Simply speaking, there are two parts to fulfilling your U.S. tax obligations. The first is the income tax return. This is where you list your income and various deductions. Generous tax credits and deductions are available to American citizens outside of the United States. As a result, most people will not owe tax. But U.S. citizens still need to file the relevant paperwork showing they owe no tax. Although there is no tax software for U.S. citizens in Canada, with some guidance most people can learn to file their own taxes.
The second step can be thought of as disclosure requirements. The Internal Revenue Service requires taxpayers to disclose various pieces of information about foreign financial holdings. For instance, if all of your Canadian bank accounts total more than $10,000, you will need to disclose them to the IRS.
U.S. tax law does not understand common Canadian financial products. Many Canadians have RRSPs and unless a special form is filed, U.S. citizens in Canada cannot defer U.S. tax owed on income that builds up inside their RRSP.
The tax-free savings account causes more problems. TFSAs shelter dividends and capital gains earned inside them from Canadian tax, but U.S. tax law does not recognize them. This means American citizens in Canada will have to pay U.S. tax on money that builds up inside a TFSA — defeating the central purpose of the account. More problematically, the IRS may consider the TFSA an offshore (think Cayman Islands) trust which would trigger an onerous filing requirement and have potentially punitive tax consequences.
Owning Canadian mutual funds may have severe U.S. tax consequences. An IRS directive may have the unintended consequence of treating Canadian mutual funds as equivalent to foreign investment companies that are often used for tax avoidance. Not surprisingly, the procedure for reporting mutual fund shares is very complicated and may require extra tax to be paid.
These disclosure requirements are the byproduct of translating financial regimes in one country to another country’s legal system. Failure to meet the disclosure requirements, or file an income tax return, could result in thousands of dollars in fines. These liabilities remain despite the relative lack of IRS enforcement actions against U.S. citizens in Canada.
But the recent Foreign Account Tax Compliance Act may change this. Simply put, it will require all Canadian financial institutions to disclose to the IRS information about accounts and assets held by U.S. citizens. Once the IRS has all of this information at its fingertips, it will be able to easily verify who has filed the required paperwork and who has not. For example, American citizens in Canada have to disclose their foreign bank accounts to the IRS. Failure to do so carries a $10,000 penalty. Since banks are now obliged to advise the IRS about these accounts, there is little chance of evading scrutiny.
There is no easy way out. Renouncing U.S. citizenship requires settling up with the IRS and paying any back taxes owed. One million Canadians are blissfully unaware of the ticking time bomb of U.S. tax liability. They, and their financial and legal advisers, would do well to be alive to these risks and take steps to mitigate them.
Max Reed is a lawyer at White & Case LLP and is co-author with Richard Pound of a Tax Guide for American Citizens in Canada. He can be reached at email@example.com.