Client caught in cross-border trap

Rob Petrovick, 55, works in communications for a large, Toronto-based corporation. He makes $150,000 a year. Born in Florida, he moved to Canada 21 years ago; a year later he married Maria Santos, and they’ve been together since. They have no children.

Maria’s a family physician with her own practice. It’s structured as a corporation and she and Rob have been drawing dividends for 20 years.

Rob’s dutifully filed tax returns in Canada and the U.S. But a recent conversation with a friend revealed he’s one of many Americans living in Canada who hasn’t been getting them right due to poor financial advice.

The experts

Matt C. Altro

partner and cross-border financial planner at Altro Levy LLP in Montreal.

Jonah Z. Spiegelman

a partner who leads Altro Levy’s Vancouver practice.

8

Degree of difficulty

8 out of 10. Altro and Spiegelman note the main challenge is determining the dollar figures for each of the mistakes Rob’s previous advisors and accountants made, and then doing the calculations for revised filings. They urge advisors to query all new clients on whether they or their spouses or children are U.S. persons or citizens, and seek the assistance of cross-border specialists when clients owe the IRS.

The issues

Rob made three mistakes.

• He opened a TFSA in 2009 and has been contributing the maximum. “It’s not considered tax-free from a U.S. perspective,” says Matt C. Altro, partner and cross-border financial planner at Altro Levy LLP. That means Rob must report the investment income to the IRS. He hasn’t been doing this.What’s making matters worse is that the IRS views TFSAs as foreign trusts.

  “And that,” Altro says, “means Rob has to file Form 3520 and 3520-A every year.” But he hasn’t been doing that either.

  Jonah Z. Spiegelman, a partner at Altro Levy, says Rob’s error is partly a result of not having a cross-border expert coordinate returns for both countries.

  Rob has always worked with a U.S.-based accounting firm. His Canadian advisor and accountant didn’t even know he was a U.S. citizen—an alarmingly common problem. Since Rob thought the income didn’t need to be reported, he didn’t bother telling his U.S. accountant about the TFSA. The result: his U.S. tax returns since 2009 have been inaccurate.

  All Americans subject to U.S. tax

  Read: Evolving the TFSA to help seniors

  Matt C. Altro and Jonah Z. Spiegelman of Altro Levy LLP note all American citizens are subject to the U.S. tax code, regardless of where they reside or whether they take on dual citizenship. To avoid this, they must renounce their U.S. citizenships; but to do that they must first make good with the IRS.

• Since he never told his advisor he was a U.S. citizen, his advisor put him in Canadian mutual funds. This leads to adverse tax consequences due to the way U.S. law classifies these investments.“New clients come to us with this problem all the time,” says Altro. “A Canadian mutual fund or ETF creates passive foreign investment income. That makes them Passive Foreign Investment Companies (PFICs).”

  PFIC rules prevent Americans from hiding investment gains offshore. There are stringent reporting requirements, and failure to comply can trigger a throwback tax. Here’s how it works. Say your client has a $100,000 basket of mutual funds and ETFs, and he’s not pulling any income; the funds are simply increasing in value, thanks to a bull market. After five years, the client sells. The total value is now $150,000.

  The first step in calculating the throwback tax is determining the average distribution over the previous three years. In this case, it’s zero because the client hasn’t pulled any money out. The rules say anything beyond 125% of the average distribution is deemed excess, which is then “thrown back” over the entire holding period.

  Read: IRS gives expats another chance to come clean

  So, because 125% of zero is zero, the entire $50,000 gain is thrown back over five tax years. That adds $10,000 to the client’s income for each of those years. It’s 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, says Spiegelman, prevents them from wiping out the entire amount.

  On the bright side, any Canadian tax the client pays for the year the securities are sold will qualify for foreign credits. That will trim the amount owed to the IRS for the portion of the excess distribution allocated to the current tax year. No credits, however, are available for the retroactive tax, interest and penalties for the prior four years.

• PFIC rules also apply to the dividends Rob received from his wife’s corporation. He normally got $100,000 a year. But this year was more profitable, so he received $150,000. Since it’s also the year he realized his filings have been wrong, he now has to figure out his throwback tax.Rob’s average distribution for the previous three years is $100,000; 125% of that is $125,000. This is subtracted from $150,000, leaving $25,000 as the excess distribution.

  The holding period is 20 years, which means $1,250 gets added to his income for each of those years. Spiegelman says Rob owes about $8,800 in throwback tax, plus around $5,700 in interest.

  “That’s $14,500, which means 58% of the $25,000 excess distribution is lost to tax.”

  Read: Foreign tax tips from Golombek

The solutions

Rob’s TFSA misstep means filing amended U.S. returns for each year he failed to report the account’s income. He also needs to file Form 3520 and Form 3520-A, given TFSA’s status as a foreign trust.

Rob also has to prepare amended returns to clear up his PFIC troubles. Spiegelman notes that while Rob’s facing hefty back taxes, interest and penalties, there’s hope for relief. “The IRS has discretion to waive interest and penalties where reasonable cause is shown.”

Since Rob got poor advice, he can apply for what the IRS calls a private letter ruling. If successful, the IRS will waive some of the penalties and interest.

Then, Rob has to reassess his financial plan. If he wants to stay in mutual funds, he should transition to companies that have recently begun handling clients’ PFIC filing requirements. This would remove the possibility of throwback tax.

Read: Help clients track income sources

Still, U.S. tax treatment of Canadian funds isn’t ideal because the units’ appreciation is taxed every year. That means Rob can’t get the tax-deferral benefits of unrealized gains. “I would steer him away from PFIC altogether,” Altro says. Given Rob and Maria’s combined income, they would be able to build a portfolio of individually purchased securities that replicates the diversification funds provide.

Altro adds that Rob should close his TFSA and redirect those funds to the new portfolio.

If Maria wants to continue paying Rob yearly dividends, he needs to have his accountant file PFIC forms. Altro notes the forms give Rob the option to take a Qualified Electing Fund election; once he checks that box, he won’t have to worry about throwback tax.

All that’s left is paying tax on the dividends. Since the Canadian rate (about 33% to 35%) is much higher than the U.S. (15% to 20%), his foreign credits will mean no dividend tax owing to the IRS.

Client acceptance

9/10

Rob’s alarmed to learn how severe his non-compliance was. He fires his advisor and his Canadian and U.S. accountants, and hires a dedicated cross-border shop to handle his amended income tax returns, as well as his PFIC and Form 3520/3520-A filings. He closes his TFSA and dumps his mutual funds, and has the new firm’s advisor build a portfolio of individual securities.

He decides to keep drawing $100,000 in annual dividends.

His new accountant applies for a private letter ruling and it turns out well: IRS forgives half his total interest and penalties.

Dean DiSpalatro is a Toronto-based financial writer.