If you’re a U.S. citizen living in Canada, then your tax and financial planning should take into account some special considerations. Here are the top six things to understand if you’re in this boat.
TFSAs and RESPs
Tax-free savings accounts (TFSAs) and registered education savings plans (RESPs) aren’t recognized as tax-sheltered vehicles in the United States. Rather, both are considered to be foreign trusts that come with annual reporting requirements (U.S. forms 3520 and 3520-A) and offer no tax sheltering of income in the United States. In the case of RESPs, Canada Education Savings Grants are taxable for U.S. citizens in addition to income earned in the plan annually. If you’re married to a non-U.S. citizen, it would be best for your spouse – or a non-U.S. grandparent – to be the subscriber of an RESP.
The United States doesn’t want its citizens gaining a tax advantage by deferring the tax on income earned inside foreign corporations. So, it came up with the Controlled Foreign Corporation (CFC) and Passive Foreign Investment Company (PFIC) rules. A non-U.S. corporation is considered a CFC if more than 50 per cent of the votes or value of the corporation are effectively owned or controlled by U.S. shareholders on any day in the year. With CFCs, you may be required to report a portion of the passive or other undistributed income of the corporation on your personal tax return. Alternatively, the non-U.S. corporation may be considered a PFIC if more than 75 per cent of its income is passive, or 50 per cent or more of its assets generate passive income (includes interest, dividends, capital gains or rents). With PFICs, you could be deemed to have received distributions in each year you own the PFIC, taxed at the highest rate, even if you don’t actually receive distributions annually. Canadian private corporations – particularly holding companies – and some mutual funds may get caught under these rules. With CFCs and PFICs there are special reporting requirements. It may make sense for a non-U.S. spouse to own the assets that might otherwise be considered a CFC or PFIC. The rules have been simplified here, so speak to a tax pro.
The good news is that registered retirement savings plans (RRSPs) can make good sense for U.S. citizens living in Canada. You’ll automatically qualify for a tax-deferral so that you won’t have to pay tax in the United States on the income earned annually in your RRSP. And if you have any concern over owning mutual funds and the application of the PFIC rules, those rules won’t apply to funds held in an RRSP.
While you can generally sell your principal residence tax-free in Canada, the rules in the United States will allow a tax-free exemption on the first US$250,000 of gain on your principal residence, and only if you’ve lived in the home for at least two of the past five years. If you have a spouse, then this can be doubled to US$500,000. Given the increase in real estate values in recent years it’s not unusual to find U.S. citizens living in Canada who could end up paying tax in the United States on very large capital gains on the sale of a residence. So, count this cost before selling.
A lot of effective tax and estate planning may require the transfer of assets, including private company shares, to another person or entity. An estate freeze, for example, usually involves the transfer of assets to a Canadian corporation. This works well on the Canadian side of the border, but the rules that allow a tax-free transfer of assets in Canada may not apply in the United States, making a transfer a taxable event there. Similarly, the lifetime capital gains exemption that is available to shelter capital gains on qualified small business corporation shares is not available stateside, so any capital gains realized on these shares would be taxable on the U.S. side of the border.
If you’re a U.S. citizen, keep in mind that death benefits paid on a life insurance policy you own will be added to your taxable estate for the purpose of your U.S. estate tax calculation after you pass away. Owning that policy through an “irrevocable life insurance trust” or having a non-U.S. citizen spouse or family member own that policy could make sense. Finally, the “exempt test” that allows tax-free accumulation of investments inside a life insurance policy in Canada is a different test than in the United States, so you’ll want to make sure that a policy on your life meets the tests in both countries to ensure tax-free accumulation continues.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at firstname.lastname@example.org.