US Tax Issues for Canadian Residents SPECIAL REPORT
US Tax Issues for Canadian Residents The IRS has recently declared new catch up filing procedures for non-resident US taxpayers who are considered innocent non-filers. Background There are approximately one million US citizens resident in Canada. Canadian residents file personal tax returns in Canada. US citizens living in Canada file personal tax returns in Canada and have an obligation to file personal tax returns in the US based on their citizenship a requirement that has been in place since 1913. However, many of them don t comply with this requirement because they are unaware of it, although the consequences for non compliance with this requirement can be significant. This white paper will address some of the issues faced by these individuals in order to assist with: (1) compliance with the law; (2) reducing the risk of financial burden or penalties that can affect them; and (3) providing some information about new measures taken by the IRS and how to benefit from these measures. For the purposes of this white paper we will define the term taxpayer to be a US citizen residing in Canada on a full-time basis. In the summer of 2012 the IRS declared new catch up filing procedures for non-resident US taxpayers who are considered innocent non-filers. The IRS had received numerous requests to provide amnesty to innocent non-filers including many Canadians. The US Ambassador to Canada, David Jacobson responded publicly in December 2011 signalling that changes were coming from the IRS. Although complete amnesty was not offered, the new procedures were released in an effort to provide some sort of relief to low risk non-filers. Canadian residents are part of this innocent non-filer group since Canada is not viewed as being a tax haven. US citizens living in Canada still have an obligation to file personal tax returns in the US based on their citizenship a requirement that has been in place since 1913. One Million US Citizens 2
New Measures Relief To Low Risk Filers American citizens living and working in Canada tend to be low risk. There are generally no US taxes owed or risks to the US treasury if all income is Canadian sourced. Being low risk, however, does not alleviate or reduce the tax requirements. To comply with the US tax filing requirements, as of September 1, 2012, new rules allow qualifying taxpayers to file three years of income tax returns (versus 6 years under the reasonable cause approach). However, these taxpayers must still file 6 years of Reports of Foreign Bank and Financial Accounts (FBARs), or Forms TD F 90-22.1 (FBAR filing requirements are discussed later). The delay in the implementation of this program allowed the IRS to develop policies regarding the program. A return is considered to be low risk if it is a simple return with less than $1,500 USD tax due per year. The level of risk associated with a return tends to increase for a number of reasons: indications of increasing income and assets of the taxpayer, sophisticated tax planning or avoidance by the taxpayer, or if material economic activity has taken place in the US. Other indicating risk factors include a history of noncompliance with US tax laws as well as the amount and type of US source income. There are generally no US taxes owed or risks to the US treasury if all income is Canadian sourced. Once the IRS has determined the filing to be low risk, its assessment will be expedited and the IRS will not pursue assessment of penalties or resulting follow-up action. However, it is unclear whether only the FBAR penalties will be waived or whether normal late tax filing penalties will also be waived. It is also uncertain whether the new program allows taxpayers to file more than three years of returns. IRS RISK ASSESSMENT Risk Factors > Balance of tax due > History of non-compliance > Sophisticated tax planning > Type of income 3
Documentation Taxpayers are to submit the following documentation if they wish to use the new procedure: Delinquent tax returns, with appropriate information returns for the past three years; Delinquent FBARs for the past six years; Additional information regarding compliance risk factors based on IRS guidance (a questionnaire has been developed for this purpose); Any outstanding payment of federal tax and interest must be included with the submission. One Million U.S. Citizens New Procedure requires the following documentation: > 3 years of tax returns > 6 years FBAR s > Compliance questionnaire > All tax and interest due In order to assert reasonable cause as a defense against penalties, the taxpayer must submit a dated statement that has been signed under penalty of perjury to explain the reasonable cause for failure to file in previous years. Under the new program, taxpayers will be allowed a late filed election with respect to the treaty deferral of income earned in Canadian RRSP or RRIF (this procedure will be discussed later in this white paper). In principle, an election to defer income must be filed in a timely manner. In the absence of this allowance, taxpayers would have to apply for a private letter ruling to back date the election. These procedures do not protect taxpayers who face the risk of criminal prosecution (non-innocent filers). As such, these taxpayers should consult with their legal counsel and may choose to file under the Offshore Voluntary Disclosure Program (OVDP). The next sections of this white paper will take you through the US reporting requirements in greater detail including: US personal tax returns, RRSP and RRIF elections, FBARs, 5471s and 8898s. 4
US Personal Tax Returns US citizens and permanent residents (i.e. Green Card holders) have been required to file US personal tax returns (1040s or 1040NRs for non-resident aliens of the US) since 1913. The rules for filing income, estate, and gift tax returns and paying estimated tax are generally the same whether the US citizen or resident alien lives in the United States or abroad. Taxpayers will need to take their world wide (including Canadian sourced) income and report it in US dollars on a 1040 return. 15 JUNE AUTOMATIC 2-MONTH EXTENTION When to file limit date Normally, the due date for taxpayers is the 15th day of the 4th month following the close of the year which is April 15. If the date falls on a weekend, the return is due the next business day. For instance, if April 15 falls a Sunday, the due date will be Monday April 16. However, if the taxpayer resides abroad, the IRS allows the taxpayer an automatic 2-month extension to file the income tax return and pay any amount due without requesting an extension. The automatic 2-month extension is to June 15. If the taxpayer is unable to file the return by the automatic 2-month extension date, he/she can request an additional 4-month extension to October 15 by filing form 4868 before the expiration of the automatic 2-month extension date, which is June 15. Failure to file interest & penalties Please be aware that the extension is only for the filing and not for the payment of the tax owed. Interest is charged from the original due date if the taxpayer has a tax liability to the IRS; that means the payment is due on April 15 if the taxpayer wants to avoid interest charges. There are also penalties that are applicable for non-filing. In addition, the IRS has an unlimited statute of limitations for failure to file, which means if a taxpayer has a tax liability for a particular year and doesn t file an income tax return; the IRS has the right to ask you to file at anytime. In some cases, if the IRS determines that the nonfiling is intentional and is related to fraud, criminal charges and penalties may be brought against the taxpayer. JONES REAL ESTATE CO. 5
RRSP/RRIF Elections According to the Revenue Procedure 2002-23 of the IRS, under the domestic law of the United States, an individual who is a citizen or resident of the United States and a beneficiary of a Canadian retirement plan (such as: Canadian Registered Retirement Savings Plans or Registered Retirement Income Funds ( RRSP/RRIF )) is subject to current United States income taxation on income accrued in the plan even though the income is not currently distributed to the beneficiary (taxpayer). An individual who is a citizen or resident of the United States and a beneficiary of a Canadian retirement plan is subject to current United States income taxation. Meanwhile, if the plan satisfies certain requirements under the domestic law of Canada, the income accrued in the plan will not be subject to Canadian income taxation until it is actually distributed from the plan. In fact, there is a special provision regarding to these plans under the Canada - US Income Tax Convention ( the Treaty ). Under this provision, Taxpayers with RRSPs or RRIFs can elect to defer the income accumulated in those plans during the year where a special election is filed with the US 1040. This election effectively defers the taxation of the income accumulating in those plans until such time as it is withdrawn. CANADIAN RRSP INCOME: DEFERMENT ELECTION FILED Untaxed in Canada Untaxed in USA as long as an annual election is filed with tax return 6
RRSP/RRIF Elections Continued... However, if in past years, the taxpayer had an RRSP or RRIF and did not make a timely election to defer such income, there is exposure. The IRS, in its bulletin IR-2012-65 dated June 26, 2012, provides guidelines for a taxpayer seeking relief for failure to timely elect deferral of income earned from these retirement and savings plans where deferral is permitted by the Treaty: submit a statement requesting an extension of time to elect to defer income tax and identifying the pertinent treaty provision; submit a form 8891 for each tax year and each plan and a description of the type of plan covered by the submission; submit a dated statement signed by the taxpayer under penalties of perjury identifying: the reasons that led to the failure to make the election; the events that led to the discovery of the failure; If the taxpayer relied on a professional advisor, the nature of the service should be disclosed. As you can imagine, the eligibility and procedures applicable to this particular situation can be confusing; and it is highly recommended to discuss these guidelines and requirements with a tax professional. 7
FBARs US Government requires an FBAR to disclose details of your foreign accounts. Failure to do so could result in significant penalties. TD F 90 22.1 Purpose Since 1972 taxpayers have needed to prepare and file annual Report of Foreign Bank and Financial Accounts (Forms TD F 90-22.1). The FBAR is required because foreign financial institutions may not be subject to the same reporting requirements as US domestic financial institutions. The US government uses this tool (FBAR) in order to help identify persons who may be using foreign financial accounts to circumvent United States law. In addition, investigators use FBARs to help identify or trace funds used for illicit purposes or to identify unreported income maintained or generated abroad. Eligibility Who must file the FBAR? The test for whether an account should be disclosed is if the taxpayer had signature authority over, or a financial interest in, foreign (Canadian) financial accounts if the aggregate value of those accounts exceeds $10,000 at any time during the calendar year. If this threshold is exceeded, all accounts over which the taxpayer had signature authority or in which the taxpayer had a financial interest, must be disclosed. There are filing exceptions for some foreign financial accounts, like certain foreign financial accounts jointly owned by spouses. In fact, the spouse of an individual who files an FBAR is not required to file a separate FBAR if the following conditions are met: (1) all the financial accounts that the non-filing spouse is required to report are jointly owned with the filing spouse; (2) the filing spouse reports the jointly owned accounts on a timely filed FBAR; and (3) both spouses sign the FBAR. Taxpayers should contact a tax advisor to determine eligibility for an exception and to review exception requirements. 8
FBARs Continued... Financial accounts include savings, chequing, brokerage, money market, securities trading, option accounts and insurance policies with cash values, mutual fund shares and pooled funds. A foreign financial account is a financial account located outside of the United States. For example, an account maintained with a branch of a United States bank that is physically located outside of the United States is a foreign account. An account maintained with a branch of a foreign bank that is physically located in the United States is not a foreign financial account. You can understand and appreciate how these FBAR requirements might reasonably require a taxpayer to disclose her chequing account, joint or otherwise, savings account, RRSP, and tax-free savings accounts (TFSAs). When to file These forms are due to be filed annually before June 30 of the subsequent year. Taxpayers should file the FBAR separately from their federal income tax return. There is no extension of time available for filing an FBAR. Extensions of time to file federal tax returns do not extend the time for filing an FBAR. The one exception to this rule is the voluntary disclosure program for innocent non-filers outlined previously. Under this program, the 6 prior year FBARs are to be filed together with the 3 prior year income tax returns. Penalties Substantial penalties exist for taxpayers who are liable for filing an FBAR and fail to do so. A taxpayer who is required to file an FBAR and fails to properly file may be subject to a civil penalty not to exceed $10,000 per violation. If there is a reasonable cause for the failure and the balance in the account is properly reported, no penalty will be imposed. A taxpayer who willfully fails to report an account or account identifying information may be subject to a civil monetary penalty equal to the greater of $100,000 or 50 percent of the balance in the account at the time of the violation, as well as criminal penalties. The OVDP program put in place last year, provides for reduced penalties and a waiver of criminal prosecution for late filed FBARs. The innocent non-filer program allows for a complete waiver of penalties for qualified low risk taxpayers. 9
Tax Free Savings Accounts (TFSAs): A Canadian tax-free savings account does not work for a US citizen living in Canada because it does not grow tax-free. Income must be claimed and filed with the IRS. Tax Free Savings Accounts began in 2009 for taxpayers over the age of 18 with a valid Canadian social insurance number. Taxpayers may contribute up to $5,000 annually into their TFSA and any of the income accumulated in that plan grows tax-free. These TFSAs do not work well, however, for US taxpayers as there is no election available in the US to defer the tax on the income earned in the TFSA. That means taxpayers have to disclose these accounts and pay tax on the income accrued on these accounts. If the taxpayer has significant taxable investment income, the tax paid on that other investment income may be sufficient to offset the US tax on the TFSA income. TFSA 10
Form 5471: Information Returns In order to ensure taxpayers do not defer US taxation by sheltering their foreign income in non-us corporations, the existence of these non-resident corporations must be disclosed by filing form 5471 even though they don t have a permanent branch in the US. The purpose of this form is to require certain US citizens and residents who are officers, directors, or shareholders in certain foreign corporations to provide information relating to the activity of the foreign company, and transactions between the foreign business entity and the US person. Successful taxpayers owning their own corporations will need to disclose those ownership interests annually with the IRS on Form 5471: Information Return of US Persons with Respect to Certain Foreign Corporations. This is a very detailed information return, requiring the conversion of the financial statements to US dollars, and a calculation of investment income earned by the corporation (which may then be taxable to the taxpayer on an annual basis, whether or not distributed from the corporation). They also have to disclose the proportion of the stock of a foreign corporation acquired and disposed of during the year. Please note that the requirements (statements, schedules, etc.) vary depending on which of 5 categories of filers the US person falls into. Taxpayers are advised to seek professional advice if they believe they may have a 5471 filing requirement. The IRS estimates about 18 hours to learn how to complete the form, and about 27 hours to complete the form and related schedules. When to file The form 5471 should be attached to the income tax return and filed by the due date (including extensions) for that return. Failure to file - Penalties Failure to file the form 5471 may lead to significant consequences. A $10,000 penalty is imposed for each annual accounting period of each foreign corporation for failure to furnish the required information within the time prescribed. In addition, if the information is not filed within 90 days after the IRS has mailed a notice of the failure to the US person, an additional $10,000 (per foreign corporation) is charged for each 30-day period, or fraction thereof, during which the failure continues after the 90-day period has expired. The additional penalty is limited to a maximum of $50,000 for each failure. Please note that in certain cases criminal penalties may apply for failure to file the required information. 11
Form 3520: Registered Education Savings Plans The IRS requires the filing of form 3520 to report certain transactions with foreign trusts and to report ownership of foreign trusts. In addition, form 3520-A which is the annual information return of a foreign trust, is required in order to provide information about the foreign trust, its US beneficiaries and any US person who is treated as an owner of any portion of the foreign trust. Taxpayers may have participated in Canadian Registered Education Savings Plans (RESPs) to take advantage of the tax-free growth of those plans and the matching Canadian Education Savings Grant funded by the Canadian Federal government. An RESP s tax-free growth does NOT apply to American citizens living in Canada. The income must be disclosed. But the rules vary depending on the citizenship of the contributor, as well as the beneficiary of the plan. The IRS views these RESPs as a type of foreign trust, the assets of which are deemed to be owned by the contributor. These RESPs require that Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts be filed annually with the IRS, as well as Form 3520-A Annual Information Return of Foreign Trust with a US Owner. Taxpayers don t have to complete all parts of the forms. The parts of the form 3520 that are required can vary, depending on whether you are the owner of any part of the assets of a foreign trust, or you are a US person who received a distribution from a foreign trust, or the amount of money received from the foreign trust. When to file Form 3520 must be filed at the same date that the taxpayer s income tax return is due, including extensions and must have all required attachments to be considered complete. Form 3520-A must be filed by the 15th day of the 3rd month after the end of the trust s tax year. For instance, the return of a foreign trust with a tax year ending December 31, 2012 is due on March 15, 2013. An extension is available by filing Form 7004 prior to March 15. 12
Form 3520: Registered Education Savings Plans Continued... Failure to file Penalties If Form 3520 is not timely filed or if the information is incomplete or incorrect, a penalty is applied. If the foreign trust fails to timely file a form 3520-A, or doesn t furnish all of the information required, or includes incorrect information a penalty is also applied. Additional penalties may be imposed if the non compliance continues after the IRS mails a notice of failure to comply with the required reporting. However, no penalties will be imposed if the taxpayer can demonstrate that the failure to comply was due to a reasonable cause and not willful neglect. A tax advisor may be helpful in the determination of the reasonableness of cause as well as to lower the risk of sending incorrect information. Obtaining a Social Security Number One Million U.S. Citizens American residents of Canada need both: > SIN to file Canadian tax returns > SSN to file US tax returns Many taxpayers were born in Canada or came to Canada at a young age before obtaining a US social security number (SSN). To obtain this SSN an application must be prepared and delivered in person to a Social Security office in the United States. The application required is Form SS-5, Application for a Social Security Card and you will need to provide original documents along with your application, to prove US citizenship (birth certificate), age, and identity (passport). Please note that taxpayers must have a SSN or an individual taxpayer identification number (ITIN) in order to file and also must list the SSN or ITIN of any person for whom they claim an exemption on the individual income tax return. An ITIN cannot be obtained for any person who is eligible for an SSN. However, a dependent child who is not eligible for an SSN, may be eligible for an ITIN, which would allow the parent to claim an exemption for the child. 13
Summary Reporting to the IRS is a complex task. The simple case of a taxpayer with an RRSP, an RESP plan for his children and his own private business can result in dozens of pages of forms and filings due at different times during the year to different branches of the US government. Contact your tax advisor for assistance with your US tax filing issues or to answer any questions you may have. IRS Because of the significant complexities and financial implications related to these issues, professional counsel is highly recommended. 14
About S+C Partners LLP S+C Partners LLP provides first-class assurance, taxation, advisory and technology services to successful enterprises to support their financial commitments and minimize tax liabilities. S+C Partners LLP has the experience to help you evaluate your US tax issues and determine a personalized tax planning strategy. We can help you get the process started with an introductory meeting scheduled at your convenience. We carry out our mission by providing our clients with timely, top-notch professional services throughout the year. S+C has recruited, developed and trained a first-class client service team to respond on a timely basis to requests for a broad range of professional services. Based in Mississauga, Ontario, S+C has operated with the same core values of client focus, trust, teamwork, and excellence for more than 25 years. Today, S+C is led by a number of Client Service Partners, who are recognized leaders and specialists in their field. For more information on S+C Partners LLP, please call (905) 821-9215 or toll-free 1-866-965-1435 or visit us on the web at scpllp.com or email info@scpllp.com. 15