The US taxation system imposes onerous tax reporting obligations on its citizens. All US citizens must report and pay tax on their worldwide income – even if they live abroad. US citizens must file US income tax returns every year, as well as other information returns. Although they may not owe any tax to the Internal Revenue Service (“IRS”) due to foreign tax credits available under the Canada-U.S. Tax Treaty for tax paid to the Canada Revenue Agency, dual US and Canadian citizens who live in Canada still have to file.
As a result, many dual US and Canadian citizens who live in Canada are subject to complex tax rules in two countries, which results in greater potential exposure to tax and considerable amounts of money in accounting fees for the services of expert cross-border accountants who have a deep knowledge of tax rules on both sides of the border.
US Tax Compliance
For US citizens living in Canada who have not continuously filed US tax returns, becoming compliant is even more pressing since the United States’ far-reaching Foreign Account Tax Compliance Act (FATCA) came into effect in Canada in 2014.
Failure to file US tax returns and to comply with FATCA and other US tax reporting requirements can result in penalties, interest and in some instances draconian fines and/or criminal sanctions. The cost of these civil and criminal sanctions is often far greater than the IRS’s amnesty programs for becoming tax compliant such as the Offshore Voluntary Disclosure Program and Streamlined Foreign Offshore Procedure.
But what can US citizens living abroad who don’t want to deal with the lifelong obligation to file US tax returns do?
Renouncing US Citizenship and the US Exit Tax
The complications of US tax rules can push a lot of dual US and Canadian citizens who live in Canada to expatriate from the United States. Expatriation entails renouncing US citizenship and taking active steps with the IRS afterwards to terminate US tax residency. If you a dual US and Canadian citizen who wishes to expatriate from the United States for one reason or another, there are serious tax implications that should be contemplated before expatriating.
Before renouncing US citizenship, a US person must be tax compliant for up to five (5) years prior to the date that he/she renounces. What happens if you renounce without being tax compliant in the United States for the five (5) years preceding expatriation? The IRS will deem you to be a “Covered Expatriate” and may slap you with an exit tax on your worldwide assets prior to expatriation. It is crucial that you be tax compliant for the five (5) years preceding expatriation before you take steps to renounce your US citizenship.
However, even if you are tax compliant in the United States for the prescribed five (5) year period, you may be subject to an exit tax on departure from the United States if (i) you have a global net worth of $2 million USD or more on the date of expatriation or (ii) your average net US income tax liability for the five (5) year preceding expatriation is more than $165,000 USD (in 2018). This tax liability threshold is annually adjusted for increases in the cost of living. In contrast, the global net worth threshold is not subject to an annual adjustment based on increases in the cost of living.
The exit tax is calculated as a percentage of the fair market value of all assets held on the date before expatriation; it is as if all assets have been sold just prior to departure, resulting in a taxable capital gain.
Not only are typical assets like homes and stocks are taxable; so are pension and retirement plans. These funds may be taxed even if they aren’t paid out to the expatriate in his/her year of departure and will only be payable in the future.
The exit tax is clearly a hurdle for US citizens seeking renunciation. However, it can be mitigated or some instances even avoided.
Mitigating the US Exit Tax
All US persons who trigger the US exit tax are entitled to a capital gains exemption that can be applied against the taxable capital gain to decrease the exit tax owed. In 2018, this exemption in the amount of $713,000 USD and it is annually adjusted for increases in the cost of living. If you are deemed to have generated a taxable capital gain of $1,000,000 USD on departure, you can apply the exemption to reduce your taxable capital gain to $287,000 USD.
In many instances, it may also be possible to plan ahead to avoid being deemed to be a Covered Expatriate altogether thereby avoiding the exit tax. For example, a US citizen living in Canada with a net worth of $2 million USD or more may be able to reduce his/her net worth to under $2 million USD in order to avoid being deemed a Covered Expatriate. This can be accomplished in a variety of ways, such as gifting assets to a spouse in an amount below the applicable annual exclusion amount allowable by the IRS. This sort of gift will not trigger any US gift tax.
However, any type of gifting must be done carefully to avoid triggering any issues under the Canadian Income Tax Act, which could result in double taxation; the type of assets gifted, as well as the timing of the gift(s), must all be appropriately planned in order to ensure that no other taxation issues are caused in either country while attempting to avoid being deemed a Covered Expatriate.
Every person’s financial situation is unique, and renouncing US citizenship is often an emotional, as well as a financial decision. If you do decide to part with your US passport, make sure you consult US-Canada tax experts who can advise you on the best course of action for your personal situation to ensure that the expatriation process is carried out properly and with the smallest tax impact as possible.
The comments offered in this article are meant to be general in nature and are not intended to provide legal advice regarding any individual situation. Before taking any action involving your individual situation, you should seek legal advice to ensure it is appropriate for your circumstances.