When employers relocate employees from the U.S. to Canada, they aim to service corporate interests by getting human resources where they need to go, ensuring efficiency and profitability. U.S. citizens relocating to Canada must address the differences between the American and Canadian tax and legal systems to ensure that their financial affairs remain sound north of the border.
Tax Distinctions Between Canada and the U.S.
As I outlined in a previous blog regarding expatriate tax issues for Canadian employees relocating to the U.S., Canadian income tax is based on residency while the U.S. generally taxes its citizens on their worldwide income even if they are non-residents. Americans working in Canada will therefore be taxed by the Internal Revenue Service (the “IRS”) on their worldwide income, regardless of residency; they will also be taxed on the employment income earned in Canada by the Canada Revenue Agency (the “CRA”). If relocated employees are considered Canadian residents under Canada’s Income Tax Act (“ITA”), the CRA will also tax the relocated American on his or her worldwide income.
U.S. citizens who are resident in Canada must therefore file tax returns in both countries. They must also comply with other, often onerous tax reporting requirements on both sides of the border. The complexity of maintaining compliance with both the IRS and CRA typically requires the expertise of cross-border tax experts.
Double taxation can also be an issue. There are, however, various income tax exclusions available under the Canada-U.S. Tax Treaty (the “Treaty”) that assuage the impact of the disparate tax regimes for U.S. citizens who earn income in Canada, such as foreign tax credits. Since Canadian taxation rates are generally higher than American taxation rates, income tax paid to the CRA will often eliminate the need to pay tax to the IRS. However, not all income earned in Canada receives the benefit of foreign tax credits.
Income Tax Traps for U.S. Citizens in Canada
Issues occur when certain types of income are taxed in one country but not the other. The IRS and CRA also have different rules regarding the timing for reporting certain types of income.
Canadian advisors may be unaware of some of the differences between the American and Canadian income tax systems. As a result, American citizens who relocate to Canada may be advised to use certain financial planning tools that work well for Canadians but are actually tax traps for American citizens working in Canada. Such income tax traps include, among others:
- tax-free savings accounts (“TFSAs”);
- registered education savings plans (“RESPs”);
- mutual funds and exchange-traded funds (“ETFs”); and
- universal life insurance policies (“ULs”).
For example, income earned inside a UL is tax-deferred, but income that is tax-exempt in a Canadian policy may not meet the test for tax-exemption in the U.S., resulting in a taxation mismatch for U.S. citizens who may owe tax on income earned inside a Canadian UL to the IRS.
Similarly, U.S. citizens who open TFSAs and RESPs after relocating to Canada may be taxed by the IRS on the income earned inside those accounts because the IRS does not provide tax breaks for these Canadian tax advantaged vehicles. The IRS also imposes reporting requirements on U.S. citizens with TFSAs and RESPs.
The IRS also imposes burdensome reporting requirements on U.S. citizens who hold Canadian mutual funds and ETFs, both of which are considered to be passive foreign investment companies (“PFICs”) by the IRS. In the U.S., PFICs are subject to severe tax. As such, Canadian mutual funds and ETFs held outside registered accounts can result in punitive taxation for U.S. citizens in Canada.
It is likely that American employees relocated to Canada will already have U.S. investment vehicles in place. Unfortunately, once a U.S. citizen becomes a non-resident of the U.S., his or her U.S. advisor may be unable to manage some or all of his investment accounts due to compliance restrictions. Instead, the U.S. citizen may want to consider working with a portfolio management team who is licenced to manage cross-border investment portfolios. Such an advisor should have knowledge of the issues surrounding mutual funds and PFICs. A cross-border investment advisor will also be aware of other issues, such as how to manage for currency risk, as well as how differences in capital gain tax rules in Canada and the U.S. may impact the portfolio.
Estate Plans: Probate and U.S. Revocable Trusts
Generally, estate plans should be created in the jurisdiction in which an individual’s assets are located. A U.S. citizen may already have a U.S. revocable trust in place upon arrival in Canada. U.S. revocable trusts work well in the U.S.: they avoid probate and guardianship proceedings if the creator of the trust dies or becomes incapacitated. Additionally, U.S. revocable trusts have no income tax consequences in the U.S.
However, U.S. revocable trusts are considered separate taxpayers in Canada, so if the assets inside the trust are distributed after the relocated employee arrives in Canada, the CRA will tax the trust. Since the trust will not be taxed in the U.S., foreign tax credits will not be available and double taxation will result.
Moreover, U.S. revocable trusts are not effective for holding Canadian assets. Consider a U.S. citizen employee who relocates to Québec. If the employee builds an investment portfolio in Canada or purchases a residence in Québec, he or she will require a Québec notarial will in order to avoid probate. A Québec incapacity mandate will also be required.
Planning for Relocation
Planning needs to be done on a case-by-case basis as each U.S. citizen’s situation is unique. Ideally, planning will be done in advance of a physical move. Advance planning does not mean that cross-border relocations will take longer to execute; rather, advance planning means that cross-border relocations will be executed with awareness and precision, favouring both employers and employees. By inviting a cross-border financial planner to analyze relocating employees’ situations prior to departure, employees will be less likely to fall into the common tax traps outlined above, which will increase their comfort level and, ultimately, their trust in their employers.