Investing Tax Traps: Americans Living in Canada
So like runaway escapees, all citizens and Green Card holders from the United States that live in Canada cannot escape US taxation and need to watch out for some common tax traps. Even if they have lived in Canada their whole lives, they still need to file an American tax return.
On this American return, they will be required to disclose all of their worldwide income – every year – including employment in Canada and on what we’re focusing on today – their investments.
This is an extremely difficult topic to navigate, so join us today as we make sense of what is going on and ways to avoid these tax headaches. This is of course a very complicated topic and it’s recommended that you speak to a professional accountant to navigate these issues further.
So, to kick things off, I’d like to start by saying how annoying these regulations are. They are extremely confusing, and many financial professionals may not even be aware of them and recommend products that can have negative consequences.
Self-investing dual citizens especially need to watch out because no one will stop you from falling into these traps.
Must Claim Worldwide Income
So what’s happening here is that basically every American citizen living in Canada needs to complete an American tax return on top of their Canadian return. Depending on the financial products that they choose, this can lead to varying amounts of soul sucking paperwork, higher accounting fees, and in worse case situations, an amount owed to the IRS.
US tax rules also essentially limit the benefits of using very important financial products that Canadians typically use to achieve their financial goals.
The tried and tested model of closing your eyes and hoping that the problem goes away will also not work. There is legislation that requires all non-US financial institutions to report any individual that meet tax criteria to the IRS. There can also be fines and penalties in extreme cases.
Thankfully, there are steps that dual citizens can take to side-step parts of this legislation. By following a couple basic rules, you can avoid issues from coming up.
How It Works
To first understand what’s going on, we quickly need to understand what’s happening behind the scenes.
All dual citizens need to claim their worldwide income on an American tax return – This includes taxable income, self-employment income, interest, dividends and capital gains earned in Canada. This also means that taxes are calculated against this income on the American return
Thankfully, there is a tax treaty that exists between both countries to prevent double taxation. On top of that, Canadian taxes are usually higher than American taxes – meaning that often no American taxes are owed.
However, there are certain investment choices that can lead to US taxes owed and add requirements to fill out complicated paperwork with also the possibility of higher accounting charges.
In addition, all dual citizens must disclose any accounts that they have authority over and that have over $10,000 USD at any point of the year.
Overall, what we really want to do is keep the amount of income of the USD return as low as possible and to minimize paperwork.
To do this, we need to plan in advance to avoid certain pitfalls.
Biggest Tax Trap For Dual Citizens
First up is one of the biggest traps that dual citizens fall into – using specific types of registered accounts. The offenders here are Tax Free Savings Accounts, Registered Educational Savings Plans and Registered disability Savings Plans. There are also special rules when it comes to RRSPs which we’ll talk about in a couple minutes.
These registered products have special rules with how returns are taxed. TFSA do not charge taxes at all while RESPs and RDSPs charge taxes when the funds are withdrawn and not when the returns are incurred. The big benefit here is that you have returns growing on non-taxed returns this leads to greater returns.
Unfortunately, the US government does not recognize these tax benefits. So dual citizens are not taxed on these returns in Canada BUT they will count as income in the United States. This can also lead to double taxation in some cases.
The elimination of this tax deferral status in many cases eliminates the benefits of using these accounts. To make things even more complicated, government grants such as is received in RESPs counts as taxable income.
Accountants also debate whether these accounts are designated as Foreign Grantor Trusts. This is unfortunately an issue that hasn’t been clarified by the tax authorities, but if it is classified as one then you would also need to file a series of complicated trust forms for each separate account. In many cases these forms will still be filled out by an accountant.
The general rule of thumb for most dual citizens is to simply avoid using TFSA and RESP accounts or at least seek professional advice. For RESPs, a spouse or direct family member can hold the RESPs if they are a not a dual citizen. Other individuals can hold RESPs too, however there are some benefits that they would not be able to access.
What About RRSPs?
When it comes to RRSPs, RIFFs and other similar plans, the IRS does recognize the tax deferral status of invested funds – so they don’t fall under the same faults as the other registered plans. However, the tax deferral benefits of new contributions do not reduce taxable income on US returns.
So dual citizens need to be careful when they may have large RRSP contributions as very large contributions could cause the foreign tax credit to be less than what is owed in American taxes – leading to US taxes owed. Likely this would not affect most individuals but it’s always a good idea to be conscious about this.
The last big pitfall for dual citizen investors is something called Passive Foreign Investment Corporations or PFICs for short. This policy was designed to prevent US person from deferring taxes on passive income earned through non-US corporations or converting this income to capital gains that are taxed at a preferential rate
Tax Trap 2: ETFs and Mutual Funds
Unfortunately, many Canadian investments fall under these rules – including Canadian Issued Mutual Funds, Exchange Traded Funds and Real Estate Trusts. What this means to you is that these are taxed at a higher rate than regular investments and a special American tax form also needs to be completed.
So to side-step these concerns, you should avoid using pooled funds issued on Canadian stock exchanges if they are not in your RRSPs. Instead you can use stocks, bonds, and ETFs issued on American exchanges.
Overall, what we see is that the solutions for dual citizens is really one of avoidance. Which is very unfortunate because certain other tax benefits available in Canada are lost. It’s hoped that these processes are simplied and clarified in the future.
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