Cross-border planning: updated

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Part 1: Advising non-resident Canadian clients

Given the number of Canadians who vacation in the U.S. each year, as well as those who move between borders for employment or other reasons, it’s important for financial advisors to be aware of the regulatory and income tax issues faced by clients who regularly spend time south of the border.

The regulatory landscape is structured in such a manner that traditional investment advisors in either Canada or the U.S. cannot directly serve such clients. My firm, Transition Financial Advisors Group, is one of the few in Canada and the U.S. that can work with clients who maintain investment and retirement accounts in both countries. In Canada, we use TD Waterhouse Institutional for our clients’ assets and TD Ameritrade in the U.S.

Even though some of the large Canadian investment advisory firms have U.S.-affiliated banks or operations, many of the advisors within these firms cannot directly work with clients who have moved to the States. In some cases, we have found a number of Canadian investment advisors working with Canadian-bank-owned firms who have met the U.S. regulatory licensing (Series 7) requirements and are able to serve Canadians who have moved to the States. However, many of these advisors, although legally entitled to work with these clients, do not fully understand the unique American and Canadian income and estate tax issues their clients will encounter.

Regulatory restrictions

In the U.S., the Securities and Exchange Commission (SEC) regulates investment-advisory firms, which are referred to as Registered Investment Advisors (RIAs). Individual states also regulate investment advisory firms and those who work within those firms.

Under the U.S. Investment Advisors Act of 1940, an investment advisor is any person who receives compensation to engage in the business of advising others, either directly or through writings, as to the value of securities or the advisability of investing in, purchasing and selling securities. The Act also regulates those who issue reports concerning investments and receive compensation as part of their regular business operations.

Under these regulations, it is unlawful for Canadian investment advisors to speak or conduct business with current clients who are temporarily or permanently in the States. Even accepting or placing a phone call to clients in the U.S. would be a violation of the Act.

However, exemptions apply if:

• You had fewer than 15 clients in the U.S. over the last 12 months
• You did not maintain an office in the U.S.
• You had no more than five clients in any one particular state
• You do not promote yourself as an investment advisor.

As long as you meet these requirements, you would be able to serve these clients in the U.S. without having to register there. However, most large Canadian firms who have many advisors and clients in the States would not qualify.

Even though you may not be required to register in the U.S. at the federal level, there are states that prohibit fraudulent conduct and require registration. Each state and protectorate (except Wyoming, the District of Columbia, and Puerto Rico) has licensing requirements for investment advisors. These licences would be obtained through filing federal Form ADV, registration fees and other state-required forms. States also require certain disclosures to clients, the maintenance of records and books, minimum net capital, bonding, and information relating to sales and marketing.

Given that Transition Financial is a Registered Investment Advisor (RIA) in the U.S., we have to provide Part 2 of Form ADV to all potential clients prior to signing an Investment Management Agreement. This part of Form ADV discloses our investment methodology, strategies and philosophy, how we are compensated, the types of clients we serve, educational and professional background, and any conflicts of interest that could arise through our investment management process. We see ourselves as financial advisors first, so we also create a comprehensive crossborder financial plan for all new investment management clients.

If you have clients contemplating relocating to the U.S., you should understand the implications of departing Canada from an income tax perspective. We often see Canadian investment advisors who have maintained Canadian accounts for former Canadians now living in the States. These are people who have exited Canada from a tax perspective, yet maintain nonregistered Canadian investment accounts. The investment advisor does not want to lose the assets, so they provide a Canadian address on the account.

This can create significant problems, not only for the investment advisor and firm, but the client as well. If the client has previously filed an exit tax return with CRA indicating that they are a non-resident of Canada, yet the Canadian non-registered investment account still cranks out T3 and T5 forms, this could cause greater scrutiny from CRA. And as we learned above, the investment advisor is no longer permitted to serve this type of client and therefore would be breaking securities laws. If this is the case for you and some of your clients, speak with your manager or firm’s compliance officer.

Withholding taxes

Under the Canada/U.S. Tax Treaty, a former resident of Canada who generates Canadian source investment income such as interest or Canadian dividend income is only subject to Canadian nonresident withholding taxes. Under the Treaty, interest income is no longer subject to withholding tax; however, Canadian source dividends are subject to a 15% withholding tax.

If a former Canadian maintains a non-registered investment account in Canada that distributes Canadian source dividends, he should file a Part XIII letter to the CRA along with payment of the 15% tax that should have been withheld at source. This would confirm to CRA that although he maintains a nonregistered account in Canada, he is at least complying with the Canadian tax rules through the payment of non-resident withholding tax. Failure to do so could be sufficient evidence to suggest your client is still maintaining Canadian tax residency and is therefore subject to tax on worldwide income.

If your client is no longer a resident of Canada for income tax purposes and lives in the U.S., rules enacted in June 2000 allow Canadian investment advisors to actively manage registered assets. Canadian firms may have to register for exemption in certain states, but most advisors can still maintain registered accounts for former Canadians in the States.

U.S.-qualified plans

What about Canadian clients who have accumulated assets in a U.S.- qualified plan, such as a 401(k) plan (an employer-sponsored, defined contribution retirement plan) or an Individual Retirement Account (IRA; similar to an RRSP)? As long as the client would not be deemed to be an American income tax resident (U.S. citizen, green card holder, U.S. work visa holder), it makes sense to transfer these accounts to Canada. Under specific provisions within the Canada/U.S. Tax Treaty and Canadian Income Tax Act, a distribution from a U.S.-qualified plan would be subject to a 15% American withholding tax.

This distribution could also be transferred or rolled over into an RRSP. This would require your client to file IRS Form W-8BEN (Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding) with the custodian or trustee of the qualified plan. Failure to do so would require the imposition of a 30% U.S. withholding tax as opposed to the 15% tax provided under the Treaty. We have seen U.S. custodians or trustees failing to properly process this form, leaving their clients with a higher level of tax withheld. If this is the case, your client would be entitled to file a U.S. non-resident income tax return called Form 1040NR the following tax year to request a refund of the excess withholding tax taken.

Although your client will ultimately get the American tax back, he will have to wait until the following tax year. If the money is mistakenly remitted to the IRS, there is no way to get it back other than with the filing of this return. We often hear from Canadian advisors who are working with clients who have U.S. Qualified Plans and are anxious to bring the money to Canada to manage. However, if the client is an American citizen, it’s generally not in her best interest to repatriate these assets to Canada. Under U.S. income tax rules, if she is under the age of 59 and six months, she could be subject to a 10% penalty on the value of the distribution —and full and ordinary income tax on the amount in the U.S.

If you are managing registered assets for former Canadians who now live in the States and are unlikely to return to Canada when they retire, it might make sense, given where the Canadian dollar presently stands against the U.S. dollar, to either encourage the client to fully distribute the RRSP and pay the requisite Canadian withholding tax or ensure that the RRSP is invested in American dollars. We often use U.S.-dollar ETFs for these clients. We also use this same strategy for our dualcitizen clients who might move to the States during retirement. With where the dollar is today, it’s a great opportunity to hedge for their future American-dollar lifestyle.

If you work with U.S. citizens who are residents in Canada or dual citizens, understand the U.S. income tax implications of some of the investment decisions that you make on their behalf. For example, TFSAs provide no U.S. income tax deferral for U.S. citizens and would be considered foreign trusts under U.S. income tax rules. The American client would have to include the income on their U.S. income tax return as well as file relatively onerous U.S. income tax forms with their U.S. income tax return. Failure to do so could create severe penalties. Therefore, under present law we recommend that American citizens do not hold TFSAs.

We often see Canadian investment advisors focusing on reducing their clients’ Canadian income tax position through the use of RRSP contributions and/or flow through-share investments. Although this might reduce the level of net Canadian income tax, because these types of tax-planning strategies in Canada are not recognized under American rules, this could cause U.S. income tax exposure. Therefore, we recommend that any Canadian tax planning is coordinated with the client’s U.S. tax planning requirements.

Part 2: Advising clients with dual citizenship

If you work with dual citizens of Canada and the United States, it’s important to be aware of the unique financial, tax and estate planning issues these clients face. Given the recent tax changes in the United States, these clients and their advisors will need to be ahead of the curve.

American citizens are deemed to be residents of the U.S. for income, gift and estate tax purposes. A U.S. citizen who is also a resident of Canada would be deemed to be a Canadian tax resident and also subject to tax on their worldwide income. Many presume this type of person would be subject to two levels of tax: on their worldwide income in both Canada and the States.

However, the foreign-earned income exclusion presently exempts US$92,900 of Canadian-source employment income. After the application of the exclusion and the application of foreign tax credits, most American citizens in Canada pay no additional U.S. income tax. However, there are still substantial U.S. income tax filing and compliance issues as well as planning requirements.

Dual citizenship not always convenient

The U.S. government acknowledges dual nationality exists but does not encourage it because of the problems it may cause. For example,dual citizens crossing into the States should not present both passports or indicate they are dual citizens. Doing so will likely delay re-entry. From a U.S. perspective, these people are simply American citizens.

If a U.S. citizen becomes a Canadian citizen, in most cases he does not automatically lose his American citizenship. Use of a Canadian passport or becoming a Canadian citizen does not put into jeopardy an American passport or citizenship status.

Regardless, using a Canadian passport as a U.S. citizen will likely mean a secondary screening. According to the American Embassy in Canada, people can hold both U.S. and Canadian citizenships but must always enter the States as an American.

U.S. citizens who are resident in Canada are required to file IRS Form 1040 annually on their worldwide income. This form is required to be filed by April 15 (April 18, 2011) if an American citizen owes U.S. tax. If no U.S. tax is due on the filing date, an automatic extension to June 15 is available for American citizens resident in Canada.

Despite the fact that an extension for filing a U.S. tax return is available to Americans in Canada, it’s important the taxpayer’s Canadian return is coordinated with the U.S. income tax return. We generally recommend a dual-citizentaxpayer return be prepared by a tax preparer familiar with both Canadian and American tax matters. A preparer with knowledge of both systems will likely source income and deductions properly and understand foreign tax credits, carryovers and additional compliance requirements.

Unfortunately, you can’t escape the clutches of the IRS by renouncing your U.S. citizenship, as this causes further complications.

Mutual fund earnings

What about U.S. citizens who own Canadian mutual funds? Last year, the IRS changed its view of the U.S. tax treatment of foreign mutual funds. Starting in 1986, many Americans used foreign mutual funds to gain tax deferral on income that wasn’t distributed to them. Thanks to the lobbying efforts of the mutual fund industry, the government enacted a new set of complex rules regarding Passive Foreign Investment Companies. A PFIC exists when 75% or more of its gross income for the taxable year consists of passive income or 50% or more of the average fair market value of its assets consists of assets that produce or are held for the production of passive income.

Passive income includes dividends, interest and its equivalents, passive rents and royalties, annuities, gains from the disposition of stocks and securities and other assets, certain gains from commodity trading, and certain foreign currency exchange gains.

As a result of the 2010 IRS policy review, the IRS issued Chief Counsel Advice 201003013, stating Canadian mutual funds should be classified as corporations for U.S. tax purposes. Therefore, if an American citizen receives income from a PFIC or sells a Canadian mutual fund that is a PFIC, U.S. tax and interest penalties could apply.

Such a taxpayer is required to file IRS Form 8621 (Return by a Shareholder of a Passive Foreign Investment Company or Qualifying Electing Fund) and can take one of two elections. The first election is called the Qualified Electing Fund (QEF) and the second is called the Mark-to-Market Election. If a taxpayer uses the QEF, he must, on an annual basis, include in his U.S. gross income his pro rata share of the mutual fund’s ordinary earnings as ordinary income, and any net capital gain as a long-term capital gain. He has to contact the Canadian mutual fund company to request a statement that details this information. Luckily, some fund companies in Canada are becoming more accommodating and are providing this information to their American investment clients.

The taxpayer could also take the Mark-to-Market election. In this case, the taxpayer would recognize the annual gain or loss of the shares as if they had sold them by the end of the year. For U.S. tax purposes, this is treated as ordinary income and not a long-term capital gain.

If he takes neither election, he would be subject to an excess distribution. In this case, the excess distribution is the part of the distribution received in the current tax year that is greater than 125% of the average distributions received during the previous three years. This amount would be considered ordinary income in the tax year.

Unfortunately, the amounts allocated to the previous three years will be subject to tax at the highest marginal rate and subject to an interest charge. Therefore, it is critical for U.S. citizens who hold Canadian mutual funds to make the appropriate election for their investment holdings. Although these rules have been in place for some time, with the passing of the Hiring Incentives to Restore Employment (HIRE) Act, taxpayers will have to comply.

Cross-border monitoring

Under HIRE, American taxpayers with foreign assets will have nowhere to hide. In fact, as of January 1, 2013, Canadian banks or investment firms doing business with Americans have to ask if they’re U.S. citizens or residents.

If the client is an American citizen (or resident under U.S. tax rules), the bank will be required to report information related to the account to the IRS. If an account holder refuses to answer, the bank or investment firm will withhold 30% of any investment earnings and remit that to the IRS. Advisors should encourage American clients who haven’t been filing annual U.S. returns to meet the compliance requirements of the IRS prior to this legislation coming into force.

The IRS requires such taxpayers to file the previous six years’ returns, even if no additional U.S. tax is payable. But it can be a lot of work and require additional IRS compliance forms (Forms 8891, 3520, FBAR, etc.). Even though the HIRE Act doesn’t come into full force until 2013, the IRS has created a draft of Form 8938 (Statement of Foreign Financial Assets), which is required to be filed with next year’s U.S. income tax return if the American citizen has $50,000 or more in foreign financial assets.

The IRS has not yet released instructions for this form, but it appears taxpayers have to file the form along with the myriad of other U.S. compliance tax forms, including the TDF 90-22.1 (Foreign Bank Account Reporting), even though much of the information appears to be similar. The new form will significantly increase the amount of data U.S. citizens need to report if they hold foreign assets. Foreign assets include Canadian rental property but not raw land or homes used personally.

As a means to encourage U.S. taxpayers to become compliant, on February 8, 2011, the IRS announced the 2011 Voluntary Offshore Disclosure Program, available through the end of August 2011. This program will require individuals to pay a penalty of 25% of the amount in the foreign accounts in the year with the highest aggregate account balance covering the 2003-to-2010 time period. Some taxpayers will be eligible for 5% or 12.5% penalties. Participants also must pay back taxes and interest for the eight years as well as accuracy-related and delinquency penalties. Taxpayers participating in the initiative must file all original and amended tax returns and include payment for taxes, interest and accuracy-related penalties by August 31.

Part 3: How long can Canadian snowbirds stay in the U.S.?

With the Canadian dollar rising to its highest level in 32 months in February 2011 and the appeal of warm weather, more and more Canadians are considering migrating to the U.S.

Canadian businesses should get used to parity, Toronto-Dominion Bank CEO Edmund Clark told Bloomberg in February 2011. In 2010, the loonie climbed 5.5% against the U.S. dollar and by 16% in 2009.

Many are forecasting that the Canadian dollar should trade around parity through next year, but Canadians also recognize how volatile the dollar can be and how many factors dictate the performance of the loonie. Even though we reached parity in September 2007 for the first time since 1976, many snowbirds remember when the Canadian dollar sank to a five-year record low, US$0.77, on March 9, 2009.

Despite the appeal of the warm weather, the value of the Canadian dollar relative to the U.S. dollar is a significant determinant in the numbers of Canadians who head down south each year.

If your clients spend time in the U.S. each year or are contemplating doing so, it’s important to understand the immigration, income tax, healthcare and estate planning considerations while they are in the States.

Overstaying your welcome

Under American immigration rules, Canadians are exempt from getting a visa stamped in their Canadian passport. However, Canadians are actually classified as either a visitor for business (B-1) or pleasure (B-2). (There are other visas available to Canadians, but these would be issued for employment, study or permanent residency in the States.)

Canadians are often confused about how long they can stay in the U.S. on a calendar-year basis. Currently, B-2 visitors are automatically entitled to be in the United States for a maximum of six months (183 days) in the calendar year. Under this visa category, their stay in the U.S. must be temporary, and they must be able to demonstrate a clear intention to depart prior to the end of the authorized period.

American immigration law presumes all persons seeking entry into the U.S. intend to be immigrants and must prove, with clear and convincing evidence, they do not intend to abandon Canada and live permanently in the States. Therefore, if you have Canadian clients that spend a lot of time in the U.S.—even if it is under 183 days per year—an American immigration officer could deny the re-entry into the U.S. or indicate on the Canadian’s passport the length of allowable stay.

A common misconception by some Canadians is that if they return from the U.S. to Canada, the six-month day count restarts again. This is not the case. Canadians who enter as pleasure visitors are only entitled to be in the States for 183 days in a calendar year. If a Canadian overstays their time in the U.S., they risk being denied re-entry and could be subject to American income tax and compliance requirements on their worldwide income and assets. It is a privilege to be able to visit the U.S., not a right—so we discourage Canadians from bending the rules.

Bending the rules can also compromise provincial health benefits. All provinces, except Ontario and Newfoundland, require you to live in your home province for at least six months plus a day in order to qualify for provincial health insurance and Medicare benefits. Ontario allows residents to be out of the country for seven months, and Newfoundland for eight months, without risking the loss of provincial healthcare. For example, if you live in British Columbia but spend one month in Alberta on vacation, you would only be entitled to spend five months in the U.S. without compromising provincial health insurance.

Substantial presence

Not only is it important to count days for American immigration and provincial healthcare rules, it is also important to count days for the purposes of U.S. income tax rules.

Under what is referred to as the U.S. Substantial Presence Test (SPT), Canadians could be deemed to be American income tax residents based on the number of days they spend in the U.S. over a three-year period.

To determine if your clients meet the Substantial Presence Test, you can add up:

• the number of days they were present in the U.S. in the current year (e.g. 2011)
• 1/3 of the days in the U.S. in the preceding year (e.g. 2010)
• 1/6 of the days present in the U.S. in the second preceding year (e.g. 2009).

If the total of this calculation equals 183 days or more, then the Canadian would be considered a resident alien and therefore a U.S. income tax resident under the SPT. As a general rule, if the Canadian does not spend more than four months in the U.S. in any tax year over a three-year period, he will not meet the substantial presence test.

If the Canadian meets the SPT, she can file IRS Form 8840 (Closer Connection Exception Statement) by June 15 of the year after meeting this test. By filing this form, she is notifying the IRS her tax home is indeed Canada and that she maintained more significant ties in Canada than in the U.S. during the current year.

Failure to file this form could cause the Canadian to be subject to U.S. income tax on her worldwide income as well as additional penalties for failure to comply with the additional income tax compliance requirements of U.S. income tax residents.

Therefore, we strongly encourage Canadians to file Form 8840 if they meet the SPT.

Canadian snowbirds might also be required to file U.S. income tax returns under two additional scenarios: when they rent U.S. property, or when they sell U.S. property.

Under American tax rules, Canadians who rent their U.S. property are required to pay tax on their American-source rental income in one of two ways: through the remittance of a 30% withholding tax on the gross rents, or through the filing of a U.S. income tax return on a net-rental basis. Canadians would be entitled to reduce their gross rents through the deduction of ordinary expenses such as property taxes, mortgage interest, insurance, management fees, and utilities. Under American income tax rules, a Canadian would also be required to depreciate the property.This is a mandatory deduction under U.S. income tax rules.

In many cases, after the application of the depreciation deduction, most Canadian taxpayers will generally break even or have a small loss on the rental property. Even though this may be the case, the Canadian is still required to file IRS Form 1040NR along with Schedule E by June 15 of the following year.

Under the recently passed American income tax laws, a Canadian who rents out their U.S. property would be required to file IRS Form 1099. This form reports the U.S. source rents received if the amounts exceeded $600. This Canadian would also be required to file Form T776 with their Canadian return reporting the rental activity in Canadian dollars.

Selling property

When Canadians sell American real property, irrespective of whether they had a gain or loss on the property, they would be required to file an American and, in some cases, a state income tax return. Under the U.S. Foreign Investment in Real Property Tax Act (FIRPTA), a Canadian could be subject to a 10% withholding tax on the gross proceeds at sale. This requirement would be imposed if the proceeds at sale are greater than $300,000, or if the proceeds are less than $300,000 and the buyers will not be using the property as their principal residence.

Given the present state of the U.S. real estate market, most Canadians currently selling their American property are doing so without realizing a capital gain. But even if there is a capital loss, under FIRPTA requirements, a withholding tax might still apply. If this is the case, Canadians are entitled to file IRS Form 8288-B (Application for Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests).

If the IRS accepts the application, it will either reduce or eliminate the withholding tax requirement commensurate to what the net tax amount would be. Canadians selling American property should be aware of this option, as failure to file Form 8288-B before closing could cause the withholding tax to be remitted to the IRS. The Canadian would be entitled to recover this tax, but would have to wait for the following year to file a U.S. income tax return to recover the tax.

In order to file a U.S. income tax return, request a reduction in withholding tax on the sale of American property, or eliminate the 30% withholding tax on U.S. gross rents, a Canadian is required to obtain a U.S. Individual Taxpayer Identification Number (ITIN). This number can generally only be obtained under the scenarios indicated above. An ITIN can be obtained with the filing of IRS Form W-7 (Application for IRS Individual Taxpayer Identification Number). This form, along with your Canadian passport, must be certified and submitted by an approved IRS Acceptance Agent. Note that a Canadian notary or attorney is not able to approve this form.

As a Certifying Acceptance Agent, I have filed many of these forms on behalf of Canadian taxpayers under a variety of U.S. tax circumstances. Unfortunately, this can become a rather frustrating process, as the IRS is in no way as efficient as the CRA. In some cases, we have submitted applications for a husband and wife where the wife’s application is approved, and the husband’s denied. There’s no rhyme or reason as to why this is the case. I strongly encourage clients to be patient through this process. One U.S. tax practitioner says her record of resubmitting Form W-7 is seven times before the IRS issued her client an ITIN.

The easiest way to obtain an ITIN is through the filing of IRS Form 1040NR. But note that an ITIN can only be issued for specific tax reasons (renting of U.S. property, reducing or eliminating federal withholding tax on the sale of U.S. property, and withholding tax on gross rents).