Thousands of U.S. citizens living in Canada are finding that Canadian investment shelters — such as tax-free savings accounts and registered education savings plans — are not recognized as sheltered by U.S. tax authorities.
Since the Foreign Account Tax Compliance Act (FATCA) came into effect in 2014 to help uncover the foreign holdings of U.S. taxpayers, the more than one million Americans living north of the border have discovered they must take a different approach to investment than their Canadian counterparts.
Not only must every U.S. person declare every asset they hold in Canada, but it's become clear that not all Canadian accounts are created equal in the eyes of the IRS.
The U.S. recognizes the tax-sheltered status of registered retirement savings plans (RRSPs) and registered pension plans (RPPs) through its tax treaty with Canada.
'They introduced FATCA after 9/11, but it wasn't clear.' - Bruce Bursey, U.S.-born retiree now living in Kingston, Ont.
But other Canadian tax-sheltered holdings either require additional reporting or are subject to tax, among them:
- Tax-free savings accounts (TFSA).
- Registered education savings plans (RESP).
- Capital gains on a principal residence.
- Canadian mutual funds.
Bruce Bursey learned about his own need to file U.S. taxes via the media, after the U.S. pushed for Canadian banks' compliance with its laws in 2014.
Caught by surprise
Bursey has been living in Canada since 1973 and became a Canadian citizen in 1984. At that time, the U.S. did not allow for dual citizenship so he assumed his connection to his birthplace was finished.
Not so, as thousands of U.S.-born people living in Canada have discovered.
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"They introduced FATCA after 9/11, but it wasn't clear," he said. "I never thought of it as something that would apply to me because it was for terrorism and money-smuggling and all this tax evasion — and that wasn't me."
"It was under the radar for too long. Then all of a sudden, the news is if you don't fill out these forms and report, you have a $25,000 fine and there is no appeal," said Bursey, now a retiree living in Kingston, Ont.
He hired a lawyer who advised him to look for an accountant to do his U.S. taxes and complete his information forms.
Bursey is on a limited income and said he resents the extra $500 a year it costs for an accountant trained in U.S. taxes, especially on top of the cost of having his Canadian taxes prepared.
It turns out he makes too little to owe Uncle Sam any money. Fortunately, his lawyer steered him away from a tax-free savings account when he considered opening one with a lump sum of money he had at retirement.
Word of warning about TFSAs
PwC Canada tax partner Beth Webel said all income from a TFSA has to be reported annually — an amount that might not be much for younger investors, but could be substantial for long-established accounts that have grown well.
Americans have to be very careful about their investment strategies, she said. Even those who have been compliant for years are finding they face additional reporting requirements.
"The big issue we're dealing with now is currency fluctuation. If you are reporting in Canadian dollars and the IRS believes you are reporting in U.S. dollars, the math won't look anything like each other, particularly now with the Canadian dollar dropping so fast," Webel said.
An RESP is particularly difficult because the U.S. regards it as a foreign trust, which requires the filing of a separate form at an additional cost.
Any income earned on an RESP is taxable in the U.S., Webel said. And when a child withdraws the money to pay for his or her education, the Canadian government taxes the money. There is no benefit to having paid U.S. tax.
"You lose the benefit of the tax deferral," she said.
For couples where one partner is Canadian, Webel recommends that the RESP be held in the name of the Canadian spouse.
Compliance is expensive
Sandra Bussey, a senior manager with TD Wealth, warns the compliance burden of filling out U.S. forms for what the IRS considers to be "foreign holdings" can be more onerous than any tax that might be owing, especially if you hire an accountant to do it for you.
While a TFSA is not recognized as a tax-deferred vehicle, it is usually regarded as a trust by the IRS, she said, which means filing two separate forms.
'Any investment they step into, they need to know … what is it going to mean to me for U.S. tax purposes and what is the compliance cost that goes with it.' — Sandra Bussey, senior manager with TD Wealth
"One is the annual return to report any transactions with the trust, deposits or withdrawals. Another one is an annual information return for every year it is in existence," Bussey said.
"If that TFSA happens to invest in a Canadian mutual fund, there's another form that you have to fill out."
Bussey recommends that U.S. persons simply not hold Canadian mutual funds because the reporting requirements are so complex.
Canadian mutual funds are regarded as "passive foreign investment companies" by the U.S. — meaning yet another form — and any gains or dividends are taxed at the top marginal tax rate, subject to a complex formula.
Different capital gains rules
Capital gains on a principal residence are also a problem: while gains on a principal residence are tax-free in Canada, the U.S. taxes anything above $250,000 for an individual or $500,000 for a couple.
U.S. residents in Canada are better off holding actual securities, Bussey said, such as U.S. or Canadian stocks or bonds.
"Under the Canada-U.S. tax treaty, because we don't want people paying tax on the same income in two different countries, they say that is a Canadian-sourced dividend. So Canada has the right to tax that first," she said.
"As a U.S. person, you are going to report it on your U.S. tax return and you'll get a foreign tax credit for the taxes you've paid in Canada."
Everything from estate planning to retirement planning becomes much more complex, Bussey said.
"Any investment they step into, they need to know what the Canadian tax implications are going to be, what is it going to mean to me for U.S. tax purposes and what is the compliance cost that goes with it," Bussey said.
Meanwhile, Bursey said he thinks it's unfair that the U.S. has the right to tax him or ferret out his financial information no matter where he is. And he thinks it's equally unfair that he cannot take advantage of a TFSA.
He said he has written to his local MP to ask "what is going on here" and is calling on Ottawa to update its tax treaty with the U.S., so the IRS recognizes tax shelters such as the TFSA and RESP.