There are many people living in Canada who have no idea that they may have exposure to U.S. income, taxes, estate taxes or both. In my view, the confusion and uncertainty stems from three factors. The first is that the United States bases its taxes on citizenship whereas most countries, including Canada, establish their tax net based on residency. The second factor is that the United States imposes an estate tax whereas Canada does not. (I do acknowledge that the provincial estate administration fee system is akin to a tax but is far less significant). The third factor is that the United States system has been in a constant state of flux over the last several years with no end in sight. So if you are sitting at your computer in your home or office north of the Forty-Ninth parallel you may have some exposure that you may not even know about. I have highlighted below some issues to watch for and considerations for possible solutions.
As I mentioned earlier, the United States tax system is based on citizenship. It is important to note that residency can also bring a person within the scope of the United States tax system. Therefore, if a person has left Canada to reside in the United States and is considered to be a permanent resident of the United Sates, that person would be subject to U.S. taxes. Green card holders are also caught within the U.S. tax net.
It may sound trite, but U.S. citizenship can be based simply on the place of birth. There are examples where a person is born on a brief shopping trip in the United States, immediately returns to Canada and yet would still be caught by the United States tax system. Similarly, a person born in Canada to a U.S. citizen would also be considered a citizen and therefore subject to taxes in the United States.
Before getting into estate tax issues, what does it mean to be subject to the United States tax system? First of all, and perhaps most importantly, there is an obligation to file U.S. income tax returns. There are countless persons living in Canada who have an obligation to file U.S. tax returns who are either unaware of this obligation or choose to ignore it. In order to address this issue, the I.R.S. has adopted various forms of voluntary disclosure programs. These programs are designed to ensure compliance with foreign reporting of bank accounts, trusts, corporate ownership as well as filing of tax returns. It should be noted that even when there is no income earned in the U.S., there is still an obligation to file tax returns for U.S. citizens living in Canada.
Turning now to U.S. estate taxes, the situation is even more complicated. Reason being, not only are U.S. citizens, Green Card holders and permanent residents exposed, but people without any citizenship or residential ties to the United States may also be exposed by virtue of the property they own. For those with ties to the United States, everything they own is subject to U.S. estate taxes. For others, the only property that is exposed is what is referred to as U.S. situs property. U.S. situs property includes real property in the United States (i.e. Florida vacation property), U.S. stocks and mutual funds. There are others on the list but the property types listed above are the most common forms of U.S. property held by Canadians.
For those that are caught within the estate tax system, the financial implications can be significant and are getting worse. For 2012 U.S. citizens currently enjoy a five million ($5,000,000.00) dollar exemption and the highest marginal rate is thirty-five percent (35%). In 2013, the expected estate tax regime will see the exemption drop to one million ($1,000,000.00) dollars and the highest marginal rate climb to fifty-five percent (55%).
Every person is entitled to a basic credit which exempts assets worth sixty thousand dollars. In addition, the Canada-U.S. Income Tax Treaty provides an additional credit which allows Canadians to benefit from the same exemption amount that U.S. persons can claim except on a pro-rated basis. The detailed calculations are beyond the scope of this article, however the bottom line is that Canadian residents with less than sixty thousand dollars of U.S. situs assets or less than five million dollars of worldwide assets (including U.S. assets) will be exempt in 2012. Once again as of 2013 that exemption will drop to one million dollars of worldwide assets. It should also be noted that even where there is no exposure due to the exemption, once the U.S. property exceeds sixty thousand dollars there is an obligation to file a U.S. tax form even though there is no tax to pay. For Canadians who do not fall below these exemption amounts, U.S. estate tax will result. As an example, a person who died in 2013 with U.S. assets of one million, two hundred and fifty thousand ($1,250,000.00) dollars and non-U.S. assets of five million ($5,000,000.00) dollars would have an U.S. estate tax liability of over three hundred, seventy-five thousand ($375,000.00) dollars.
Now that we have identified some of the risks, what are the possible solutions? In terms of U.S. income tax and foreign asset reporting compliance, the best approach is to sit down with an advisor who is familiar with the U.S. compliance issues and try to understand the exposure with respect to taxes and penalties. Based on this analysis it can be determined what the best course of action might be and whether to take advantage of the voluntary disclosure programs.
From an estate tax standpoint, the solutions depend on who the parties are, their citizenship, the nature of the assets and a look at both current structures and testamentary planning through wills. There are various forms of trusts which incorporate special language accepted by the I.R.S. to minimize estate tax consequences. As a Canadian, if you are contemplating the acquisition of U.S. property, there may be solutions involving trust ownership or other options to minimize the exposure. The important point to take away is that the exposure is there, whether we know it or not, and the solutions require a comprehensive look at ownership structures as well as estate planning options. All of the planning aspects must be coordinated, failing which there could be unforeseen and preventable exposure.
Harold Feder is a partner with the law firm of BrazeauSeller.LLP. He practices in the areas of tax and estate planning for individuals and business owners. Harold can be reached at (613) 237-4000 ext. 242 or at email@example.com. For more information about Harold, visit www.brazeauseller.com.