PLEASE NOTE: THIS INFORMATION WAS ORIGINALLY SUBMITTED BY COOPERS & LYBRAND, CANADA
As the United States requires its citizens to file U.S. tax returns when residing abroad, special problems will be encountered by U.S. citizens who become resident in Canada. They will have to comply not only with Canadian tax requirements, but also with U.S. federal and possibly state taxes as well. While the two systems are not markedly different, there are many areas where they do not mesh, and situations can arise where different timing produces unexpected results. Consequently, United States citizens coming to Canada should seek professional advice in most situations. The following outlines a few of the more common problems:
Principal Residence - When an individual is transferred from the United States to Canada, the individual may acquire or rent a home in Canada. The individual's United States residence may be either rented or sold.
Under prior law, where an individual intended to dispose of the U.S. residence, it was important that the individual considered carefully the two-year deferral rules for replacement of the home and the further two-year extension of the replacement rules for moves outside the U.S. If a Canadian home was purchased, it may have qualified as a replacement for U.S. purposes. The selling price of the U.S. residence and the cost of the Canadian residence would determine whether a gain must be reported for U.S. purposes or not.
New U.S. law permits an individual to exclude $250,000 ($500,000 if married filing jointly) of gain on the sale of a principal residence. In general, the exclusion is allowed for each sale or exchange of a principal residence provided it had been treated as a principal residence for at least two of the preceding five years. If the two-year requirement is not met due to a change of employment, health or other unforeseen circumstance, the exclusion is allowable based on a ratio of the qualifying months to 24 months. However, in some circumstances, U.S. citizens on assignment in Canada for more than three years can be denied the exclusion on the sale of their former principal residence in the U.S. In general, this provision is effective for sales of principal residences on or after May 7, 1997, and replaces the prior rollover and exclusion provisions.
For Canadian purposes, the individual will be deemed to have reacquired the U.S. residence at its fair market value on establishing residency. Any gain from a subsequent sale during the individual's Canadian stay may be subject to Canadian tax unless the residence qualifies for exemption under the Canadian principal residence rules.
Where the U.S. residence is rented during the stay in Canada, the income received will be taxed in Canada. Deductions for expenses will be allowed and any loss is generally available for offset against the individual's other income. Where a home is purchased in Canada and occupied by the taxpayer throughout the period of residency as a principal residence, any gain from the subsequent disposition while resident in Canada, or in the first year after the year residency is terminated, will be exempt from Canadian tax. U.S. tax will be a consideration on such a disposition where a citizen or resident of the U.S. disposes of the Canadian home.
Individual Retirement Account - U.S. tax law limits the availability of Individual Retirement Accounts (IRAs) for making tax deductible contributions. For Canadian taxation purposes, an IRA will be seen as a non-resident trust but the income should only be taxed upon withdrawal from the plan. Canadian tax laws may allow an individual to transfer amounts from an IRA to a Canadian Registered Retirement Savings Plan on a tax-free basis. Taxpayers who have IRA accounts should seek professional advice before making such a transfer. All other receipts from an IRA may be taxable in Canada during residency.
Canadian Pension Plans - Canadian tax laws allow tax deductible contributions to certain pension plans registered in Canada. In addition, a Canadian resident may make certain deductible contributions to an individual Registered Retirement Savings Plan. Withdrawals from the pension plans and Registered Retirement Savings Plans are subject to regular Canadian tax. Although such contributions are not deductible for U.S. purposes, it may be advantageous for a U.S. citizen resident in Canada to make contributions to a Registered Pension Plan or a Registered Retirement Savings Plan to save Canadian personal taxes. (In some circumstances, membership in a U.S. pension plan may limit deductibility of Canadian Registered Retirement Savings Plan contributions.) Provided that funds are not withdrawn from these plans prior to the individual's return to the U.S., the Canadian tax liability on withdrawal will be limited to 25% withholding tax. As the capital contributions to the plans are not deductible for U.S. purposes, such contributions would not be taxable in the U.S. on withdrawal. Accordingly, the effective rate of tax on the amount of contributions may be reduced to 25%, or perhaps even to 15% if the withdrawals qualify as periodic pension payments rather than a lump-sum withdrawal.
RRSPs - In the past, an individual, after leaving Canada, had the ability to withdraw small amounts from his or her Registered Retirement Savings Plan on a tax-free basis. This is no longer possible where the individual has other sources of income. However, where the contributions have been made to a spousal plan and the spouse has no other income, it may still be possible (if the timing is right) to withdraw limited amounts on a tax-free basis.
Stock Options - An individual holding an employee stock option should consider exercising the option prior to moving from the United States to Canada. In certain cases, the exercise of the option will not be a taxable event for U.S. purposes; the option benefit is taxed only when the stock is sold and at a capital gain rate of tax. Further, if the option is exercised before moving to Canada, the market value (rather than the exercise price) will become the cost base of the stock for Canadian purposes. If the option is not exercised until after the individual has taken up residence in Canada, the difference between the option price and the market value of the stock at the time of exercise (subject to a possible 25% deduction of that difference) will be taxed in Canada as employment income in the year of exercise.
Alimony - Alimony and child support payments made by a resident of Canada to a resident of the United States are not subject to Canadian withholding tax.
Social Security - Social security contributions are generally due in the country where one works. However, where an employee is sent to work temporarily in the other country, the Canada-U.S. Social Security Agreement provides for contributions to continue in the home country only. Application should be made for certificate of continuing coverage under the home country system, although this will not usually be granted if the assignment is expected to be for more than five years. In addition, if contributions have been made in both the U.S. and Canada, the agreement provides for contributions to both systems to be taken into account in order to meet eligibility requirements for social security benefits. It should be noted that the Canada-U.S. Tax Treaty recognizes U.S. social security taxes as a creditable tax for purposes of the Canadian foreign tax credit.
Holding Companies - It has been a common practice for individuals resident in Canada with substantial investments to hold them through a corporation. Such an approach is generally ineffective (and potentially costly) for a U.S. citizen as a result of the U.S. "foreign personal holding company" rules. These rules provide that investment income earned by a Canadian corporation controlled by a U.S. citizen will be taxed for U.S. purposes in the hands of the individual. Where such a situation exists, professional advice should be sought.
Tax-Shelter Investments - A U.S. citizen resident in Canada should exercise caution when investing in Canadian and U.S. tax-sheltered investments. A tax-sheltered investment generally provides the investor with substantial income tax write-offs or credits. While a thorough review of such investments is well beyond the scope of this summary, it suffices to say that Canadian investments are usually ineffective in reducing U.S. income tax. However, a U.S. tax-sheltered investment may provide an effective tax shelter in Canada. Before this can be determined, an examination of the "at risk rules", the "matchable expenditure" proposals, capital cost limitation rules, and foreign currency translation rules, in respect of each investment must be undertaken.
The information provided herein is for general guidance on matters of interest only. The application and impact of laws, regulations and administrative practices can vary widely, based on the specific facts involved. In addition, laws, regulations and administrative practices are continually being revised. Accordingly, this information is not intended to constitute legal, accounting, tax, investment or other professional advice or service.
While every effort has been made to ensure the information provided herein is accurate and timely, no decision should be made or action taken on the basis of this information without first consulting a Coopers & Lybrand professional. Should you have any questions concerning the information provided herein or require specific advice, please contact your Coopers & Lybrand advisor, or: David W. Steele, Coopers & Lybrand, 145 King Street West, Toronto, Ontario M5H 1V8 Canada on Fax: 1-416-941-8415 or E-mail: ca.services.tax@ca.coopers.com
David W. Steele PricewaterhouseCoopers 145 King Street West Toronto, Ontario M5H 1V8 Canada Fax: 1-416-941-8415 E-mail: Click Contact Link
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