US tax rates are scheduled to go up next year—to levels even higher than Canada's. US citizens residing in Canada and Canadian citizens with US real estate or business interests may owe tax to the IRS for the first time. Many Canadians with US connections are unaware of what is happening next year or how best to plan for the consequences.
Background: Tax Armageddon cometh - maybe
The United States Congress is out for the summer. Before leaving to campaign in their home districts and states during the traditional August recess, lawmakers proposed a flurry of last-minute tax bills, none of which made it past the finish line.1 Absent a Congressional solution, drastic tax changes are automatically scheduled to take place in 2013. There was the possibility of a legislative fix before the August recess, but that opportunity has come and gone. The upshot is that nothing will happen before the election in November, if at all. The Republicans hold their convention at the end of August; the Democrats hold theirs at the beginning of September. After that, election season will keep lawmakers busy until we know who wins in November.
Unfortunately for US citizens living in Canada and Canadians doing business in the US, this means planning for uncertain 2013 rules that might be changed in November or later. The three most likely outcomes are:
1. The worst case (and the least likely) is that Congress does nothing, which means that tax rates jump to the highest levels seen in decades. Pundits are calling this scenario the "fiscal cliff" or "Taxmageddon."
A. Top rates on ordinary income rise from 35% to 39.6%;
B. Top rates on long-term capital gains rise from 15% to 20%;
C. Top rates on dividends rise from 15% to 39.6%;
D. An additional 3.8% "Medicare contribution tax" will be imposed on the investment income of high-earners (meaning $250,000 income for marrieds and $200,000 for singles) and on payrolls (the payroll tax is split between the employee and the employer);
E. Top rates on the estate tax rise from 35% to 55%;
F. The estate and gift tax credit equivalent falls from $5,132,000 down to $1,000,000;
G. And a whole host of minor provisions change as well, which are listed in the footnote for those of you with a strong stomach and a fresh cup of black coffee.2
2. The middle case?? (and most likely???) is that the lame-duck Congress3 takes action in November or December, to delay the effect of the new rules for a year or two, as happened in 2010, or to pass a compromise between the current rules and the ones scheduled to take effect in 2013.
3. Least likely? A retroactive change is made early in 2013 to undo some or all of the scheduled changes. For various reasons this scenario is more likely if Romney wins in November.
Whichever scenario occurs there is likely to be a number of consequences for US citizens living in Canada. Moreover, taxes are probably going up—whether sooner or later.
Why taxes are going up—sooner or later
We are optimistic that legislation avoiding the worst case scenario, "Taxmageddon," will be enacted, whether in 2012 or 2013. But we doubt that things will remain as they are today. In the postwar period, US government revenues have trended at about 18-19% of GDP.4 This figure has dropped to about 15% during the past few years.5 A quick look at current budget deficits confirms that the present fiscal situation is unsustainable. Some popular figures blame this on out-of-control spending, but the reality is that low tax receipts, brought on by a weak economy and historically low tax rates, bear most of the blame. Whether in 2013, 2014, or (gasp!) 2015, tax rates will need to rise.
Further, the "Medicare contribution tax" has some staying power. This tax is part of the funding for the Affordable Care Act (better known as "Obamacare"), which was recently upheld as mostly constitutional by the Supreme Court.6 Were any legislation to undo this tax to pass Congress, a current or re-elected President Obama would surely veto it. For the tax to go away, Romney would need to take the White House and votes in Congress would need to be found for whichever mix of Republicans and Democrats comprise its chambers in 2013. But even then it is not so easy. A repeal of the Affordable Care Act would raise the deficit over the ten-year budget horizon that Congress is required to operate under because Obamacare is structured to take in revenues before it begins spending them, thus creating a temporary surplus within the budget window. That creates some legislative procedural difficulties that are way too "inside baseball" for our purposes here. Complete repeal may be difficult as well, because at least some provisions of the legislation are quite popular. The application of the "Medicare contribution tax" to investment income may be the part most vulnerable to change. The concurrent raise in the Medicare payroll tax to 3.8% is probably less so. Payroll taxes in the US have only gone up, have never been cut, and tend to face little opposition.
What you need to know and what you need to do
US persons living in Canada sometimes confront surprising situations where US tax is due. See, e.g., US Citizens Resident in Canada – Common Circumstances Where US Tax May Be Payable. But here we highlight a few key areas that would be particularly affected by the automatic changes in 2013.
Capital gains and losses
Of course the best capital gains strategy is to avoid paying capital gains tax at all, by making long-term investment choices that minimize the need to sell, by borrowing against appreciated securities rather than selling them, and by matching gains against losses. But life is messier than that and sometimes capital gains must be realized. If you are planning to sell assets at a long-term capital gain in the near future, we would generally recommend that you consider doing so before the end of 2012. Depending on the type of asset you are planning to sell and your overall situation, it may make sense to get it done soon, or it might make sense to wait and see what the lame-duck Congress does after the election. But remember that even if capital gains stay at 15%, the Medicare contribution tax adds 3.8% on the capital income of high-earners.
You might wish, however, to save any capital losses for a future year. You are allowed to net your capital losses against your capital gains, and you are allowed to deduct up to $3,000 of net capital losses against ordinary income. As tax rates on capital gains go up the importance of matching only increases.
For the first time in years, the US tax on Canadian dividends may be higher than the Canadian tax. For persons with tax obligations in two countries that provide reciprocal foreign tax credits, the standard approach is to concentrate on minimizing the taxes of whichever country has the highest rates. Here, US persons who are residents of Canada and in receipt of dividends will need to change their focus from traditional Canadian strategies, such as dividend sprinkling with lower income family shareholders, to reducing the impact of US tax on dividends. US persons holding Canadian stock may be in for a particularly nasty shock upon receiving Canadian capital dividends, which are tax-free in Canada, but not in the US. It might be expected that the shareholders of US listed stocks, facing high dividend rates, may demand that corporate boards retain earnings rather than pay out dividends.7 But Canadian boards will face no similar pressure. Once shareholder taxes are factored in, US shareholders may value Canadian stocks less than Canadian shareholders will, and so dumping these stocks may make sense for US persons.
Employment stock options
The rules are complex. On the Canadian side the general result is that stock option benefits are only 50% taxable upon exercise. The US rules depend on the type of stock option (i.e., incentive stock options, qualifying stock options, or other). But with rates going up, careful planning with regard to employment stock options becomes even more crucial.
Foreign tax credit
The typical American living in Canada has probably found themself owing more in Canadian tax than in US tax in past years and thus has had enough foreign tax credit to cover his or her entire US tax liability. But higher rates in 2013 would likely change his or her situation. Instead, there could be US tax liability remaining after application of the credit. Non-compliant taxpayers face not only failure to file penalties, but now could face failure to pay penalties as well. Some compliant taxpayers may, however, owe interest (or even penalties) on failure to make estimated quarterly tax payments to the US. Taxpayers accustomed to filing US returns after April 15 should realize that tax is due on that date regardless of foreign residency status. Interest begins to accrue after the April 15 due date, while penalties on unpaid tax begin to accrue after June 15th.
Excess foreign tax credits may be carried forward for ten years. For taxpayers that have accumulated substantial excess credits this may blunt the effect of higher US rates, at least until the credits run out. Taxpayers with more US tax liability than foreign tax liability (meaning that they are able to use all of their foreign tax credits) are in what we tax people call an "excess limit" posture. The foreign tax credit limitation rules that "excess limit" taxpayers face are labyrinthine. A good tax preparer is essential. For individuals with significant income, a good tax planner is as well.
One of the most significant changes expected in 2013 is with respect to estate and gift taxes. US citizens are allowed a lifetime exemption on US tax for gifts made while alive and on bequests made after death. The current exemption is $5,132,000 and is schedule to change to $1,000,000 in 2013. Just as bad, the tax rate on amounts above the exemption is scheduled to go from 35% to 55%. This is a troubling situation, but there is some reason to hope for a last-minute fix. For one reason, the estate tax remains extraordinarily unpopular. Perhaps this is because it is seen as a form of double taxation (the income from which the estate derives was presumably taxed over a lifetime of hard work and investing). For another, there is bipartisan support in favor of a higher limit. But for the time being politics is standing in the way.
Thus older taxpayers may wish to take advantage of the current low 2012 rates by gifting some assets. So might US taxpayers married to Canadians. In general, the tax due upon death is less in Canada than in the US, and so some US taxpayers may wish to gift assets to a Canadian spouse in order to use up their year 2012 $5,132,000 lifetime gift/estate credit. For some unmarried younger taxpayers it might make sense to purchase term life insurance to cover any additional estate tax due upon an untimely death if the 2013 rates go into effect as scheduled. That may be a cost-effective way to cover a situation where the 2013 rates go into effect as scheduled but are reversed in a later year.
There is much to say about FATCA, and much of that is beyond the scope of this article. A few words, though: beginning in 2013, foreign banks are to share information on US account holders, directly or indirectly, with the IRS. Although there have been some recent rumblings about the ill effects of this legislation and the exact timeline of implementation varies, there is nonetheless considerable momentum to FATCA and it'll take more than a couch on the tracks to slow this train. Make no mistake. US citizens who have not been regular with their filing obligations will need to get in compliance. Soon it will be much, much more difficult for Americans living abroad to escape IRS detection. The prudent course is to reach out to the IRS before the IRS reaches out to you. There are a number of ways and means of doing so and a qualified advisor can help you navigate these waters. See our prior coverage on this topic—New Regulations Clarify How Non-US Banks Will Find And Report US Customers To The IRS.
We are staying on top of these issues as they develop. Check back for updates as 2013 approaches.
1 Technically, Congress didn't actually adjourn as is customary during August. But enough lawmakers left town that it is clear that no meaningful legislation will take place this month. Instead, Congress will likely observe the formality of gaveling in and out of business once every three days, a five minute procedural farce.
2 The provisions scheduled to expire include: "marriage penalty" relief, increased dependent care credits, adoption and child credits against the Alternative Minimum Tax (the "AMT"), employer-provided care credits, some work credits, the repeal of overall limits on itemized deductions (the "Pease limitation"), the repeal of the personal exemptions phase-outs ("PEP"), mortgage debt forgiveness relief, various energy industry credits, some educational assistance provisions, some accelerated depreciation provisions, and more. "List of Expiring Federal Tax Provisions 2011-2022," Joint Committee on Taxation, Jan. 6, 2012.
3 "Lame-duck" refers to the remaining portion of the current Congressional term after the election. Incumbents that lose their seats in the election face the situation of going back to work after being given notice of termination. With such diminished status the name "lame-duck" fits. Yet, lame-duck sessions of Congress are surprisingly productive. The losers are removed from the pressures of re-election and the winners are as far from the next election as possible. Lawmakers are often able to reach compromises that are otherwise difficult. So there is some hope.
5 Ibid. See also Congressional Budget Office, http://cbo.gov/publication/43373 (concluding that household tax burdens are at their lowest point in 30 years).
6 The portion of the legislation that was struck down by the Supreme Court involved an expansion of Medicaid through grants to the states. States are now effectively free to opt-out of the expanded program by refusing the additional federal funding.
7 In fact, a long-term secular trend doing just that has been a feature of the US corporate world for several years.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.