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The Federal Court of Canada said the collection of the information from large Canadian banks by the Canada Revenue Agency, which intends to hand it to the U.S. Internal Revenue Service starting next week, does not violate the terms of the Canada-U.S. tax treaty.MacXever/Getty Images/iStockphoto

A legal challenge by two dual U.S.-Canadian citizens that aimed to block Ottawa's move to hand the banking information of American citizens with Canadian accounts to U.S. tax authorities has failed.

In a ruling released on Wednesday, the Federal Court of Canada said the collection of the information from large Canadian banks by the Canada Revenue Agency, which intends to hand it to the U.S. Internal Revenue Service starting next week, does not violate the terms of the Canada-U.S. tax treaty.

However, the decision by Justice Luc Martineau does not rule on the lawsuit's arguments that the collection of the information violates the Charter of Rights and Freedoms, which are still before the courts.

In a 46-page decision, Justice Martineau refused to issue an injunction blocking the transfer of the information, which was agreed by Canada and the United States to make it easier for Canadian banks to comply with the controversial U.S. Foreign Account Tax Compliance Act (FATCA). The U.S. law aims to crack down on Americans using foreign bank accounts to evade U.S. taxes all around the world.

The agreement between the two countries allowed Canadian banks to report data on American account holders to the CRA, rather than supplying it directly to the IRS. Small lenders and credit unions were exempt.

The lawsuit challenging the Canadian legislation implementing the deal was filed last year. Critics say that FATCA unfairly exposes dual citizens to stiff penalties south of the border because the U.S., unlike Canada and most other countries, requires citizens living abroad to file U.S. tax returns.

For example, those who moved to Canada as children and were unaware of the requirement that they file U.S. tax returns, even if they do not live or work in the United States.

The lawsuit was prepared by a group called Alliance for the Defence of Canadian Sovereignty, but was filed on behalf of two Canadian women, Gwen Deegan and Virginia Hillis.

Ms. Deegan was born in Washington in 1962 to one American and one Canadian, according to the lawsuit. She moved to Canada at age five, and has not lived in the U.S. since, nor has she worked there or held a U.S. passport, according to the lawsuit.

Ms. Hillis was born in the U.S. in 1946 to two Canadians, and also moved to Canada at age five, having never lived in the U.S. since then, according to the lawsuit. She also has not worked in the U.S. or held a U.S. passport, according to the lawsuit.

Matias Milet, a tax lawyer with Osler, Hoskin & Harcourt LLP, said U.S. citizens living in Canada who neglected to file U.S. tax returns, even if they would not owe U.S. taxes, were caught in the middle of an attempt by the IRS to go after Americans using offshore accounts, in Switzerland or other tax havens, to evade U.S. taxes.

But he said the deal Canada made with the U.S. made the disclosure obligations that would have been forced on Canadian banks much less onerous for the financial institutions. Britain made a similar deal.

If the deal were struck down by the court, the computer systems and compliance measures set up by Canadian banks to hand the data to the CRA would have to be scrapped: "It wouldn't be the end of the world for them, but it would be a big compliance nightmare."