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As U.S. taxes are based on citizenship, not residency, U.S. persons living outside of that country are required to report their worldwide income to the Internal Revenue Service.ROMAN/iStockPhoto / Getty Images

For U.S. persons living in Canada, navigating the tax-filing requirements around investments can be cumbersome and challenging. Financial advisors who serve these individuals need to ensure they have a solid understanding of the implications that their recommendations could have on these clients’ tax burden.

That’s especially important as U.S. citizens, income-tax residents or green-card holders living in Canada have the “worst of both worlds” when it comes to filing their taxes, says Matt Altro, certified financial planner, president and chief executive officer at MCA Cross Border Advisors Inc., in Montreal.

As U.S. taxes are based on citizenship, not residency, U.S. persons living outside of that country are required to report their worldwide income to the Internal Revenue Service (IRS), which Mr. Altro says can be an “aggravating filing exercise” – even in cases in which tax credits align with those in Canada.

One of the biggest challenges for U.S. persons living in Canada and who have investments here is not being aware of which products may cause problems on their U.S. tax returns, says Peter Guay, portfolio manager at PWL Capital Inc., in Montreal.

A big pitfall, he says, involves the treatment of tax-free savings accounts (TFSAs) and registered education savings plans (RESPs), which the IRS considers foreign trusts. Owners of foreign trusts are required to file forms 3520 and 3520-A with the IRS annually and they will be taxed on the income earned in these investments.

Canadian-issued mutual funds and exchange-traded funds (ETFs) held in non-registered accounts also require annual filings as the United States considers them passive foreign investment corporations (PFICs).

“An example would be plain-vanilla Canadian mutual funds. The IRS can tax those in a very ugly way,” says Brent Soucie, vice-president and financial consultant at T.E. Wealth in Toronto.

There are two problems with PFICs, Mr. Altro says. One is that form 8621 needs to be filed with the IRS annually for each holding, resulting in extra work and expenses. The other is the tax treatment of the funds themselves.

“The taxation when you go to sell a PFIC on the U.S. side can be very punitive. You would think you would get capital gains treatment as you would in Canada, but you don’t in the U.S. It’s ordinary income taxed at the top rate.”

If a taxpayer is audited, the penalties associated with failing to file these forms can also be exorbitant, Mr. Altro says. In the case of a form 3520-A, for example, the IRS can charge the greater of US$10,000 or 5 per cent of the gross value of the trust’s assets owned by the U.S. person at the close of that taxation year.

There are certain strategies that may allow U.S. persons in Canada to benefit from these vehicles, Mr. Altro says. For example, a non-U.S.-citizen spouse can hold an RESP on behalf of their child. Clients can also opt for U.S.-listed investment products.

U.S. persons are also shielded from PFIC treatment if they hold their investments in registered accounts, such as registered retirement savings plans or locked-in retirement accounts, Mr. Altro says. Or, in certain cases, a Qualifying Electing Fund election can mitigate some punitive tax consequences, if a fund provides a PFIC annual information statement.

However, to minimize the tax-filing burden on clients, a straightforward approach is often best, given that most strategies aimed at Canadians lose their benefit when used by dual citizens.

“Invest in a way for your client that will not trigger any of those issues,” Mr. Guay says. “Recommend that if your client files U.S. tax returns as a green-card [holder] or U.S. citizen, that they not have a TFSA, that you unwind the TFSA, that they not have an RESP – either find someone else to hold it for the benefit of your child or do away with it altogether – and definitely don’t hold any Canadian-issued ETFs or mutual funds in non-registered accounts.”

For advisors, providing relevant advice to those with U.S. ties means asking in-depth questions at the outset – not just about tax residency, but also place of birth.

For example, so-called accidental Americans – often those who were born in the United States but returned to Canada as children – face the same reporting obligations as other U.S. persons and need to ensure they’re compliant.

Advisors should also inquire whether a client’s spouse or children have U.S. ties, if the family owns property south of the border, and where they plan to retire, as these factors can have implications for U.S. estate planning, Mr. Altro says.

Ultimately, while most advisors may be able to identify clients who are considered to be U.S. persons, Mr. Soucie says they may question what to do next. Given the complexity of this area and the potential for changes to the tax rules, he suggests liaising with a cross-border specialist. It is also advisable to develop a working relationship with the client’s U.S. accountant.

That’s particularly important in cases in which clients who are U.S. persons living in Canada may have a substantial 401k or individual retirement account, which can make retirement or cash-flow analysis difficult using standard tools and assumptions, Mr. Altro says. Working alongside specialists who can walk the client through the options and tax implications of these accounts can be key.

“It’s a matter of making sure you’re connected with firms and partners who are spending time with their nose to the grindstone on this,” he says.