The close connections between the US and Canada are well known; we share the longest unguarded border in the world, and as many as 90% of Canadians live within 100 miles of that border. Further, a quarter century into NAFTA, it`s no surprise that our economies are highly integrated.
However, there remain significant cross border taxation issues that are less well known despite the frequency with which they arise for unsuspecting Canadians. Notwithstanding the excellent tax treaty between the US and Canada, the domestic tax systems of each country are remarkably different and cross border planning is critical to avoiding the tax traps that remain. This post outlines the very basics of an important set of issues for Canadians.
1. Am I a US taxpayer?
The premise of this post is US tax issues for Canadians, but it’s important first to establish whether you are in fact a `non-resident alien` from the US perspective. The Internal Revenue Code has three triggers for US Person status: citizenship, lawful permanent residency and substantial presence in the US. Each of these triggers can contain surprising results.
Pursuant to the 14th Amendment to the US Constitution, anyone born on US soil is a natural born citizen, regardless of how long you lived in the US, or whether you have taken steps to document that citizenship. Citizens are required to file complete US income tax returns and report worldwide income regardless of where they live. Lawful permanent residency (evidenced by a `Green Card`) also triggers taxation on worldwide income. This remains true even after the expiry of the Green Card itself, or a return to your home country, unless you take active steps to abandon permanent resident status. Substantial presence is a statutory concept that looks at physical presence in the US over a three year period based on a time-weighted formula. For now, suffice to say that exceeding 120 days per year will result in US residency for income tax purposes on the third year, unless active steps are taken to deflect that treatment by making appropriate filings with the IRS.
US taxpayer status raises a host of issues for Canadian residents, which are not the subject of this post. The important point here is that if any of these triggers may apply, you should seek advice from a qualified cross border tax lawyer to determine the implications. The remainder here is focussed on Canadians who are non-resident aliens for US tax purposes.
2. How should I take title to my US property
For the past decade or more, Canadians have consistently been among the top foreign investors in US real estate. Whether the purchase is for personal vacation use or an investment strategy to generate rental income and capital gains, the volume of purchases is significant. A key question that savvy Canadian buyers need an answer to is how to take title.
Of course, the answer to the question is that it depends on a great many factors including the intended use of the property, anticipated holding period, source of funds, and net worth of the buyer. Furthermore, there are myriad options for taking title: personal names, corporations, partnerships or trusts, each of which have different configurations to choose from.
The bottom line is that there is no one-size-fits-all solution to structuring title. Therefore, potential Canadian buyers of US real estate should seek advice from a tax professional that understands how the Canadian and US tax systems interact to get the optimal structure.
3. My children live in the US, what does that mean for my will and trust planning
When a beneficiary of a Canadian estate or trust resides in the US, it is important to understand the income tax consequences of how the will and/or trust is drafted. The US tax law has incorporated many specific rules intended to counter the practice of using offshore entities to evade tax on its residents. However, these rules are often broadly framed, resulting in impacts to otherwise innocent US residents who happen to be beneficiaries of Canadian trusts.
When naming a US resident as a beneficiary of a Canadian trust, it is critical to understand that accumulations of income within the trust are taxed at significantly higher rates when such income is eventually distributed to a US taxpayer. Without proper reporting, even capital distributions from a trust can be taxed as ordinary income in the US. Proper structuring of a trust is needed to ensure that information reporting and income inclusion is properly timed to avoid unnecessary taxation, or double taxation of distributions to US beneficiaries.
Furthermore, if a US person is named as the executor of a will, or trustee of a trust, that trust will have additional US income tax reporting obligations that can complicate the administration of the estate plan. Canadian residents with US beneficiaries should seek expert cross border advice when developing an estate plan, or administering an estate.
4. I want to freeze my Canadian business; does it matter that my children live in the US.
Canadian tax planning for business owners often involves reorganizing the corporate structure to ‘freeze’ the value of appreciating business or investment assets to limit the eventual Canadian tax payable on death. This strategy usually involves exchanging common shares for preferred shares that do not increase in value, while new commons are issued to the next generation in the family, for whose benefit post-freeze gains will accrue. To maximize flexibility and retain control for the business owner, the new common shares are typically owned by a trust that has the kids as beneficiaries.
As discussed above, US beneficiaries of foreign trusts are faced with adverse income tax consequences in the US. The problems can be even worse where the trust’s primary asset is shares of a Canadian corporation, especially when that corporation has significant retained earnings used to generate investment income.
Does this mean that a Canadian business owner should never freeze a corporation when the kids live in the US? No, but understanding the US tax rules and how they may apply to the Canadian entities involved is critical to preventing unwelcome tax consequences. The drafter of the family trust, for example, can avoid punitive tax results for the US beneficiary with careful drafting that accounts for both Canadian and US tax law.
5. I want to move to the US; what tax issues should I be aware of?
Whether you are moving for work or because the snowbird lifestyle doesn’t offer enough time in the US each year, there are important issues to consider when considering a move from Canada to the US. Indeed there are far more issues than this post can cover, but the following are the primary ones.
Upon terminating residency, Canada will impose a deemed disposition of most assets, which often results in a significant tax bill in the year of departure. This is a tax that would have been payable at some point (whether on actual sale or on death of the owner), but without actual proceeds to pay the tax, there can be a cash flow issue. Fortunately, CRA will often accept security for the departure tax, allowing a deferral in payment, and will not charge interest while the security remains in place. South-bound migrants are wise to consider the extent of the departure tax well in advance in case pre-departure tax planning can reduce the Canadian tax bill.
In addition, pre-departure planning is important to prepare one’s financial situation for becoming subject to US tax laws. Where assets are left behind in Canada, understanding the US tax treatment of foreign investments can illuminate changes that should be undertaken prior to departure. For example, Canadian mutual funds should not be retained in a Canadian nonregistered portfolio. In addition, Canadian equities should be examined to ensure that the US anti-deferral rules (i.e. passive foreign investment company rules) are not going to wreak havoc on the tax efficiencies of the investments that will remain in Canada.
For higher net worth migrants, there is a window of opportunity to restructure assets into trusts that will ensure that US estate tax does not become an problem for those who may pass away while living in the US. Similarly, traditional Canadian life insurance planning often doesn’t fit well in the US context because the proceeds of the policies may well be included in the taxable estate of the owner on death.