Tax Traps for Americans Living in Canada

Americans living in Canada can often reduce their IRS tax bill with foreign tax credits that they receive for paying tax to the CRA. Unfortunately, the foreign tax credit system does not work perfectly; Americans living in Canada are often caught in situations where foreign tax credits aren’t available or where IRS reporting requirements are extremely onerous and expensive.

Examples of these “tax traps” abound. Some of the most common ones include the following:

• The different ways the CRA and IRS tax capital gains on the sale of a principal residence.
The IRS’s treatment of Tax-Free Savings Accounts (“TFSAs”) and Registered Education Savings Plans (“RESPs”) as “foreign trusts”. Foreign trusts require complicated tax filings and produce taxable income in the eyes of the IRS.
• The characterization of Canadian mutual funds and exchange-traded funds (“ETFs”) held in non-registered accounts as “Passive Foreign Investment Companies” (“PFICs”). The IRS taxes PFICs harshly; moreover, PFICs require complex, costly annual tax filings.
• The classification of Canadian holding companies as either PFICs or “Controlled Foreign Corporations” (“CFCs”); CFCs are also treated harshly by the IRS.
• The discrepancy between the way certain whole and universal life insurance policies’ investment components are taxed in Canada and the US.
• Being subject to the US gift and estate tax regime.
• Contending with cross-border tax rules on US rental property income.
• The Canadian tax issues triggered by US revocable trusts.

The above is not an exhaustive list, but it does provide some insight into the more common tax traps that exist for Americans living in Canada.

Fortunately, with proper cross-border financial planning in place, many cross-border tax traps can be eliminated or, at the very least, minimized.