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Americans Living in Canada

Mitigating Exchange Rate Risk: Effective Strategies

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Where do you see the exchange rate going? This is a common question amongst our client base, many of whom enjoy a cross border lifestyle.  In fact, as Americans living in Canada may have noticed, the exchange rate is right up there with hockey and the weather in Canada’s national conversation.

The trouble is, accurately predicting the exchange rate is exceedingly difficult over both short- and long-term periods.  Even amongst currency analysts, who are the experts in this field, there is usually no consensus, a lone exception possibly existing when the loonie is trading at extreme values (either above par, or at 60 cents on the dollar).

The loonie is not currently at either extreme, but it has been volatile.  It fell about 8% against the greenback in 2018, rose significantly in January 2019 and moved lower through March.  Why is it so volatile, and why is it inherently difficult to predict the direction of the exchange rate?  The rate is impacted by more than one factor, which may push it in opposite directions.  For instance, the loonie is sometimes described as a petro-currency, driven by the price of oil.  As the price of oil (which is priced in USD) increases, all else being equal, the Canadian dollar would also increase relative to the US dollar.

The loonie is also driven by the differential between US and Canadian interest rates.  If rates on Canadian bonds are higher than those available in the US, then investors from outside Canada will tend to invest more money in Canada.  To purchase these investments, they need to convert their money into Canadian currency, driving the demand for loonies upward. This raises the value of the loonie relative to the US greenback.

It’s certainly possible to have the price of oil and the interest rate differential between Canada and the US pushing the exchange rate in opposite directions.  In the situation where oil prices are declining yet Canadian interest rates are rising relative to the US, it’s an open question which factor will have more impact.

Aside from these types of macroeconomic currency catalysts, there’s a school of thought that looks at what the value of a currency “should” be, based on equalizing what money can buy in various countries.  This is known as Purchasing Power Parity.  On this basis, the Canadian dollar is undervalued and should be worth somewhat more than it is now.  Unfortunately, it can stay this way for years, and does not spend much time at parity.  As a result, this metric is interesting but not necessarily any more helpful than other foreign exchange predictions for long term planning.

Given the notion that experts and scholars cannot make accurate predictions, how can cross-border financial planning be undertaken, and investment portfolios designed, for clients with assets in both currencies domiciled on either side of the border?  Financial planning is, to some extent, the practice of making assumptions about the future in order to provide clients with a picture of how that future will unfold provided the assumptions are perfectly correct.  As a result, financial plans are best presented with the caveat that they need to be refined over time to accommodate revisions to the assumptions as conditions change.

Unfortunately, the foreign exchange rate over the client’s lifetime is not the only unknown variable to consider.  Future rates of inflation and taxes on both sides of the border, as well as returns on investments in the stock and bond markets, are critical inputs.  Since the actual future values for these variables are uncertain, risk management tactics are utilized in portfolio design to reduce these risks.  This is equally true when it comes to currency risk.

One important consideration in cross-border wealth management is hedging investment securities into the currency of the country where retirement income will ultimately be spent.  It is often argued, correctly, that currency fluctuations tend to even out over the long term, and there is a financial cost to hedging strategies.  However, over the short term, those fluctuations can have a significant impact on investment portfolios and the income they provide.  While this extra layer of volatility can be worrisome for clients at any stage of life, it becomes increasingly critical when it has a direct impact on the amount of retirement spending a client can do from one year to the next.  A cross-border wealth management firm like Cardinal Point will use a prudent hedging strategy to manage the costs and benefits appropriately.

In addition, where possible, migrating assets over time into the client’s expected currency of residence in retirement can make a lot of sense.  For example, Americans working in Canada who plan to move back to America in retirement may hold their RRSPs in US dollars. The result is the minimization of the currency impact they experience long term.  Reducing the variability of future returns based on  exchange rate risk brings a dimension of certainty into an uncertain future.

Finally, it’s important to pay attention to the costs of converting money from one currency to another.  These costs can be 2% or more of the amount of money being converted.  If there is an ongoing need for a certain currency, a bank account denominated in the currency can be used to meet this need.  It’s best to minimize the movement from one currency to another, which can occur when money is moved between bank accounts, or a credit card issued in one country is used outside that country.  Where the need for conversion exists, using a specialized service provider such as OFX can result in significant savings on the transaction.

The exchange rate between the US and Canadian dollar is a significant source of risk for many clients. For Americans living in Canada and Canadians living in America, working with a cross-border financial planning firm is a prudent way to manage this significant financial and emotional process.

RRSP Withdrawal Tax Implications for Non-Residents

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A large number of the clients that we work with are those that move from Canada to the United States. In these cases, we spend quite a bit of time making our clients aware of the income tax implications of leaving Canada and establishing tax residency in the U.S. We have written many publications on this topic, including a recent article, “Moving from Canada to the United States: What You Need to Know.”

For many of these people transitioning from Canada to the U.S., some of their larger financial assets are held within their registered plans (RRSPs, LIRAs, RRIFs, etc.). Given that our firm is properly registered and licensed in both Canada and the U.S., we can provide ongoing financial planning, tax and investment management for our clients who choose to leave their registered assets in Canada.

Summary and Takeaways

The article reviews the tax implications for Canadians moving to the United States, particularly concerning the withdrawal of funds from Registered Retirement Savings Plans (RRSPs). It highlights the firm’s experience in managing financial planning, tax, and investment for clients who retain their RRSPs in Canada, navigating both Canadian and U.S. tax systems. Tax withholding rates on RRSP withdrawals vary depending on the individual’s tax residency status and the amount withdrawn. For residents of Canada, the tax withheld ranges from 10% to 30%, whereas non-residents are generally subject to a 25% withholding rate, which can be reduced to 15% under specific conditions outlined in the Canada-U.S. Tax Treaty. The article emphasizes the importance of proper departure planning to ensure that the appropriate tax residency status is recorded to avoid unnecessary tax implications. Additionally, it mentions the potential for non-residents to file a Canadian income tax return under Section 217 in certain circumstances to benefit from Canadian tax deductions and credits.

Key Takeaways

  • Tax Implications for Canadians Moving to the U.S.: Awareness of income tax consequences is crucial for Canadians relocating to the U.S., especially regarding RRSP withdrawals.
  • RRSP Withdrawal Tax Withheld: Canadian residents face a sliding scale of withholding taxes on RRSP distributions, while non-residents typically see a 25% rate, adjustable to 15% under specific treaty conditions.
  • Importance of Accurate Tax Residency Status: Proper departure planning and documentation are vital to ensure the correct withholding tax rate is applied to RRSP distributions for non-residents.
  • Potential Tax Treaty Benefits: The Canada-U.S. Tax Treaty offers a reduced withholding tax rate on RRSP/RRIF distributions under certain criteria, highlighting the need for experienced, time-tested financial guidance.
  • Filing Under Section 217: In some cases, non-residents may file a Canadian income tax return to claim deductions and credits, potentially reducing the tax burden on RRSP withdrawals.
  • Canada-U.S. Investment Management: The firm’s capability to manage clients’ investments and retirement accounts with a thorough understanding of Canada/U.S. tax efficiency can significantly benefit those moving between the two countries.

By leaving these assets in Canada, continued tax deferral in Canada and most U.S. states will continue. The State of California, however, has a different set of tax rules that relate to registered plans that remain in Canada. See our article, “California Residents: Does Your Financial Advisor Tax-Manage Your RRSPs?”

As we develop our clients’ comprehensive Canada/U.S. financial plans, discussions and decisions with respect to taking distributions from their RRSPs for future lifestyle or retirement planning purposes are reviewed. For the vast majority of our clients, RRSPs continue to be managed by us through our Canadian institutional custodian until clients retire or are required to convert their RRSP to a RRIF.

However, what if one was looking to take a distribution from their RRSP as a non-resident of Canada prior to retirement, i.e. for the down payment on a new U.S. home or to meet current lifestyle requirements?

Let’s first review the tax impact of de-registering a Canadian RRSP before becoming a U.S. tax resident. As a resident of Canada, distributions from an RRSP are be subject to ordinary income tax rates depending on the province of tax residency. The bank or custodian holding the RRSP would be obligated to withhold tax upon the RRSP distribution at the following rates:

Withdrawal Amount % Federal Tax Withheld
From $0 to $5,000 10% (5% in Quebec)
From $5,001 to $15,000 20% (10% in Quebec)
Greater than $15,000 30% (15% in Quebec)

The withholding tax rates above would only be applied for those individuals who would still be considered tax residents of Canada. If one were to become a U.S. tax resident or non-resident of Canada, the Canadian withholding tax imposed on distributions would be 25%. Under Article XVIII(2) of the Canada-U.S. Tax Treaty, distributions from RRSPs/RRIFs can be reduced to 15% under certain and very specific guidelines. This would generally only be the case if one was to convert their RRSP to a RRIF and take periodic distributions from the RRIF. Under the Canada-U.S. Tax Treaty, this would include payments out of a RRIF where the total amount paid in the current year does not exceed twice the “minimum amount” and 10% of the value of the RRIF at the beginning of the tax year. The “minimum amount” is determined by a percentage factor based on the RRIF holder’s age at the beginning of the tax year.

Some Canadian financial advisors and individuals believe that the above table of withholding tax rates would be applied irrespective of Canadian and U.S. tax residency, which is incorrect. If the departure planning is done properly, then the Canadian institution should have the correct U.S. address on record and the tax residency indicated as a non-resident of Canada. This would generally be acknowledged by the bank or custodian via the completion of CRA Form NR301 and IRS W-9 form at the time the account becomes tagged as a non-resident of Canada account. Therefore, a 25% Canadian withholding tax would apply for lump-sum distributions.

If the individual or advisor still maintains a Canadian address on the account while claiming to no longer be a tax resident of Canada, they are opening themselves up for a number of issues. For example, the ability of an advisor to properly and legally manage registered accounts can be problematic, and so can the indication to CRA that Canadian residency is maintained (though the use of a Canadian address) when a previously filed Canadian tax return indicates a date of departure from Canada.

In some unique situations, former residents of Canada might be able to file a Canadian income tax return as a non-resident under Section 217. Filing a return under this election allows a non-resident to file a Canadian tax return if it would be beneficial for them to do so. In this case, the non-resident taxpayer would be able to claim the same deductions and credits as that of a traditional Canadian taxpayer. There are limited reasons for a non-resident to make this election. One reason is when an individual has a non-working spouse in the U.S. with, for example, $50,000 in their RRSP. In this case, the individual could withdraw the RRSP tax free over five  years without paying any Canadian income tax. Conversely, if the non-working spouse withdrew the $50,000 in a lump sum, there would be a 25% withholding tax imposed at the time of distribution.

As part of our comprehensive wealth management process, and based on our clients’ specific financial planning objectives, we can provide an RRSP distribution analysis to review the options available and the related Canada and U.S. income tax results. Further, because we manage our investment and retirement accounts on a Canada/U.S. tax-effective basis (we understand tax!), we can ensure that withholding tax paid in Canada can be recovered over time through proper portfolio and tax management.

 

 

Americans Exiting Canada: Understanding the Five-Year Deemed Disposition Rule

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American citizens living in Canada for more than five years face an imposed exit tax on unrealized gains.

One of the most common questions we receive from Americans moving to Canada is how to navigate around the Canada Revenue Agency’s five-year deemed disposition rule. Canada assesses an exit tax on any unrealized capital gains inside taxable accounts in cases where the U.S. citizen moves back to the United States after having been a Canadian tax resident for longer than 60 months.

It is important to note that this rule does not apply to any tax-deferred investment accounts or plans.

Some visa holders arrange their date of return to the United States to be 60 months less a day in order to avoid qualifying for this event. But in many cases, this is inconvenient for the corporations that employ them. And it can create personal family hardship, should it occur, for example, in the middle of a school year.

The Canada-U.S. tax treaty requires that non-tax-deferred securities accounts be taxed in the country of the beneficial owner’s residency. Accounts that are transferred to Canada from the United States “in kind” retain their original cost basis (usually the purchase price) for U.S. tax purposes. But a second cost basis—equal to the accounts’ market value on the day the beneficial owner became a Canadian resident for tax purposes—is automatically generated. This can cause confusion, and in many cases erroneous tax reporting, in both Canada and the United States.

Does leaving your accounts in the U.S. help?
In the past, some U.S. citizens would simply leave their U.S. taxable and trust accounts in the United States in an attempt to get around the Canadian five-year tax rule. Prior to 2013, this sometimes worked. The CRA required, but did not rigorously enforce, reporting of unrealized capital gains of all taxable accounts, including those remaining in the U.S.

In 2013, however, the CRA introduced a revamped, more robust version of a form called the T1135 Foreign Income Verification Statement, which is somewhat similar to the IRS’ foreign reporting requirements in the United States through IRS Form 8938 and the FinCEN 114. The CRA T1135 form requires a detailed annual accounting of all foreign accounts (including those in the United States) held by a Canadian tax resident. Failing to file this form leads to penalties. And given the increased information sharing initiatives now in place between the CRA and IRS, taxpayers must be compliant. If an American moves back to the United States after five years, the CRA will have a complete record of all of their taxable investment accounts in both countries. When completing the Canadian exit tax returns, you will be assessed on any unrealized capital gains from the date of when you entered Canada to the date of departure. This is reported on your Canadian exit return through Forms T1161 and T1243.

How do the tax rules work?

  • Let’s use a hypothetical example to illustrate how the rules work. For simplicity’s sake, we will ignore currency exchange. Bear in mind that in real life, currency exchange must be accounted for to determine the proper Canadian basis and ultimate proceed numbers for Canadian and U.S. purposes.
  • You purchase a number of investment securities (stocks, bonds ETFs etc.)in a taxable account that has a U.S. cost basis of $50,000. When you later move to Canada, the account is worth $100,000 ($50,000 of which is unrealized gains). Regardless of where the account is domiciled (Canada or the United States), you now have two adjusted cost bases for tax purposes. The U.S. basis is $50,000. The Canadian basis is $100,000.
  • Five years later, you move back to the United States; the account has now grown to a value of $150,000 ($100,000 capital gains for U.S. tax purposes and $50,000 for Canadian tax purposes). For Canadian tax purposes, you will have an imposed departure gain of $50,000. In Canada, 50% of the gain is taxable at your respective marginal rate. Assuming that you are in the highest marginal rate in Ontario upon exit, your net tax would be 24.76%.

For U.S. tax purposes, you would have to pick up capital gains of $100,000.
The current U.S. long-term capital gains rate of 15% would be applied. However, depending on your filing status and U.S. Adjusted Gross Income amounts, you could be subject to an additional 5% capital gains tax and a 3.8% levy on all net investment income for the tax year. Therefore, it is extremely important to proactively gain a sense of what exposure might exist in Canada and the United States prior to departure or the end of the tax year in order to avoid any unnecessary surprises.

  • On any Canadian tax paid, you would receive a passive foreign tax credit. The credit may be used for U.S. tax reporting purposes under the Canada-U.S. tax treaty—provided that it is properly filed by your accountant. It should be noted that this is a “deemed” sale, and not an actual sale of the securities in the account. For U.S. tax purposes, your original adjusted cost basis is still $50,000.
  • Interestingly, when moving back to the United States, the IRS does not allow for a stepped-up basis to be used for securities bought while living in Canada. Unlike in Canada, where the basis for Canadian tax purposes is calculated based on the market value on the day that the beneficial owner became a Canadian resident for tax purposes, the U.S. will only recognize the original basis. This means that if a security was bought in Canada for $50,000 and it was valued at $100,000 at the time you move back to the U.S., the IRS would consider $50,000 to be the cost basis—it will not allow it to be stepped up to $100,000.

How to minimize the Canadian exit tax
A qualified Canada-U.S. cross-border financial advisor will keep track of both your Canadian and U.S. cost bases, and tax-manage your portfolio accordingly. Actively and prudently employing tax-loss harvesting to offset gains can reduce the amount of exit tax owed. Contact Cardinal Point to learn more about our tax-managed portfolio strategies for Americans living in Canada, and how we personalize our investment process to fit your needs.

Investment Basics for Americans in Canada

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It’s a good idea for Americans living in Canada to understand which kinds of registered investment accounts they can have without having to confront onerous taxes and paperwork.

Two kinds of plans are friendliest for Americans: The Registered Retirement Savings Plan (RRSP) and the Registered Retirement Income Fund (RRIF).

Effectively, U.S. citizens are simply taxed on the distributions from these accounts as they would be in Canada.

On the other hand, Americans should generally avoid Tax Free Savings Accounts (TFSA) and Registered Education Savings Plans (RESP). The IRS considers both to be offshore trusts, and as such, they involve burdensome filing requirements, with significant penalties for non-compliance. What’s more, their accrued earnings are taxable in the United States.

Check out Terry Ritchie’s recent Globe and Mail video segment for more details about U.S. citizens investing in Canada.