the ways to deal with PFIC.

2. What is an RRSP and how it affects your tax return?

The Registered Retirement Savings Plan (RRSP) is a Canadian program designed to encourage retirement savings in two ways: the contributions paid are tax-deductible for the year and the investment income earned on these contributions is taxable only at the time of their withdrawal.

However, the IRS does not routinely treat RRSPs as tax-deferred retirement savings accounts. By default, these plans are treated as simple investment accounts: the increase is taxable as soon as it is realized and no deduction is granted for the deposits assigned to the account.

The Canada-U.S. Tax Convention provides some relief in this regard, namely that the taxpayer can defer the taxation of investment income from his or her RRSP. It used to be done by attaching Form 8891 to his or her tax return (Form 1040). Since 2014, the mere fact of not reporting income coming from the RRSP was to be treated as an irrevocable election to defer the income. However, RRSP contributions are not deductible from taxable income in the United States. As a result, the foreign tax credit may not fully offset the tax payable in the United States.

You can read more about RRSP taxation here.

3. Last but not least: TFSA and RESP

Other accounts with favourable tax treatment in Canada can cause problems for U.S. citizens living in Canada. For example, Registered Education Savings Plans (RESPs) are considered trusts by the IRS and are therefore subject to tax rules and regulations which have no equivalent in Canada. We, therefore, recommend that U.S. citizens avoid these products.

Tax-Free Savings Accounts (TFSAs)’s status is less clear. In many cases, they are not trusts. That said, their tax-free status doesn’t exist in the United States. Since no tax would be paid to Canada, a foreign tax credit wouldn’t be available. Income accrued within the TFSA is taxable, but without a foreign tax credit to offset tax owing, it could lead to actual tax payable to the IRS. We also covered TFSA in details before.

If you have any questions, do not hesitate to contact us or leave a comment below and we will get back to you within 24 hours.

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