New year, new tax

There’s a new tax that may do serious damage to high-income Americans living in Canada.

Americans have to file U.S. tax returns and pay U.S tax on worldwide income, no matter where they live. There are special provisions for Americans living abroad (the foreign-earned income exclusion and foreign tax credit), so in most cases there’s no U.S. tax.

But to help fund Obamacare, the U.S. has a new tax — effective January 1, 2013 — on high-income earners: the “Net Investment Income Tax.” The tax clips 3.8% of investment income from taxpayers whose total earnings are above:

• $250,000 for a married couple filing jointly
• $125,000 for a married person filing separately
• $200,000 for a single taxpayer

Investment income includes interest, dividends, annuities, rents, royalties, most net gains, and other earnings from passive activities. It does not include distributions from qualified retirement plans.

This tax is described as a “Medicare contribution,” not an income tax. Canada has a Social Security Totalization Agreement with the United States, and under the agreement Americans living here contribute to the Canada Pension Plan, not Social Security and Medicare. So one would assume the tax shouldn’t apply. There are two problems with this assumption:

1. The tax is not dedicated to the Medicare Trust Fund, so it might not be considered a Medicare tax

2. The Social Security Totalization Agreement doesn’t cover this tax

But if it’s not a Medicare tax, it should be an income tax, which the U.S. provides a foreign tax credit against. If the tax paid to Canada is higher than the U.S. would charge, the system is designed to eliminate the U.S. tax. This is the main way double taxation is avoided.

There are several reasons this tax is dangerous:

• The investment income could be generated from U.S. investments. Normally, the Canadian foreign tax credit would offset the U.S. tax. But a resident of Alberta or a territory could have an effective Canadian tax rate lower than the U.S. rate, and the overall tax will now climb.

• The problem can occur in other ways in the rest of Canada. Some income is exempt from Canadian tax, but subject to U.S. tax. For instance, the Canadian real estate market has been doing well recently. On a sale of a principal residence, there may be a gain of over US$250,000 ($500,000 for a married couple). The excess is subject to regular U.S. tax and to the new tax, even though the gain is entirely exempt from Canadian tax.

• To add insult to injury, the Canadian dollar has appreciated against the U.S. dollar. The gain measured in U.S. dollars may be much greater than when measured in Canadian dollars. Of course, U.S. tax is paid on the U.S.-dollar gain.

  A similar result occurs with the sale of shares of some small businesses (“Qualified Small Business Corporation Shares”). The first CAN$750,000 of gain is exempt in Canada, but the whole gain is taxable in the U.S.

• There can even be a problem with regular Canadian investment income. For residents of provinces other than Alberta, the income is generally subject to Canadian tax at rates that are higher than the U.S. rates, even taking into account the new tax. But residents of Alberta and the territories could find themselves writing cheques to Uncle Sam.

• Finally, under the Internal Revenue Code, there is no foreign tax credit allowed against this new tax. It might be argued the tax treaty provides for a credit, but at this point, this argument is far from a sure thing.

How the cliff bill affects estate taxes

Estate tax portability

Bypass trusts work as a credit shelter to help protect cross-border clients

If you have married U.S.-citizen clients in Canada, it’s important to draft their wills so as to reduce or defer U.S. estate tax.

This is typically achieved through credit shelters, also known as bypass trusts or A/B trusts. These testamentary trusts make it so a person’s surviving spouse doesn’t directly inherit the estate and become subject to higher estate tax exposure.

Some could argue the cliff act makes these trusts unnecessary, because the surviving spouse will be entitled to take the unused exemption from her husband’s estate.

Even so, there are still many reasons why clients with cross-border exposure will want to use these trusts:

• Protecting assets for children or the surviving spouse due to a second marriage by surviving spouse
• Asset protection from creditors
• Assets could increase in value and would be subject to exposure if held directly by the surviving spouse.
• Administration of the estate could be reduced given the formality of such trusts.

U.S. gift tax

The lifetime U.S. gift tax exemption is $5.25 million for the 2013 tax year.

The annual gift tax exclusion amount for individuals now increases to $14,000 from $13,000. The annual gift tax exclusion made by a U.S. citizen to a non-citizen spouse increases to $143,000. The top rate is now 40% from the previous 35%.

Terry F. Ritchie, CFP (U.S.), RFP (Canada), TEP, EA, is co-founder of Transition Financial Advisors Group Inc.

Kevyn Nightingale, CA, CPA (IL), TEP, is a partner with MNP in Toronto. He leads the firm’s expatriate tax practice.