U.S. tax law requires strategic planning

The U.S. investment reporting rules just got a whole lot more stringent. The IRS has been relentless in going after U.S. citizens owning foreign assets.

Apart from the resident population, the new tax rules will also impact Americans living abroad, including those in Canada.

The 2012 edition of PwC’s Wealth and Tax Matters, a compilation of articles focused on cross-border tax matters, draws attention to stricter reporting requirements.

These changes, which place a heavy compliance burden on U.S. citizens with significant Canadian financial assets, come in addition to the already onerous filling requirements for U.S. citizens living in Canada holding certain types of Canadian assets and Canadian bank and investment accounts.

Specified Foreign Assets (SFA)

A new reporting requirement can apply to U.S. persons with certain foreign financial assets, known as Specified Foreign Assets (SFA), which include interest, dividends or other income.

The definition of SFA is broad and includes any financial account maintained by a foreign financial institution. It includes, but is not limited to, RRSPs, stocks, mutual funds, pension and annuities, and debt instruments.

A U.S. national must file Form 8938 if their SFA exceed the thresholds. For a married couple filing jointly, the threshold doubles.

“U.S. citizens domiciled in Canada qualify for reporting thresholds four times as big if they meet the presence abroad test,” said the PwC report.

To pass the test, the individual must be a bona fide resident of Canada, having lived in here for an entire tax year uninterrupted or for 330 full days in any 12 consecutive months.

The penalty for failure to file Form 8938 is $10,000 US, “with the possibility of additional penalties.”

For married U.S. taxpayers, the penalties are assessed “as if the spouses are single persons.”

Gifts: estate tax saving tools

In the event of death, U.S. nationals residing in Canada are subject to a deemed disposition of their capital assets for an amount equal to their fair market value. Consequently they may pay capital gains tax in Canada.

“As a U.S. citizen, everything you own is subject to the U.S. estate tax. This encompasses U.S. and non-U.S. assets, including any that have been subject to a deemed disposition at death in Canada.”

The Canada-U.S. tax treaty provides some relief from double taxation by way of foreign tax credits. Ultimately, the estate pays the higher of the two taxes, which normally is “U.S. estate tax because of its high rate,” the report says.

However, considering this relief is only available at the federal level, and not on provincial or territorial tax, the element of double taxation cannot be ruled out altogether.

Careful planning, therefore, is crucial to reducing or eliminating estate tax. One way to do it is to donate property during one’s lifetime. But it’s not that simple.

“In addition to estate tax, the U.S. also has a gift tax regime that applies to any gifts made to individuals unless the recipient is a U.S. citizen spouse,” says the PwC report.

U.S. gift tax rates are the same as the estate tax rates and, therefore, any lifetime giving must be carefully considered.

Exemptions

Gift tax planning is possible because of various exemptions, one of which is the $5.12 million unified exemption. Valid until the end of 2012, this exemption is shared between the gift and estate tax regimes, giving taxpayers the option to make $5.12 million in lifetime gifts without paying a gift tax.

“The current unified exemption of $5.12 million provides an unprecedented opportunity to transfer wealth during your lifetime, not pay any gift tax, and potentially save on estate tax,” the report points out.

However, given that it is time sensitive, taxpayers must “ensure that any gift is completed before year-end and file a 2012 U.S. gift tax return,” which is due at the same time as U.S. income tax return.

There are other exemptions: such as gifts made to prescribed educational institutes or medical payments on behalf of someone else. “Also exempt are gifts of $13,000 per year to an unlimited number of individuals. This amount is increased to $139, 000 per year if the recipient is a non-U.S. citizen spouse.”

Strategic use of self-directed RRSP

A useful, but underutilized, investment strategy is investing your self-directed RRSP in your own mortgage. The strategy is based on the theory that mortgages typically charge a higher rate of interest than that paid by conventional fixed-income investments, such as GICs.

“By replacing low-yield investments with higher-yielding mortgage, a self-directed RRSP will earn a higher return on its investment over the long term,” the report says.

Here’s how it works: The client, or a related person, borrows a lump-sum amount from their self-directed RRSP and use it to take out, or re-finance, a mortgage. The borrower is required to make scheduled mortgage payments, at pre-arranged commercial interest rates, terms and conditions, to their self-directed RRSP.

“Neither the principal repayment nor the mortgage interest paid is considered to be a contribution to your self-directed RRSP. Rather, the amounts are treated the same as interest income from a GIC held in your self-directed RRSP.”

It is crucial, however, to not miss any payments as that could put the mortgage into default. “In the worst case, the administrator would attempt to collect proceeds upon a power of sale of the property and/or through mortgage insurance.”

Becoming your own mortgagor is conditional. “A non-arm’s length mortgage to be held in your self-directed RRSP must be administered by an approved lender under the National Housing Act, which includes most financial institutions.”

Another condition, the mortgage must be insured by either the Canada Mortgage and Housing Corporation (CMHC) or a private insurer, so that in the event of a default, the self-directed RRSP is protected.

The good and bad

Like any investment strategy, there are pros and cons to this one, too. Advantages include the ability to keep mortgage interest instead of paying it to a bank, not to mention the additional benefit of a higher return on a mortgage than on other fixed-income investments.

Conversely, there are high fees to consider. They include one-time costs of mortgage set-up, appraisal and legal fees and annual fees for self-directed RRSP and mortgage administration.

Last but not least, if the mortgage within a self-directed RRSP constitutes a large part of retirement savings, then a lack of diversification may prove detrimental to growth that may be gained as a result of a flexible equity/fixed-income mix.

	The regular way	This way
RRSP holdings	$100,000 in GICs (a five-year term earning compound interest at 1.85% per annum)	Same terms and amounts but borrowed from your self-directed RRSP.
Mortgage	$100,000, 25-year mortgage from bank is a five-year closed mortgage. Fixed rate of 5.29%. Bi-weekly payments of $275.
Additional costs	n/a	$5,000 of fees, insurance premiums and legal.
Earnings after five years	$10,000 of tax-deferred GIC interest income paid to your self-directed RRSP.	$25,000 of tax-deffered mortgage interest paid to your self-directed RRSP.
Mortgage interest payments over five years	$25,000 of mortgage interest paid to bank	$25,000 of tax-deffered mortgage interest paid to your self-directed RRSP.
Mortgage principal payments over five years	$11,000 mortgage principal paid. Remaining mortgage balance of $89,000.
Net difference	n/a	$10,000 more in your RRSP