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U.S. Tax Residency Ebook – Cardinal Point Wealth

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Most Canadians who move to the U.S. have a good understanding of their immigration residency status. However, many do struggle to determine their residency status for U.S. income tax purposes. While it is common knowledge that U.S. citizens and green card holders are responsible for filing U.S. tax returns, most people who move to the U.S. on a non-resident visa – such as a TN, E1 or E2, O-1, L-1 – are unfamiliar with the U.S. tax residency rules that can subject them to U.S. taxation on their worldwide income.

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Canada-U.S. Tax Treaty Explained

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Understanding Cross-Border Taxation: The Canada-U.S. Tax Treaty Explained

Does Canada have a Tax Treaty with the US? So, what do you do when both Canada and the United States claim you as a taxpayer?  Maybe you are a U.S. citizen who moved to Canada, but all of your income comes from the U.S.  Maybe you are a Canadian who stayed too long at your winter home in Arizona for a few more rounds of golf and have now surpassed 183 days in the U.S.  Perhaps you are a U.S. person who inherited a cottage in New Brunswick, but you do not see yourself going there anytime soon and want to sell it.

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Summary and Takeaways

Canada and the United States do honor a mutually agreed upon Tax Treaty. Generally its intention is to help dual citizens, or those who live in one country and earn income in other, to avoid or reduce double taxation. The way that is done is by applying foreign tax credits that effectively offset your taxable income – up to the amount of taxes you are liable for in your home country of primary residence.

Key Takeaways

  • One of the keys to understanding whether the Treaty applies to you is to identify your country of residence. That usually refers to the country where you spend the majority of your time.
  • But both countries have the first right of taxation on income derived from real property in their country, regardless of where the property owner lives.
  • The Treaty also outlines tie-breaker rules applied for people who exceed the number of days they may live in a country without being deemed a resident, even though they don’t regard that nation as their home country.
  • Under the Treaty you may also be eligible for less stringent reporting requirements and tax filings, and there are additional provisions of the Treaty applicable to estate and death taxes.

Tax Treaties U.S. citizens – and in most cases U.S. green card holders – are considered to be U.S. persons for U.S. income tax purposes.  As a U.S. person, you are required to annually file U.S. income tax returns and to pay U.S. tax on your worldwide income. This is irrespective of where you live, earn income, hold assets, or ultimately die. If you are a U.S. citizen who also lives and works in Canada, Canada wants you to pay tax on your worldwide income as well. This can present quite the conundrum.

Like most countries in the OECD (The Organization for Economic Co-operation and Development), Canada and the United States have an income tax treaty.  The primary purpose of The Canada-United States Tax Convention (1980) (the Treaty) is to help to resolve these types of conflicts.

To determine if the Treaty can help you, the first step to take is to understand how your situation is treated under domestic law.  By ‘domestic,’ we simply mean the law of the country you physically spend most of your time in.

Canada imposes income tax on its residents regardless of citizenship or legal immigration status in the country.

Alternatively, and as we indicated above, the United States imposes income tax on its residents, regardless of status. This then requires the filing of an annual income tax return and additional reporting and filing compliance requirements from U.S. persons regardless of their country of physical residence.

Both countries have the first right of taxation on income derived from real property in their country – through rental income or the sale of the real property – no matter where the beneficiary or owner of that income is resident.

Both countries also have the first right of taxation to income earned or sourced in the specific country. De minimis rules allow taxpayers to earn small amounts other than from real property that are only taxed in your country of residence.  We consider whether the income is effectively connected to a U.S. trade or business or if the cost is borne by a permanent establishment in the other country.  Under the Tax Treaty, a “permanent establishment” includes a fixed place of business (i.e., office) through which one would carry on business to generate income or activities.  For example, if you physically reside in Canada, but your income is earned in the U.S. and you are a U.S. person, then you report even de minimis earned income on both your Canadian and U.S. income tax returns.

So, what is a ‘resident’?  A ‘U.S. person’?  Income ‘derived from real property’?  “Effectively connected” taxable income’?  A ‘permanent establishment’?  These terms are all defined.  Understanding when they apply to you matters.  They are defined for each country’s purposes under that country’s domestic tax law.  In Canada, tax laws and definitions are in the Income Tax Act (the Act).  U.S. income tax legislation is found under Title 26 of the Internal Revenue Code (the Code).

Beyond the protection of certain provisions of the Treaty, as a means to avoid or reduce a taxpayer’s exposure to double taxation on income subject to tax in both countries, taxpayers are entitled to take a foreign tax credit.  This credit can be taken on foreign income up to the amount of domestic tax payable on the same reported income.  Not all of the taxpayer’s income can be offset by these foreign tax credits (FTCs).  However, the general scheme is for taxpayers to only pay tax, to both countries combined, like they would pay in their country of residence. It does not always work perfectly but the objective is to eliminate the taxpayer’s exposure to tax in both countries on the same income.

The Act in Canada and the Code in the United States are not identical.  They define residence, income sources, and many other items without regard to the other country’s tax laws.  Situations arise where both countries may claim first right of taxation on an item of income, or more commonly, that a taxpayer is resident in both countries under their domestic tax laws.

That is where the Treaty comes in.  The Canada-United States Tax Convention (1980) was entered into force on August 16, 1984 and has been updated with five protocols. The most recent update was the Fifth Protocol, which was entered into force on December 15, 2008.  If an additional form of income tax –for example, like the U.S. Net Investment Income Tax (U.S. NIIT) passed by the Obama Administration—is created after the Treaty’s last Protocol, then it is not covered and cannot be eliminated using FTCs.

The Treaty has thirty-one articles dealing with a variety of topics.  Article IV covers residence and provides tie-breaker tax residency rules for people who over-stay “their tax welcome” in the country they don’t consider “home.” Article XIII covers gains, including gains from real property (the cottage in New Brunswick, for example).  Article XXIV is titled Elimination of Double Taxation and is particularly helpful for the U.S. citizen living in Canada who is required to report worldwide income to both countries.

Let us walk through a simple example.
George and Ida are U.S. citizens who moved to Toronto for work when they were in their 40’s.  They liked it, ending up staying in Canada, and ultimately chose to retire to a winterized cottage in the Muskoka’s – Ontario’s Cabin Country.  George and Ida would be considered Canadian tax residents under Canadian domestic law.  They did not renounce their U.S. citizenship and do not intend to, which means that there are also considered U.S. residents for U.S. tax purposes.   Their income includes U.S. Social Security, Canada Pension Plan (CPP), and Old Age Security (OAS) benefits along with distributions from their U.S Individual Retirement Accounts (IRA) and Canadian Registered Retirement Income Funds (RRIF).  George and Ida also have various forms of investment income from a variety of taxable accounts in various countries.  As required, they file Canadian income tax returns annually reporting their worldwide income to Canada and then take a foreign tax credit for taxes withheld at source on their U.S. IRA and foreign investment income including the 15% withheld in the U.S. from U.S. sourced dividend income.  Their U.S. Social Security income is only 85% taxable under Article XVIII of the Treaty in Canada and No longer taxable on their U.S. return.

Being U.S. citizens, George and Ida also must file a U.S. tax return annually reporting their worldwide income.  Since their income is all retirement and investment income, it is all sourced to Canada, except their U.S. dividend income.  However, this source of income has to be recalculated and reported under principals in the U.S. Code.  On their U.S tax return, they can take a foreign tax credit for income taxes paid to Canada on most of their income and for taxes paid to other countries for their global investments.  These foreign tax credits can eliminate everything except tax on the U.S. dividends and the U.S. NIIT, which tax is referred to as ‘latter-in-time’ under the Treaty.  Further, there is also Article XXIV, which will apply in their case and provides for an additional foreign tax credit to bring the amount of tax paid to the United States on U.S. dividends down to 15%.  Fun math but doable if you know the rules and have the right software!

We hope your key take-away thus far is to recognize that there is a Tax Treaty is in place between Canada and the United States.  The Tax Treaty can be utilized to relieve some of the unique filing and reporting requirements for those of you who might have filing and reporting obligations on the same level of income to both countries.  Traditionally, this often relates to U.S. citizens resident in Canada and dual citizens.  But it also has implications for snowbirds or those individuals who might have worked in one country in the past and are now receiving pension or retirement income in their “home” country.

As this article is focused on the income tax issues under the Treaty, it is important to note that the Treaty also covers other issues that relate to the death and taxation of assets in either country of citizens/residents and the application of the income at death (Canada) or Estate Tax issues (U.S.). Maybe now you understand the answer to the question of Does Canada have a Tax Treaty with the US.

As those issues are very important and part of the overall comprehensive financial planning that we do for our clients, we will cover those issues in a future article.

Cross-Border Implications of Holding a 529 Plan

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Thousands of Canadians relocate to the U.S. for career opportunities each year. They often envision staying a couple years to garner valuable experience before returning home. However, what was originally meant to be a short sojourn can quickly become a decade or more. Their life may change significantly during that time, perhaps due to a marriage or the birth of children. This article focuses on 529 plans for children and the tax implications of this educational investment vehicle in a move back to Canada.

Plan

Summary and Takeaways

So-called 529 plans are an investment vehicle you can take advantage of in the United States in order to help you save tuition money to fund your child’s future education. A 529 plan may be very beneficial in terms of offering savings growth that can be eligible for some tax deductions or tax-free withdrawals. However, if you move to Canada, that could result in taxation on the earnings in the account. But there are strategies to help avoid tax exposure, if you plan ahead before you move across the border.

Key Takeaways

  • There are two types of 529 plans, those for prepaid tuition plans and those for educational savings plans.
  • The plans are sponsored by states, and while 34 states allow income tax credits or deductions for 529 plans other don’t. Many people don’t legally reside in the same state where their 529 plan is based.
  • 529 plans are deemed taxable brokerage accounts for Canadian income tax purposes.  Investment income earned in the account is taxable annually.
  • To avoid Canadian tax on your 529 you may want to transfer ownership of the 529 account to a trusted U.S. citizen before you move to Canada.

529 Basics
As its name suggests, this plan is derived from Section 529 of the Internal Revenue Code. It states that a qualified tuition plan shall be exempt from taxation. There are two types of 529 plans: prepaid tuition plans and educational savings plans. For more information on the nature of these categories see Cardinal Point’s blog titled: Canada & U.S. Education Savings Options.

529 plans are sponsored by individual states, and it is not uncommon for a resident of one state to utilize another state’s 529 plan. Why? Because not all states allow for an income tax deduction or credit on the 529 contributions (34 states do). As such, the resident of that state may look for a 529 plan in a state where there are better investment options, lower fees, lower minimum contribution amounts, or higher total lifetime account balance thresholds.

529 Mechanics
As of 2022, contributions made to a 529 plan are limited to an annual $16,000 per beneficiary. This amount doubles to $32,000 if the donors are married filing jointly. There is also an option that exists to “front load” the 529 with up to five years’ worth of contributions ($160,000) if married filing jointly. As long as no additional contributions to that beneficiary are made within that five-year window, no gift tax filing obligations are required.

Money contributed does not receive a tax deduction at the federal level. However, if the contributor resides in one of the 34 states that allows for a state income tax deduction or credit, then there is a tax benefit that can potentially be utilized. The earnings on the associated investments within the plan grow tax free as long as future withdrawals are utilized for qualified higher education expenditures.

Expenses that do not qualify for tax-free withdrawal include room and board, transportation, and medical expenses to name a few. If the withdrawal is deemed unqualified, then the earnings on the distribution are subject to income tax and an additional 10% penalty per the “Kiddie Tax” rules (see below).

The Tax Cuts & Jobs Act (TCJA) of 2017 added a feature to qualified 529 withdrawals that allowed $10,000 of annual distributions to be used for K-12 school tuition. The Secure Act of 2020 preserved this condition in the legislation. In addition, the Secure Act revitalized the old “Kiddie Tax” regime.

Kiddie Tax Basics
The tax applies to children under the age of 19 unless they are full-time students. In the latter scenario, these tax rules apply until the young adult turns 24. Under these rules, a portion of a child’s unearned income could be taxed at the parent’s marginal income tax rate. This would include any unqualified distributions from a 529 plan.

When analyzing the federal income tax bill of the child subject to the “Kiddie Tax,” the standard deduction rules apply. For 2020, the child’s standard deduction is the greater of: $1,100 or earned income plus $350, not to exceed $12,950 for 2022. Any annual unearned income between the standard deduction and $2,200 is taxed at the child’s tax rate. Once the annual $2,200 threshold is exceeded, the remaining unearned income is taxed at the parent’s marginal tax rate, which could be as high as 37%.

Cross-Border Implications of 529 Plans
Let’s assume a Canadian family living in Texas had two children during their U.S. tenure.  These children are dual citizens of Canada and the U.S., are currently in high school, and plan to go to a Canadian university for higher education. Now that the entire family has made the decision to return to Canada, how should they deal with the 529 plans they’ve accumulated and what are the tax considerations?

U.S. Taxation – If the Canadian college or university is eligible for Section 529, any qualified distributions are tax free for U.S. tax purposes. Many, but not all, Canadian institutions are eligible, and the list evolves over time. The Federal School Code Lookup Tool gives you an easy way to determine whether your chosen Canadian college or university is eligible for Section 529. The custodian of the 529 reports the distribution on a Form 1099-Q and, assuming the funds were paid to the 529 beneficiary, college/university, or student loan provider, the distribution would be reported on the child’s tax return.

Canadian Taxation – Although 529 plans provide income tax savings for U.S. residents, they are effectively taxable brokerage accounts for Canadian income tax purposes.  As such, any investment income earned in the account would be taxable on an annual basis.  Upon re-establishing Canadian tax residency, there is a step up in the cost basis (converted into CAD) that is applicable to certain assets inclusive of 529 accounts. This is called the “deemed acquisition date” and resets the book value for Canadian tax purposes to the fair market value on the date Canadian residency is established.

There is also an argument that the 529 plan would be a deemed resident trust that would require Canadian trust filings.  In order to avoid Canadian taxation of these accounts in some form or another, you may want to consider transferring ownership of the account to a trusted family member or other individual who resides in the U.S. prior to your move to Canada. That transfer should not trigger any tax.  After transfer of ownership, you could continue to contribute to the fund through gifts, and the account would avoid taxation in Canada. However, some do not feel comfortable transferring ownership of their 529 accounts.

In Conclusion – The future changes constantly, and it’s difficult to know with certainty where you’ll choose to reside or where your child will decide to pursue his or her higher education. If you are confident your child will choose to go to school in the U.S. or enroll in an international institution that is 529 eligible, then a 529 plan is worth exploring. For a more detailed analysis of the options available to meet this goal, it is prudent to have a conversation with a cross border expert. Contact Cardinal Point for more information.

Cross Border Retirement Income: Canada Pension Plans, Canadian Old Age Security, U.S. Social Security and the Windfall Elimination Provision

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Calling all eligible benefit holders of the Canada Pension Plan (CPP), Canadian Old Age Security (OAS) and U.S. Social Security (SS)…

Does your or your spouse’s story narrate a history of employment in both Canada and the U.S.? If so, you may have the privilege of drawing from SS, OAS and CPP. The confusion lies amidst the qualifications and how these benefits interact with one another given the Windfall Elimination Provision (WEP).

Let’s break it down…

Social Security (SS)
To qualify for retirement benefits under U.S. Social Security, you must have 40 credits of covered work.  Each credit represents a quarter (i.e. 3 months) of full-time employment.  Thus, generally speaking, you must have 10 years of full time employment in order to qualify for retirement benefits.

All monthly benefits are based on your Primary Insurance Amount (PIA), which is the amount you would receive if you retired at your full retirement age (FRA). The FRA is age 65 for people born before 1938, gradually increasing to age 67 for those born in 1960 and later. You can choose to take it as early as age 62, resulting in a 25% reduction in benefits. At a more granular level, the monthly PIA is reduced by 5/9ths of 1% for each of the first 36 months before your FRA. You can also choose to earn delayed retirement credits (DRCs) for any month from FRA up to age 70. DRCs increase the benefit for the retired worker but not the spouse (if utilizing the spousal benefit). If you were born in 1943 or later, you earn 8% DRCs for each full year (prorated for months) up to age 70 for a maximum increase of 32%.

Individuals have the opportunity to take a SS benefit on the greater of their own record or 50% of their spouse’s SS benefit.

Canadian Old Age Security (OAS)
The rules to qualify for full OAS benefits under the Canadian system are centered on residency in Canada beyond the age of 18, not employment history. A full benefit is received when an individual has accumulated a Canadian residence history of 40 years. The pension can commence as early as the month following one’s 65th birthday or be delayed as late as age 70. By deferring one’s OAS, the benefit increases by 0.6% per month/7.2% per year, which equals a 36% increase if OAS is deferred to age 70. Partial OAS benefits may be available in certain situations. Let’s review a few scenarios:

Let’s assume you’ve lived in Canada less than 40 years and you are currently residing in Canada. As long as you are 65 years or older, a legal resident of Canada or Canadian citizen, and have lived in Canada at least 10 years since the age of 18, you are eligible for a prorated OAS benefit.

To take it a step further, let’s assume the same scenario with a bit of a twist. Instead of currently residing in Canada, you are now living in the U.S. These circumstances dictate you must have resided in Canada for a minimum of 20 years since the age of 18 in order to receive a partial benefit.

If neither of these examples apply to you, there may still be an opportunity to collect on the benefit if the country in which you currently reside has a social security agreement with Canada.

One final item on OAS; if one were to reside in Canada at the time of receipt of the OAS benefit, the individual may be subject to the OAS clawback. This would be created when your income exceeds certain threshold levels. For the 2019 tax year, the OAS clawback kicks in when income exceeds, $77,580. On the other hand, if OAS payments are made to a physical resident of the U.S. – and not a Canadian physical or tax resident – the clawback provisions are eliminated, and the entire benefit is paid to the recipient. No OAS clawback would apply.

Canada Pension Plan (CPP)
Unlike Old Age Security, CPP is based upon your pension contributions through your employment record, subject to certain maximums. As long as you’ve made at least one contribution to the plan, you are entitled to receive a CPP benefit. This benefit is available at age 65, but one can opt for a reduced benefit as early as age 60 (reduced by 7.2% annually) or a delayed benefit as late as age 70 (increased by 8.4% annually). In addition, the CPP benefit is not subject to any clawbacks.

How then do these benefits tie in with the Windfall Elimination Provision (WEP)?

Understanding the Windfall Elimination Provision
Under Title II of the Social Security Act, the Windfall Elimination Provision was born. It authorized the Social Security Administration to reduce an individual’s Social Security benefit in the event the recipient was also receiving a foreign pension (e.g. CPP). To understand the “why” behind the WEP, it’s important to comprehend how the SS benefit is calculated, specifically the Primary Insurance Amount (PIA).

A worker’s PIA is based off their average monthly earnings separated into three amounts. These values are then multiplied utilizing three distinct factors. Here’s an example:

For a worker who turns 62 in 2018, the first $895 of average monthly earnings is multiplied by 90%, earnings between $895 and $5,397 by 32%, and the balance by 15%. The sum of these three amounts equals the PIA, which is then either increased or decreased depending on when a worker decides to draw SS. This is how the monthly payment is determined.

Social security was meant to replace part of an individual’s pre-retirement earnings. With the previous calculation in mind, one can conclude that workers with lower average monthly earnings have a higher percentage of their pre-retirement earnings replaced via Social Security than those with higher average monthly earnings. For example, a 62 year old worker with average earnings per month of $3,000 could receive a benefit at FRA of $1,479 (49 percent of their pre-retirement earnings), increased by cost of living adjustments. For a worker with $8,000 of average earnings per month, the benefit starting at FRA could be $2,636 (32 percent of their pre-retirement earnings) plus cost of living adjustments.

For those individuals whose primary job wasn’t covered by Social Security, yet had their benefits calculated as if they were a long term, low-wage worker, they would end up receiving a benefit that would cover a higher percentage of their earnings, plus a pension from a job for which they didn’t pay Social Security taxes. This is true for someone who spent time working for an employer in Canada, earning CPP credits.

Under the Windfall Elimination Provision (WEP) the calculation for a worker’s Social Security benefit needs to account for the CPP payment. The 90% factor on the first $895 of monthly average earnings (when estimating PIA), could be reduced depending on the number of years of U.S. earnings history. The WEP is eliminated once a worker has 30 or more years of substantial earnings in the U.S.

The U.S. Social Security Administration has an Online WEP Calculator that is available here.

Despite the current provisions of WEP, a U.S. Class Action lawsuit has been filed on behalf of Canadians who receive SS benefits and have been impacted by WEP.  The suit was recently filed in the State of Indiana against the SSA. The crux of the lawsuit is whether the application of WEP against individuals who also receive the same benefits in Canada is lawful.  The Plaintiffs in the Class Action are claiming that the application of WEP to U.S. benefit recipients is unlawful and presents a violation of the plain meaning of the U.S. Social Security Act, U.S. Social Security Act Regulations and the Social Security Agreement (1983-1984) between United States and Canada (the “Social Security Agreement”). The Plaintiffs are seeking retroactive payment of the amounts that have been deducted through the application of WEP and the ending of the application of WEP moving forward.  The claim has been certified but has yet to move forward at the trial court level.

In Summary: Although a worker’s Social Security is potentially reduced by CPP, the good news is that OAS does not factor into the WEP calculation. Whether the WEP impacts your Social Security depends on the uniqueness of your individual circumstances and the potential result of the Class Action Lawsuit. If you think you might be impacted by WEP, we recommend you have a cross border financial planner such as Cardinal Point analyze your situation.

 

 

 

How U.S. Residents Can Receive Tax-Free Alimony from Canada

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While most people know that alimony is normally taxable income to the recipient and tax deductible by the payer, in the case of cross-border taxes, alimony can be received tax free while the payer still gets a tax deduction.

Let’s look at an example where this would apply.

Sarah is a U.S. Citizen who has been transferred to Toronto for a job opportunity. While living in Canada, she meets and falls in love with John, a Canadian citizen. After a few years of dating, Sarah and John decide to get married and live together in Toronto. Five years into their marriage, due to irreconcilable differences, they decide to divorce. Sarah chooses to return to the U.S. to live close to her family. As part of the divorce settlement, John must pay Sarah alimony.

Since John is a Canadian tax resident, he will be able to deduct the alimony payments to Sarah on his Canadian tax return. But with the right cross border tax planning, Sarah can exclude her alimony from U.S. tax. How? By including specific language required by the IRS in the divorce agreement. In our couple’s case, they would include language along the lines that John agrees not to deduct the alimony payments for U.S. tax purposes. Since John is a Canadian tax resident only, he is still able to deduct the alimony on his Canadian taxes and is not affected by the agreement.

While this is a very simplified example – the rules to make this legitimate are more complex – the fact remains that in Sarah’s case, a U.S. resident can receive alimony tax free for U.S. tax purposes. In John’s case, he also gets to reap the tax benefits from this strategy, unless he decides to take up a job in the U.S. and become a U.S. tax resident.