For individuals all over the world, the concept of personal tax compliance is relatively straightforward. When residing and earning income in a particular country, individuals report and pay taxes on that income earned. In contrast, if there is no residency and no income, then it only makes sense that there should not be a tax filing requirement, right?
This logic would prevail in most tax jurisdictions across the world. However, for U.S. citizens and permanent residents (i.e., ’green card’ holders), that logic does not play out so well. The United States is one of the few countries in the world that requires its citizens and permanent residents to file annual tax returns, no matter where they reside and earn their income, and pay taxes on this income.
For U.S. citizens and permanent residents living in Canada, annual dual filing tax compliance requirements (i.e., both Canadian and U.S. tax filings) are an administrative cost of maintaining their U.S. citizenship or immigration status, and many hidden tax issues may create exposure in the United States. In principle, individuals can avoid double tax using the foreign tax credit mechanism (i.e. taxes paid in Canada can offset the taxes due in the United States); however, the foreign tax credit is unable to offset the taxes related to many common Canadian investments. In addition, many of these investments also create significant reporting requirements on the U.S. side, which adds another layer to the administrative costs of being a U.S. citizen or permanent resident investing in these Canadian products.
Many popular investments for Canadians qualify for favourable tax treatment in Canada. Unfortunately, U.S. citizens and permanent residents may not be able to fully capitalize on these benefits, and in some cases, these investments may be detrimental from a U.S. tax and reporting perspective. The following are some of the most common investments used by individuals, and a summary of the U.S. tax issues surrounding them.
Registered Retirement Savings Plans (RRSPs)
For dual filing U.S. taxpayers, RRSP contributions are not deductible on their U.S. tax return, but are deductible on the Canadian return. This has the potential to cause a mismatch in the taxation of income between the Canadian and U.S. returns. In the year of contribution, Canadian taxable income is reduced, which reduces the total tax liability on the T1. This reduces the foreign tax credit available to offset U.S. tax, which may result in a U.S. tax liability.
As Canadian personal tax rates are typically higher than U.S. rates, a foreign tax credit ‘buffer’ is generated every year, which may be enough to offset the mismatched income. However, tax years with significant RRSP contributions may result in taxes owing in the United States, so if possible, taxpayers should attempt to smooth the contributions year-over-year to reduce the potential for tax liability.
Tax Free Savings Accounts (TFSAs) and Registered Education Savings Plans (RESPs)
TFSAs and RESPs allow Canadians to earn tax-free investment income, but the same benefit is not offered from a U.S. tax perspective. The accrued income within these accounts is recognized on the individual’s 1040 return on an annual basis. This results in a similar mismatch of income situation as with RRSPs, since taxable income for U.S. purposes is higher due to these income inclusions, which may result in insufficient foreign tax credit coverage from the Canadian return.
In addition, TFSAs and RESPs also generate additional reporting requirements. Unlike their status as a tax-free investment vehicle in Canada, the United States considers these accounts as foreign grantor trusts. This means that U.S. individuals with TFSA or RESP accounts are considered owners of foreign trusts, and must file Form 3520 and 3520-A on an annual basis to report the activity and income of these trusts, despite their deferral status in Canada. Failing to meet the reporting requirements with regards to the filing of these forms can also attract significant penalties in the United States - $10,000 per instance of non-compliance.
These forms are difficult and time-consuming to prepare, and the cost of compliance may exceed the Canadian tax benefits that these investment vehicles provide. Therefore, these investments for U.S. taxpayers should be carefully considered.
Foreign mutual funds are one of the most common investments used by U.S. citizens and permanent residents living abroad, but they too lose their luster from a U.S. perspective and are potentially subject to onerous reporting in the United States. Canadian mutual funds may fall under the definition of a “passive foreign investment company”, often referred to as a “PFIC”. U.S. taxpayers that own shares or units of a PFIC must file Form 8621 to report the income and distributions from the PFIC on an annual basis. Additionally, distributions must be tracked, since “excess” distributions can be subject to an additional high tax rate.
Taxpayers may use the qualified electing fund (QEF) or mark-to-market (MTM) elections to reduce the impact of the excess distribution tax, but to be effective, these elections should be made in the year the mutual fund shares are acquired. Additionally, most Canadian mutual funds are simply unable to provide their investors with the adequate information needed to make the QEF election. Mutual funds also often lack the marketability needed to make the MTM election, and makes it difficult for taxpayers to stay compliant with the informational filing requirements.
Individuals who fail to report their PFIC activity may be subject to IRS examination. Once again, the benefits of investing in Canadian mutual funds may be outweighed by the significant cost of compliance, and U.S. taxpayers should tread carefully before entering into these types of investments.
For U.S. citizens and permanent residents living outside the United States, the continuing obligation to be in full compliance with U.S. tax reporting can be challenging. For individuals who have not been in full compliance with the U.S. reporting related to these foreign investments, the IRS does offer ‘amnesty’ type programs that present a path to compliance outside the normal penalty regime. However, these programs are not permanent. The IRS has recently announced that the Offshore Voluntary Disclosure program that has been in place for a number of years is being discontinued on September 28, 2018. Thus, taxpayers should carefully consider whether a voluntary disclosure under this program is appropriate before the program closes.
Talk to your RSM advisor if you have any questions on how these U.S. tax issues can apply to you and your investments.