Avoid mistakes as an American in Canada

If you’re an American living and working in Canada, you need to be extra careful with your finances, especially when considering taxes.

Here are two mistakes to avoid and what to do if you’ve already made a misstep.

1. Failing to report Tax-Free Savings Accounts to the IRS

Tax-Free Savings Accounts (TFSAs) are an easy way to build your savings without being hit by taxes. An easy way for Canadians, that is.

“It’s not considered tax-free from a U.S. perspective,” says Matt Altro, partner and cross-border financial planner at Altro Levy LLP in Montreal. That means you must report the investment income to IRS on your annual returns.

The IRS also views TFSAs as foreign trusts. “And that,” Altro says, “means [you have] to file Form 3520 and 3520-A every year.”

2. Investing in Canadian mutual funds

As a U.S. citizen, buying Canadian mutual funds leads to adverse tax consequences due to the way U.S. law classifies these investments.

“A Canadian mutual fund or ETF creates passive foreign investment income. That makes them Passive Foreign Investment Companies (PFICs),” explains Altro.

PFIC rules prevent Americans from hiding investment gains offshore. There are stringent reporting requirements, and failure to comply can trigger a throwback tax.

You’re taxed at the highest marginal rate (around 39% in the U.S.), so long-term capital gains don’t get the break they normally would under U.S. tax rules.

It’s also hit with interest charges (about 5%) and penalties for underpayment (up to 25%). Rules say these back taxes, interest charges and penalties can’t total more than the excess distribution. But nothing prevents them from wiping out the entire amount says Jonah Z. Spiegelman, a partner at Altro Levy in Vancouver.

On the bright side, any Canadian tax you pay for the year the securities are sold will qualify for foreign credits. That will trim the amount owed IRS for the portion of the excess distribution allocated to the current tax year.

The solutions

If you’ve made TFSA missteps, you’ll need to file amended U.S. returns for each year you failed to report the account’s income. You also need to file Form 3520 and Form 3520-A, given TFSA’s status as a foreign trust.

If you made your mistakes, in part, because of poor professional financial advice, you can apply for what the IRS calls a private letter ruling. If successful, IRS will waive some of the penalties and interest.

Once you’ve settled your accounts, stay clear of any PFICs, and consider building a portfolio of individually purchased securities that replicates the diversification funds provide.

Next, close your TFSA and redirect those funds to your new portfolio.

Remember, all American citizens are subject to the U.S. tax code, regardless of where they reside or whether they take on dual citizenship, caution Altro and Spiegelman. The only way to avoid this is to renounce your U.S. citizenship. And to do that you must first make good with the IRS.