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Overview of U.S. Expatriation

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U.S. citizens and Long-Term Residents who renounce their U.S. citizenship or surrender their Green Card (GC) could be subject to a U.S. Expatriation Tax.  This unique form of U.S. income tax could be levied if  any one of three tests are met. The rules and tests relating to U.S. expatriation for U.S. citizens and Long-Term Residents are discussed below.  However each individual’s situation is unique and should be analyzed separately. Please contact Cardinal Point for more information and a detailed analysis of your situation with a qualified cross-border financial or tax advisor.

US Expatriate Tax

Summary and Takeaways

You may be liable for a U.S. Expatriation Tax if you renounce your U.S. citizenship or surrender your Green Card. But whether or not you are liable for that tax depends on three different criteria or legal tests.

As is true with virtually all tax rules, particularly those that relate to citizenship status, the regulations are complex, and can be difficult to understand. That’s why this blog helps to clarify them so that, based on your own unique situation, you can get a better idea of whether or not you are impacted.

Key Takeaways

  • First determine whether you are, indeed, a U.S. Citizen or Green Card holder
  • If you are, your tax status is confirmed by a Net Worth Test, a Tax Liability Test, and a Certification Test
  • If you meet any of those testing criteria, you are liable to pay the U.S. Expatriation Tax
  • But there are certain exceptions that may still exempt you from the U.S. Expatriation Tax
  • Tax payment can also be deferred until your taxes are due for the year of expatriation.

Am I a U.S. Citizen or Long-Term Resident?

Generally, you are a citizen of the U.S. if you were born in the U.S. or born to a U.S. citizen parent who lived in the U.S. for a certain number of years after age 14. If you do not know whether you are a U.S. citizen, please contact Cardinal Point to help determine your U.S. citizenship status.

A U.S. Long-Term Resident is defined as a Green Card Holder who has had that status of lawful permanent resident in eight of the last 15 years. Note that only one day out of the calendar year is required for that year to qualify for lawful permanent resident status. However, do not count years in which:

  • you are not yet a Long-Term Resident (Green Card Holder), and
  • you make a treaty election to be taxed as a nonresident alien of the U.S. for the entire calendar year.

How do I Terminate U.S. Citizenship or Long-Term Resident Status?

U.S. citizens terminate by filing Form DS-4079 – Request for Determination of Possible Loss of United States Nationality and taking an oath of renunciation.

U.S. Long-Term Residents terminate by filing Form I-407 – Record of Abandonment of Lawful Permanent Resident with the U.S. Citizenship & Immigration Service (USCIS) and physically turning in your Green Card. Note that letting your Green Card expire is not an act of expatriation. Until you have properly completed, signed, and submitted your I-407, you are still considered to be a U.S. taxpayer.

What are the Three Tests for U.S. Expatriation Tax?

The three tests involved in determining if you are subject to the U.S. Expatriation Tax are as follows:

    1. Net Worth Test – is your individual net worth $2,000,000 USD or more as of the date of expatriation?
      • Typical assets include bank accounts, investment accounts, U.S. and foreign real estate, ownership of businesses, beneficial ownership of a trust, personal assets, etc.
      • Note that each individual has a $2,000,000 USD threshold. Married couples cannot combine their thresholds.
      • Note that property ownership follows local laws, such as community property laws.
    2. Tax Liability Test – is your average tax liability for the five years before expatriation $178,000 USD (2022; indexed annually) or more?
      • Note that if you filed a joint tax return, you should use your joint tax liability for that year.
    3. Certification Test – do you certify that you have not complied with all of your U.S. tax obligations for the five years before expatriation?

If you meet any one of these three tests at the time of U.S. expatriation, then you are considered a Covered Expatriate and are subject to the U.S. Expatriation Tax unless an exception applies. The exceptions are as follows:

      • You became, at birth, a U.S. citizen and a citizen of another country, and as of your expatriation date, you continue to be a citizen of, and are taxed as a resident of, that other country. In order to meet this exception, you must also have been a resident of the U.S. for less than 10 years during the 15-tax-year period ending with the tax year during which your expatriation occurred. Note that the Substantial Presence Test is used for the purpose of determining U.S. residency.
      • You expatriated before you were 18 ½ years old and you were a resident of the U.S. for less than 10 tax years before your expatriation occurred. Again, note that the Substantial Presence Test is used for the purpose of determining U.S. residency.

I am a Covered Expatriate. What Next?

Covered Expatriates should file IRS Form 8854 – Initial and Annual Expatriation Statement alongside their  annual IRS U.S. Form 1040 – U.S. Individual Income Tax Return. The expatriation date stated on Form 8854 should match the date stated on your Form DS-4079 or USCIS Form I-407.

Covered Expatriates pay an exit tax upon expatriation, although by posting security and paying interest, you can defer the payment of this tax until the due date of your IRS Form 1040 for the year of expatriation. The four exit tax rules are as follows:

      • specified tax deferred accounts (eg. IRAs & 529 plans) – subject to a deemed distribution upon expatriation (no early distribution penalty)
      • deferred compensation – “Ineligible” is taxed as a deemed present value lump sum distribution upon expatriation whereas “eligible” has 30% tax withheld from future distributions and no current tax implications upon expatriation
      • trust distributions – 30% tax withheld from the taxable portion of the trust distributions when paid in the future and no current tax implications upon expatriation
      • all other items – there is a deemed sale, with gain/loss recognized upon expatriation. The first $767,000 USD (2022; indexed annually) of capital gain recognized on the deemed sale is exempt from taxation.

As mentioned previously, the rules and tests relating to U.S. expatriation are complex and each individual’s situation is unique. Please contact Cardinal Point for more information and a detailed analysis of your situation with a qualified cross-border tax advisor and financial planner.

The Health Savings Account in a Canada-U.S. Context

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You work hard to earn your money. You live below your means and have extra funds to save for retirement or a rainy day. But with all the different types of savings and investment accounts available, which should you prioritize? Once you’ve stashed away three to six months of living expenses in a basic savings account to cover unexpected emergencies like insurance deductibles, out-of-pocket medical expenses, and auto repairs, it’s time to turn your attention to other savings or investment accounts that have tax advantages that provide a benefit from the investment, allowing more of your money to be invested and ultimately returned back to you. Below are the factors to consider:

HSA Canada

Summary and Takeaways

The Health Savings Account (HSA) is the only type of account that allows you to deduct contributions, create tax-free investment income, and enjoy tax-free distributions as long as those are used to pay for eligible healthcare expenses. That can be a user-friendly tax-saving tool if an HSA is appropriate for your circumstances. But in a cross-border context, an HSA may complicate tax filing and expose you to Canadian taxes in ways that essentially offset the benefits. That’s why it is advised that cross-border taxpayers seek the guidance of a qualified cross-border tax planner before opening or closing an HSA account.

Key Takeaways

  • There is no required minimum distribution, and HSA funds can be withdrawn for any reason with no penalty after the age of 65.
  • Generally, those living in Canada are not eligible to make U.S. tax deductible HSA contributions. Those contributions are also not deductible for Canadian tax purposes.
  • It is generally advisable that if you already have an HSA account but you’re moving to Canada you should keep the account open to avoid a distribution penalty.
  • But after moving to Canada, you should spend the funds for eligible healthcare expenses to avoid the risk of potential penalties and to simplify your tax filing.
  • Are contributions to the account deductible?
  • Does the account provide tax deferral of investment income?
  • How are distributions taxed?

The best scenario for an investment account is one that allows deductible contributions, tax-free investment income, and tax-free distributions. This means you never pay tax on the contribution, the income, or the distributions. The following chart summarizes the tax treatment of the most popular types of accounts in the US and Canada. With the exception of differing contribution and income limits, IRAs, 401(k)s, 403(b), SIMPLE IRAs, SEP IRAs, and individual Defined Benefit plans are all very similar, and those accounts are usually rolled into an IRA upon retirement.

Taxable Investment 401(k) IRA Roth IRA HSA 529 RRSP TFSA RESP
Deductible Yes Yes Yes Yes
Income Deferral Yes Yes Yes Yes
Tax-free Investment Income Yes Yes Yes Yes
Tax-free Distribution Capital gains are taxed Yes Yes Yes Yes Taxed to student
Annual Contribution Limit Unlimited $19,500 $6,000 $6,000 $3,600
($7,200 for family coverage)		 $27,830 $6,000 20% CESG up to $2,500
Catch-up contributions $6,500 for 50+ $1,000 for 50+ $1,000 for 50+ cumulative limit cumulative limit cumulative limit
Lifetime Contribution Limit $235,000+ determined by state $75,500 $50,000
Age Restriction 59.5 59.5 65 31 years after inception
Early Withdrawal Penalty 10% 10% 20% 10% 20%
Penalty Portion Full Full Full Earnings Earnings
RMD Yes Yes Yes 36-year limit

The HSA is the only type of account that has the benefit of a deduction for the contributions, tax-free investment income, and tax-free distributions. HSAs combine the tax attributes of an IRA and a Roth IRA in that you get a deduction on the way in, and it is tax-free on the way out but only if distributions are used to pay eligible healthcare expenses. HSAs  are also similar to Roth IRAs in that there is no required minimum distribution. Distributions from taxable investment accounts are not fully taxable like distributions from an IRA, but capital gains are taxed. HSAs (healthcare) and 529s (education) must be spent on qualified expenses or else they are taxable with a penalty rather than tax free. The exception to this rule is that HSA funds can be withdrawn for any reason with no penalty after the age of 65. In this case, the distribution is taxable like an IRA, but no penalty applies.

Another benefit of HSAs is they are the only account that provides for an “above-the-line” deduction, which means they are deducted before totaling Adjusted Gross Income (AGI) so there are no income limits on HSA deductibility. IRA contributions are also above the line but are potentially subject to income limits. Many employed taxpayers are eligible for executive compensation packages through their employer, have a spouse who has an employer-sponsored retirement plan, or their high income disqualifies them from contributing to a traditional IRA. There is no income limit for IRA and Roth IRA contributions if neither spouse has access to a qualified employer sponsored retirement plan. The only qualification for receiving a deduction for a contribution to an HSA is the participant must be enrolled in a qualified High Deductible Health Plan (HDHP). Retired clients generally are on Medicare, do not need the tax deduction, or have retirement health benefits provided by their former employer which are not considered a HDHP.

For the most part, the HDHP requirement means that those living in Canada are not eligible to make U.S. tax deductible HSA contributions. Canadians are covered by provincial healthcare, which is not considered a HDHP. Besides, there is no deduction in Canada for HSA contributions. There would be no advantage to contribute because people generally pay more tax in Canada and need Canadian deductions. Even as a dual resident, the deduction in the U.S. will not benefit you because the foreign tax credits created in Canada will usually offset your U.S. tax payable.

HSAs were not included in the Canada-U.S. Tax Treaty, so investment income is taxable in Canada even though it is not taxable in the U.S. Our advice to those moving to Canada with existing HSA accounts is to keep the account open because you would not want to take a taxable distribution with the penalty before you leave. However, you should make sure to use the HSA account for all your healthcare needs in the U.S. and Canada. Expenses incurred for healthcare in Canada are considered qualified healthcare expenses and will not trigger a penalty. The reason you want to make sure to spend your HSA down as quickly as possible once entering Canada is because:

  • Having an account that is tax-free from a U.S. perspective, but viewed as a taxable investment account in Canada, will create accounting complexities for tax reporting purposes. HSAs do not issue tax slips to detail investment income. You will have to review the account transaction history to determine the taxable investment income from a Canadian perspective. You will then have to convert the income to Canadian dollars on the date of the transaction, then sum all the Canadian income by type to report on your Canadian return. As you can see, this could get complex.
  • HSA providers have become more uncommon in the U.S. over the past 10 years. Many large banks used to offer HSA accounts, but many providers have exited the market.
  • Investment options may be limited and may require a minimum account balance.
    • Many HSA providers do not offer the option of investing in equities. Often the only option is a high-yield savings account. If your provider does offer equity investments, the account may be frozen once you change your address to a foreign address. Once that happens, you will only be able to sell securities, not purchase new ones. This may not be an issue if your investments are appropriate before you move. The equities in your account may also be frozen once your account balance drops below the minimum.
  • If you are not able to invest in equities, the small amount of interest income you are receiving is only complicating your life.
  • Once you move to Canada, your HSA essentially becomes a taxable account with the downside of potential penalties and tax reporting complications. You are no longer receiving tax-deferred or tax-free investment income, so you should use the HSA for Canadian medical expenses rather than your taxable investment account.
  • Many providers will not mail a new debit card to a foreign address if you lose your debit card. You may also have checks to use, or you could transfer balances from your HSA to your checking account online or via the phone. Make sure to save your health expense receipts if you do this.

While HSA accounts are not appropriate for everyone, they are the tax-friendly accounts in the U.S.. They may be included in the sixth protocol to the Canada-U.S. tax treaty when it is updated in the future.

There are similar issues with Tax-Free Savings Accounts (TFSA) and Registered Education Savings Plan accounts (RESP) for Canadians living in the U.S. in that they are not recognized by the treaty, create taxable investment income in the U.S., and complicate your tax filings. The problem is worse with TFSAs and RESPs than with HSAs because they can be considered foreign trusts.

If you have moved across the Canada-U.S. border or are living a cross-border lifestyle, it is important you work with a qualified cross-border specialist to optimize your financial situation and avoid the landmines inherent in cross-border financial planning, tax planning, and investment management.

The Key

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I don’t care too much for money, money can’t buy me love
-Paul McCartney

My typical days the last 16 years may involve some combination of reading the latest academic research paper, running different scenarios of minor adjustments to a model portfolio or keeping tabs on the newest investment vehicles available to clients- all in the hopes of trying to eek out a few extra basis points of return. When this far in the weeds, it can be easy to forget the reasons we invest our money in the first place.

Growing up in the Bay Area of California, I frequented the Oakland and San Francisco zoos with family or during school field trips. While I was grateful for the time outside to play and admire the amazing animals, there was always something I was envious of: those other kids who had the cash to buy a zoo key.

A zoo key is a silly little plastic ‘key’ shaped like an elephant that allows you to play a recording at designated areas that gives background on the animal you were looking at. It probably cost $2.00 back then. It wasn’t even the recording that I was excited about, it was what that key symbolized. Having a key meant you were one of the cool, rich kids for which money was no obstacle. It was like the Tesla Model X  for an eight-year-old in the 1980s.

thezookeyphotoLast month we took a family trip to the Oakland zoo with our two young children. The following is a picture of my 2 year old son turning a key into the same recording box at the Giraffe exhibit that I wished I could have all those years back.

It hit me- does this mean I’ve made it in life? Because I can afford these minor luxuries that were beyond my family’s modest reach a generation ago, does that make us wealthy? After all, the couple dollar purchase won’t keep me up at night. My money worries center more around funding 529 plans for the kids, determining the right neighborhood for the next house we buy, or helping our parents prepare for their retirement.

This seemed to bridge the gap in my mind between money and meaning.

Perhaps these thoughts were heavy on my mind because I had just finished reading The Geometry of Wealth by Brian Portnoy, a fantastic book that prods the reader to evaluate their relationship with wealth and how it can help them live a more meaningful life- whatever that means to each individual.

An old saying came to mind at this moment- that money can’t buy you love. But in some ways it can help free you up to be able to enjoy experiences that make you happy, like going to the zoo with your children whenever you’d like. The end goal of earning wealth over time wasn’t the ability to invest in a hedge fund or own a vacation house. The goal was to have the financial freedom to enjoy those experiences with the ones we hold dear.

Financial planning expert Michael Kitces wrote, “The fundamental problem with goals-based investing… is that we don’t really have any real clue what our goals actually are”. This rung true to me, as 10 years ago I had no notion of what feelings I would have as a parent. 10 years from now I might feel strongly about a certain charitable cause or want to pick back up with the global travel we often did before having children. What being financially successful, or wealthy, meant to me in the past is likely to change over time.

The book mentions four C’s that wealth may be able to be employed towards in order to bring deeper meaning to one’s life.

  • Connection: Social connections
  • Control: The ability to direct and define your life
  • Competence: Being good at something you care about
  • Context: attachment to something bigger than ourselves

What are you investing for? What ability do you hope to have in the future that you don’t have today? If you hit the lotto tomorrow- what would you do with your time? Where would you live?

Using the framework of the four C’s above can help formulate goals. For example, it may be something like, “I enjoy volunteering for a certain nonprofit, and the ability to spend more of my time using my skills to help them is going to bring great satisfaction to me.” Or “I’d like to get to the point where I could pursue that architecture interest I’ve always had by taking some college courses.”

The author summarizes the book with the statement: “The ability to underwrite a meaningful life is achievable for anyone who combines the right mindset and the right plan.”

We at Cardinal Point couldn’t agree more.

While I spend most of my days ensuring we have an investment strategy that is grounded in academic research that can be tailored to our clients’ evolving and complicated cross border needs, we believe working with clients to help understand how we can best position their assets to help meet those future aspirations and needs is the foundation of a successful financial advisory relationship.

In my distant future that might simply mean the ability to bring grandkids to the zoo, and maybe even splurge for a plastic zoo key.

Cardinal Point Wealth Management | Cross Border Financial Advisor

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We are dedicated to helping affluent families oversee their ongoing U.S., Canada and cross-border financial planning complexities.

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Is the Stock Market too Concentrated?

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It probably doesn’t come as a surprise that Amazon, Netflix, Microsoft, Apple, Alphabet and Facebook have been some of the best performing stocks in the first half of this year. But what may be surprising is that those six stocks made up 98% of the S&P 500 Index returns for the first half of 2018 according to a recent CNBC article1!

Many headlines over the last year have pointed out just how large these tech giants have grown For the first time since 20002, the tech sector now represents 25% of the S&P 500. When viewed another way, the market capitalization- the amount investors have deemed the companies are worth of the top (largest) five companies is approximately equal to the bottom (smallest) 282 companies in the S&P 500, as illustrated by the amazing pie chart below created by Michael Batnick of Ritholtz Wealth Management3.

 

Weight of top 5 companies in S&P 500 versus bottom 282 companies

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In other words, the bottom 56% of the S&P 500 has the same market capitalization as the top 1%. That’s a lot of companies. Those 282 listed include many household names such as Chipotle, Kohl’s, Clorox and H&R Block, all of which are multi billion-dollar firms on their own. Which begs the question, is it typical for a handful of the largest companies to dominate an index?

It turns out that historically it’s not uncommon for the largest companies to represent an enormous percentage of the index. Today the largest 10 companies represent a little over 20% of the large cap space  That’s right about the average we’ve seen over the last few decades, and significantly lower than it was in the 1960s, according to a recent study by Travis Fairchild at O’Shaughnessy Asset Management4. This study also found that on average, about 6-7 of the top 10 names fall out of the top 10 within the following decade, suggesting that many of the current top ten companies will be replaced in the next ten years.

This phenomenon isn’t limited to just the U.S. According to Benjamin Felix of PWLCapital, through July 13th of this year, 75% of the S&P/TSX return came from just 10 of its 246 stocks, led by Suncor Energy, Toronto-Dominion Bank and Shopify5. This may lead you to ask, is there anything I should be doing as an investor to take advantage of this?

First off you should note that well diversified portfolios likely hold all the names mentioned in this piece; Amazon, Apple, TD, etc. are some of the largest holdings for most North American investors. But investing a portfolio solely in those largest companies has two pitfalls- undue concentration of risk and missed opportunities in other areas of the market.

The first pitfall of investing solely in individual names – even some of those red-hot tech stocks, came home to roost at the end of July. Both Facebook and Twitter reported earnings which fell short of market expectations. On July 26th, the day after their quarterly earnings announcement, Facebook fell by a whopping 19%, erasing $120 Billion USD in value! This amount is greater than the entire value of large companies like GE, Nike or Starbucks. A day later, following Twitter’s earnings announcement, that stock also fell 19%. Twitter had been one of the best performing stocks over the previous year prior to that announcement.

While these companies are included in most major stock market indexes, the performance of any individual company is going to be relatively small in comparison to the entire index- for example the S&P 500 was basically flat on July 26th, even with Facebook falling dramatically. But if you owned them individually- they would likely represent a far greater percentage of your overall assets.

Another major downside of only holding those largest of companies is missing out on large potential gains elsewhere. Small companies outperformed their large cap counterparts in the U.S. and Canada significantly over the second quarter of this year. And academic research shows that historically small companies have outperformed their large counterparts over decades6. Yet for the average investor, it’s difficult to not want to go all in on the large gains you’ve recently seen on familiar companies you likely interact with every day.

If outperforming were as easy as picking the recent winners and calling it a day, active fund managers would have a far better track record than they currently do. But as we’ll explore in a future blog, the record of both U.S. and Canadian active stock managers is poor, supporting the idea that it’s extremely difficult to outsmart the market and predict in advance who the winners of tomorrow will be.

Like the Apples or TDs of today, or the IBMs or Blackberrys of the past, a few large high-flying companies will often garner the headlines. Yet the key to reaching your financial goals is not the fool’s errand of trying to guess what the wonder company of tomorrow will be, but in keeping a well-diversified portfolio that will own all the companies that may provide that growth.

By Matthew Carvalho, Chief Investment Officer

1Just three stocks are responsible for most of the market’s gain this year, CNBC, Jul 10, 2018
https://www.cnbc.com/2018/07/10/amazon-netflix-and-microsoft-hold-most-of-the-markets-gain-in-2018.html

2S&P 500 Hits Tech-Heavy Milestone Last Seen With Dot-Com Bubble, Bloomberg, Feb 28, 2018
https://www.bloomberg.com/news/articles/2018-02-28/s-p-500-hits-tech-heavy-milestone-last-seen-amid-dot-com-bubble

3@michaelbatnick tweet, July 18, 2018
https://twitter.com/michaelbatnick/status/1019680856837849090/photo/1

4@tbfairchild tweet, Jun 6, 2018
https://twitter.com/tbfairchild/status/1004375185179529217

5@benjaminwfelix tweet, July 13, 2018
https://twitter.com/benjaminwfelix/status/1017869943226937345/photo/1

6 Common risk factors in the returns on stocks and bond, Journal of Financial Economics 1993, Fama and French