Foreign Income & Taxpayers
Canadians looking to immigrate to the United States must consider a number of tax issues. Despite similarities in the countries' taxing systems, some significant differences must be properly planned for to avoid paying significantly higher cumulative taxes. This item focuses on a couple of the major differences that need to be considered before emigrating from Canada.
Income Tax Residency
One of the major differences from an income tax standpoint between the United States and Canadian tax systems is which taxpayers are subject to taxation on their worldwide income and which taxpayers are subject to taxation on only their income sourced to that country. U.S. persons, which includes citizens and resident aliens under Sec. 7701(a)(30)(A), are subject to tax in the United States on their worldwide income. A resident alien is a person who (1) is lawfully admitted for permanent residence; (2) meets the substantial presence test; or (3) satisfies the requirements and makes an election to be treated as a resident (Sec. 7701(b)(1)(A)). If the person is a noncitizen and nonresident, he or she is subject to U.S. taxation on his or her U.S.-source income and not on worldwide income.
Canada, similarly to the United States, taxes its residents on their worldwide income, while nonresidents are taxed on their Canada-source income (Canada Revenue Agency Income Tax Folio S5-F1-C1). Unlike the United States, however, citizenship is not a determining factor. Therefore, a Canadian citizen who is not a Canadian income tax resident is taxed in Canada on his or her Canada-source income only. Another distinction is that the United States has codified the definition of "resident," while the meaning of the term "resident" in Canada has been left to judicial interpretation (id.).
Transfer Taxes: How Estates and Gifts Are Taxed
Another major difference between the Canadian and U.S. taxing systems is how the countries levy taxes on estates and gifts. In the United States, estates and gifts are subject to a transfer tax under Subtitle B of the tax code. The value of the property transferred, less allowable deductions, exclusions, and credits, is subject to tax. The current maximum tax rate for estates and gifts is 40% (Secs. 2001(c) and 2502(a)). The estate or gift is reported, if required, on Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return , or Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return , respectively.
In general, in the case of gifts of appreciated property, the donee takes a carryover basis in the property and has a tacked holding period (Secs. 1015(a) and 1223(2)). In the case of inheritance, "a person acquiring the property from the decedent or to whom the property passed from a decedent" gets a step up (or down) in basis to the property's fair market value (FMV) at either the date of death or, if elected, the alternative valuation date provided in Secs. 2032 and 1014(a). Whether property is acquired or passed from a decedent is determined under Sec. 1014(b) and is important not only for determining the basis of the property under Sec. 1014(a) but also in determining the holding period of the property under Sec. 1223(9).
In Canada, estates and gifts are subject to a deemed-disposition tax on the transfer. The deemed-disposition tax operates as though the donor/decedent sold the property for the property's FMV. The donor/decedent determines his or her gain or loss by comparing the deemed proceeds of disposition against his or her adjusted cost basis. The gain or loss is then reported on the donor/decedent's income tax return. Thus, under Canadian law, a transfer of property at death or by gift during the donor's lifetime is treated as a "sale" of the property and taxed under Canadian income tax principles and not under a transfer-tax regime such as the one the United States uses.
The deemed-disposition concept is also important to understand for Canadians thinking of emigrating. When Canadians who are Canadian residents for income tax purposes emigrate from Canada, they will be subject to the deemed-disposition tax on their property. Certain types of property, however, are excluded from the deemed disposition. Form T1243, Deemed Disposition of Property by an Emigrant of Canada , provides the list of excluded properties, including:
- Canadian real or immovable property, Canadian resource property, and timber resource property;
- Canadian business property (including inventory) if the business is carried on through a permanent establishment in Canada;
- Pensions and similar rights, including registered retirement savings plans, pooled registered pension plans, registered retirement income funds, registered education savings plans, registered disability savings plans, tax-free savings accounts, and deferred profit sharing plans;
- Rights to certain benefits under employee profit sharing plans, employee benefit plans, employee trusts, employee life and health trusts, and salary deferral arrangements;
- Certain rights or interests in a trust;
- Property the person owned when he or she last became a resident of Canada, or property inherited after he or she last became a resident of Canada, if he or she was a resident of Canada for 60 months or less during the 10-year period before emigration;
- Employee security options subject to Canadian tax; and
- Interest in life insurance policies in Canada (other than segregated fund policies).
Property not excluded is deemed to be disposed of and reacquired for its FMV when the taxpayer leaves Canada. A taxpayer emigrating from Canada can make a couple of elections regarding the deemed-disposition tax. First, he or she can elect to recognize the deemed disposition of the excluded properties in categories 1 and 2 of the list above. The election to include these properties is made on Form T2061A, Election by an Emigrant to Report Deemed Dispositions of Property and Any Resulting Capital Gain or Loss , and attached to the taxpayer's return. Second, the taxpayer can elect to defer the tax on the deemed disposition. This election is made by filing Form T1244, Election, Under Subsection 220(4.5) of The Income Tax Act, to Defer the Payment of Tax on Income Relating to the Deemed Disposition of Property , by April 30 of the year after the taxpayer emigrates from Canada. Depending on the amount, the Canada Revenue Agency may require the taxpayer to provide adequate security to cover the tax being deferred. If the election to defer the tax on the deemed disposition is made, then the tax would be due when the taxpayer disposes of the property. Lastly, the taxpayer can elect to unwind the deemed disposition that occurred upon his or her emigration if the taxpayer later reestablishes Canadian income tax residency and still owns some or all of the property that was subject to the deemed disposition at the time he or she emigrated.
The U.S.-Canada tax treaty becomes an important tool for a Canadian emigrant who was subject to the deemed-disposition tax when he or she left Canada. Article XIII, Paragraph 7, of the U.S.-Canada tax treaty provides:
[w]here at any time an individual is treated for the purposes of taxation by a Contracting State as having alienated a property and is taxed in that State by reason thereof and the domestic law of the other Contracting State at such time defers (but does not forgive) taxation, that individual may elect in his annual return of income for the year of such alienation to be liable to tax in the other Contracting State in that year as if he had, immediately before that time, sold and repurchased such property for an amount equal to its fair market value at that time.
The Technical Explanation to the 2007 Protocol explains that the purpose of this election is to "provide a rule to coordinate U.S. and Canadian taxation of gains in the case of a timing mismatch." It goes on to add that "[s]uch a mismatch may occur, for example, where a Canadian resident is deemed, for Canadian tax purposes, to recognize capital gain upon emigrating from Canada to the United States." The Technical Explanation also discusses the effect of the election:
If the individual is not subject to U.S. tax at that time, the effect of the election will be to give the individual an adjusted basis for U.S. tax purposes equal to the fair market value of the property as of the date of the deemed alienation in Canada, with the result that only post-emigration gain will be subject to U.S. tax when there is an actual alienation. If the Canadian resident is also a U.S. citizen at the time of his emigration from Canada, then the provisions of new paragraph 7 would allow the U.S. citizen to accelerate the tax under U.S. tax law and allow tax credits to be used to avoid double taxation. This would also be the case if the person, while not a U.S. citizen, would otherwise be subject to taxation in the United States on a disposition of the property.
The election is made on the taxpayer's timely filed U.S. income tax return for the first tax year ending after the taxpayer's change of residence on Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b) (Rev. Proc. 2010-19). The information and documents required to make the election are also found in this revenue procedure.
As discussed above, the deemed-disposition tax applies whether the Canadian resident gifts property or emigrates with the property. Therefore, gifting of unneeded assets before emigration may be a planning opportunity for Canadian residents who are considering emigrating in the near future. From a Canadian tax standpoint, if property is gifted as opposed to being retained upon emigration, the only difference in the deemed-disposition tax that would result would be due to the change in the property's FMV between the time of the gift and the time of emigration. If the property's FMV increased between the time of the gift and the taxpayer's emigration, the deemed-disposition tax would be lessened by gifting the property. However, if the property's FMV decreased between the time of the gift and the taxpayer's emigration, the reverse would be true. Also, one should consider the time value of money, since gifting the property before emigration accelerates the tax into the year of the gift rather than the emigrant's final Canadian tax year.
If the donee is a Canadian resident, he or she would take an adjusted cost basis in the property equal to the FMV on the date of transfer. This makes sense since the donor recognized a gain on the deemed disposition. If, however, the donee is a U.S. citizen or resident, the answer is not as simple. As discussed earlier, for U.S. tax purposes, the donee generally takes a carryover basis in property received by gift. Fortunately, Article XIII, Paragraph 7, of the U.S.-Canada tax treaty also provides relief in the case of gifts from Canadian residents to U.S. residents. The Technical Explanation to the 2007 Protocol states:
In the case of Canadian taxation of appreciated property given as a gift, absent paragraph 7, the donor could be subject to tax in Canada upon making the gift, and the donee may be subject to tax in the United States upon a later disposition of the property on all or a portion of the same gain in the property without the availability of any foreign tax credit for the tax paid to Canada. . . . [T]he election will be available to any individual who pays taxes in Canada on a gain arising from the individual's gifting of a property, without regard to whether the person is a U.S. taxpayer at the time of the gift. The effect of the election in such case will be to give the donee an adjusted basis for U.S. tax purposes equal to the fair market value as of the date of the gift. If the donor is a U.S. taxpayer, the effect of the election will be the realization of gain or loss for U.S. purposes immediately before the gift. The acceleration of the U.S. tax liability by reason of the election in such case enables the donor to utilize foreign tax credits and avoid double taxation with respect to the disposition of the property.
By gifting the property before emigrating and making this election, the taxpayer could eliminate U.S. transfer taxes in the future for himself or herself and reduce U.S. income taxes for the donee on the later disposition of the property.
Example 1: Taxpayer A is considered a Canadian resident and a nonresident alien for U.S. tax purposes. This means A is subject to tax in Canada on his worldwide income and in the United States on only his U.S.-source income. A has a significant estate that, if he were a U.S. taxpayer, would be subject to the U.S. estate tax.
If one of A' s assets is stock in a publicly traded Canadian corporation with an adjusted cost basis of $10 and an FMV of $100, what would the potential taxes be if he were to emigrate? The gain on the deemed disposition in Canada upon emigration would be $90, which would be subject to the Canadian income tax rules. Furthermore, if A failed to make the election provided for in the U.S.-Canada income tax treaty and later sold the stock for $100 while considered a U.S. taxpayer, there would be another $90 gain taxed in the United States. A now has $100 cash less the U.S. income tax paid included in his taxable estate. Therefore, the taxpayer could be subject to two levels of income tax on the "sale" of the stock, as well as an estate tax upon his death.
Example 2: Assume the same facts as Example 1, except that A gives the stock to a U.S. taxpayer before emigration. A would still be subject to tax on the $90 gain in Canada under the deemed-disposition concept. However, if the election under Article XIII, Paragraph 7, of the U.S.-Canada tax treaty is made, the donee would get an adjusted cost basis of $100 so a later sale of the stock for $100 would result in no U.S. income tax. The $100 asset (i.e., stock or cash) would be out of A' s estate, so no additional estate tax would apply.
The idea of gifting property before emigrating from Canada needs to be evaluated for a number of reasons. First and foremost, tax professionals are always looking for ways to reduce a client's tax burden, but that savings cannot come at the expense of a client's future economic independence. Secondly, the term "resident" in the United States for purposes of estate and gift taxation differs from that term's definition for income tax purposes. Therefore, an individual could be a resident for U.S. estate and gift taxation without being a resident for U.S. income taxation and vice versa.
Planning for Canadian Registered Accounts
Often one of the largest assets a Canadian emigrant has accumulated while a Canadian resident is a registered retirement savings plan (RRSP) or registered retirement income fund (RRIF) (collectively referred to as RRIFs). RRIFs are not subject to the deemed-disposition tax on emigration from Canada. Therefore, a Canadian emigrant needs to understand how the United States views and taxes these assets.
From a Canadian point of view, these types of accounts are treated in the same manner as a 401(k) or IRA would be treated in the United States. However, from the U.S. perspective, RRIFs are nonqualified plans, and the U.S. treatment is akin to a brokerage account or grantor trust. Therefore, RRIFs do not receive tax-deferred growth as they would in Canada or as a 401(k) or IRA would in the United States. The U.S.-Canada income tax treaty does provide a solution for Canadian emigrants who wish to continue to receive tax-deferred growth in their RRIFs. Article XVIII(7) of the tax treaty allows for an election to be made in the United States to defer the taxation "with respect to any income accrued in the plan but not distributed by the plan, until such time as and to the extent that a distribution is made from the plan." This election is made on IRS Form 8891, U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans . This election is irrevocable and applies to the year the election is made and all subsequent years. Because the election is irrevocable and applies to all subsequent years, careful consideration should be given to whether a particular taxpayer should make the election. Incorrectly making or failing to make the election could be costly. Regardless of whether the election is made, Form 8891 needs to be completed by all U.S. taxpayers who are beneficiaries or annuitants of Canadian registered retirement plans.
If the election is made, the RRIF will be taxed in the United States in a manner similar to how it is taxed in Canada. The tax will be deferred until distributions from the RRIF are made; then, the distributions will be taxed at ordinary income rates. If the election is not made, the taxpayer will be required to report the RRIF's underlying income (i.e., interest, dividends, gains, etc.) on his or her U.S. tax returns. This can sometimes be a difficult task because the adjusted cost basis of an RRIF's underlying assets is not always readily available and the taxpayer does not receive a consolidated Form 1099 as he or she would if the investments were held in a U.S. brokerage account. However, in most cases, this information can be obtained from the RRIF custodian. By not making the election, the taxpayer may benefit by reporting the underlying activity because of the preferential tax rates on long-term capital gains and qualified dividends. The taxpayer may also benefit by not making the election if the income of the underlying assets is less than the distributions the taxpayer is receiving, regardless of a tax rate differential.
Regardless of whether the taxpayer makes the aforementioned election for U.S. federal income tax purposes, the same treatment may not be afforded to him or her for state income tax purposes. For example, the state of California takes the position in Information Letter No. 2003-0040 that:
[T]he Franchise Tax Board considers a RRSP to be similar to a savings account. The Franchise Tax Board will treat a taxpayer's original contributions to the RRSP, made while a Canadian resident, as a capital investment in the RRSP. A California resident must include any earnings from their RRSP in their taxable income and pay taxes on this income in the year earned. After a taxpayer pays tax on these earnings, the earnings will also be treated as capital invested in the RRSP. Therefore, when a taxpayer receives a distribution from their RRSP, the amount consisting of the contributions and the previously taxed earnings is considered a nontaxable return of capital.
As such, the letter determines that "the federal election to defer taxation on earnings of the RRSP is inapplicable for California income tax purposes." The taxpayer needs to be aware of this potential divergent treatment for state income taxes, which depends on the state of residency after he or she emigrates.
Another issue that should be addressed before emigration is the nature of the RRIF's underlying assets. It should be determined whether any of the assets would be classified as a controlled foreign corporation (CFC) or passive foreign investment company (PFIC) under U.S. law. If any of the assets are CFCs or PFICs, the rules related to these types of investments could change the character and timing of tax in the United States. Before emigrating, the taxpayer should understand the taxation of CFCs and PFICs in order to decide whether it makes sense to keep the investments post-emigration or dispose of them before emigrating. After the taxpayer emigrates, Canada will continue to tax the RRIF; however, the tax will be collected through nonresident withholding by the RRIF custodian at the time of distribution. The withholding rate is either (1) 15% if the distributions qualify for period payment treatment under Article XVIII of the U.S.- Canada income tax treaty or (2) 25% if they do not qualify for the treaty rate. The Canadian withholding tax will be an allowable foreign tax credit in the United States. If the election is made under Article XVIII(7), the timing of the foreign tax credits will not be an issue. If the election is not made, the taxpayer and his or her tax professional should consider the timing mismatch that can occur. Additionally, the sourcing of income becomes more important if the election is not made, as not all of the income the RRIF generated will likely be foreign-source. For example, capital gains from the sale of investments are generally sourced to the taxpayer's resident country.
If the taxpayer determines it is prudent not to make the special election under Article XVIII(7), then additional preemigration planning should be done. As noted above, in Canada an RRIF is treated as similar to an IRA in the United States. As such, gains realized on the sale of investments in the RRIF are not taxed. As noted above, if the election is not made, the account is treated as the U.S. taxpayer's brokerage account or grantor trust. Therefore, realized gains and losses are reportable on the U.S. taxpayer's (beneficiary's) return as they arise. Since a transfer tax is not paid with respect to the RRIF's assets upon emigration, the election to step up the basis of the assets is not available. Therefore, the "new" U.S. taxpayer will have a carryover basis in the RRIF's assets. If the assets have substantially appreciated at the time of emigration, the "new" U.S. taxpayer would have a substantial tax to pay on a later disposition of the assets. This tax cannot be offset by any excess foreign tax credit, as the gain will generally be considered U.S.-source income. The U.S. income tax can be avoided, however, if the highly appreciated assets held in the RRIF are sold before immigrating to the United States and replaced with new investments. This technique essentially steps up the basis of the assets for the "new" U.S. taxpayer with no additional tax cost, since in Canada the activity of the RRIF is not subject to tax.
Another important consideration of a U.S. taxpayer who is a beneficiary of an RRIF is the taxation of the RRIF upon his or her death. Since Canada does not have an estate tax in the way the United States has an estate tax, there is no treaty between the countries on this issue. However, Article XXIXB of the U.S.-Canada income tax treaty does cover "Taxes Imposed by Reason of Death." Article XXIXB(7) provides:
[i]n determining the amount of estate tax imposed by the United States on the estate of an individual who was a resident or citizen of the United States at the time of death . . . a credit shall be allowed against such tax imposed in respect of property situated outside the United States, for the federal and provincial income tax taxes payable in Canada in respect of such property by reason of death of the individual . . .
The credit is allowable in the United States "for an amount of federal or provincial income tax payable in Canada only to the extent that no credit or deduction is claimed for such amount in determining any other tax imposed by the United States" (id. at (c)).
The Technical Explanation to the 2007 Protocol explains that this paragraph of the treaty "applies where an individual who immediately before death was a resident or citizen of the United States held at the time of death an RRSP." For this purpose, RRSP and RRIF are interchangeable. The Technical Explanation goes on to add that "[t]his provision ensures that the Canadian income tax will be allowable as a credit against the U.S. estate tax." Without this provision, a U.S. resident or citizen who held an RRIF at death would be subject to Canadian nonresident withholding on the final distribution from the RRIF and U.S. estate tax on the entire value of the RRIF without any foreign tax credits available.
There will inevitability be additional issues that a taxpayer and his or her advisers will need to consider and address before emigrating from Canada to the United States. Some of these will be tax related and others will not. However, without a comprehensive understanding of the tax issues, the taxpayer may end up paying taxes he or she could have otherwise avoided with the proper preemigration planning.
Anthony Bakale is with Cohen & Co. Ltd., Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Cohen & Co. Ltd.