Getting Rid of Your U.S. Citizenship

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    Written by Max Reed

    Many US citizens in Canada want to be rid of their citizenship to avoid being subject to American tax rules.

    Let’s use an example. John is a Canadian citizen who lives in Ottawa. His mother was American, so John is a US citizen too. He keeps reading in the paper that as a US citizen living in Canada, he’s subject to US tax rules. Having lived in Canada all of his life, he’s annoyed that he has to file extra tax returns. So he marches down to the American Embassy, pays the $2350 (the current fee) and renounces his US citizenship.  

    Before deciding to wave goodbye to the USA, John should know that Uncle Sam will want to try and collect one last income tax before letting John leave. This “exit tax” is levied on the difference between John’s basis in all of his assets (essentially what he paid for them) and their current value. The precise way that the exit tax is calculated is quite complicated, but the bottom line is that John might find it very expensive to renounce his American citizenship.

    John has to pay the exit tax if a) the average US tax he owes exceeded USD $160,000 a year over the past 5 years, or b) his total assets on the date he gave up his citizenship exceed USD $ 2 million, or c) he hasn’t been tax compliant for five years.

    If John was a dual US/Canadian citizen at birth, he could avoid the exit tax, regardless of his total assets, if he files US tax returns for the last five years. In short, John has to come clean with the IRS to get out of the US tax system. John can file three years of past US tax returns under the streamlined program that was discussed in an earlier column. He would then file tax returns for two future years. With this, John would be tax compliant for five years and may be able to avoid the exit tax.

    For John, the advantages of giving up his citizenship are obvious — no more tax problems. But there are also downsides. John can no longer vote in US elections, rely on US consular services abroad, or live and work freely in the US. John might also be subject to future problems at the border. The 1996 Reed amendment gives the US Attorney General the power to deny entry to former US citizens who have renounced their citizenship for tax reasons. This law has rarely been applied, but it remains on the books. Some US lawmakers have tried, without success, to pass harsher versions of it. It’s hard to say what future laws will look like.

    Some Americans who have renounced their citizenship tell stories of being hassled at the US-Canada border, but the vast majority report no problems. They simply enter on their Canadian passport like the millions of other Canadians who enter the US every year.

    FATCA’s Impact on Canadians

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      Written by Max Reed

      The US Foreign Account Tax Compliance Act (FATCA) has made waves in Canada since the 2014 federal budget made it Canadian law. It obliges financial institutions to report the accounts of US citizens to the Canada Revenue Agency, which passes the information on to the IRS.

      Consider this example. Vangie is an American citizen born in Denver who moved to Calgary when she was young. She’s not compliant with her US taxes. Her consulting business has clients on both sides of the border. Vangie has personal and business bank accounts with RBC. FATCA affects both.  
      Under FATCA, RBC is obliged to report Vangie’s personal accounts to the IRS. Because Vangie was born in the US, RBC will likely ask Vangie to complete a Form W-9, to certify that she’s a US citizen. Simply filling out this form shouldn’t cause Vangie to panic — even if she is behind on her US taxes.  This is just the first step in a long, winding road by which Vangie’s information will make its way to the IRS. While determining what exactly gets reported is complicated, accounts worth less than $50,000 and Canadian RRSPs, TFSAs, RESPs, and RDSPs should not be reported.

      It’s not entirely clear what the IRS will do with the information it receives from the thousands of financial institutions all over the world required to report to it. That’s a lot of information to sort through. Processing it will take time. Theoretically, the IRS could easily cross-reference the detailed information it receives through FATCA against the list of people who file US taxes and send out letters to those who are not filing. Postage is cheap. Flying an IRS agent to Canada to conduct an examination is the opposite of cheap. Most US citizens in Canada won’t owe US tax. So even if the IRS did start aggressive enforcement, which they currently do not do, it’s not clear how much money they would collect. For someone like Vangie, the cautious course of action is to get caught up on her US taxes before the IRS gets her information through FATCA.  

      FATCA will affect Vangie’s business as well. Since she does business in the US, she may receive Form W-8-BEN-E which looks, and is, pretty complicated. It may require Vangie to determine the FACTA classification of her business. Businesses filing this form for the first time should consult a professional tax advisor. After the initial determination has been made, the information can simply be replicated on all future W-8-BEN-E forms.

      As a US citizen and person doing business in the US, Vangie to have more paperwork as a result of FACTA.  But she doesn’t have to fear FATCA — like all other new laws it can be dealt with.

      Canadian Mutual Fund: US PFIC?

        istock bank

        Written by Max Reed

        Canadians have invested over a trillion dollars in mutual funds, but the IRS has not issued guidance on how the estimated 1 million US persons in Canada should report mutual fund investments on their (mandatory) US tax returns. The general view is that a Canadian mutual fund is a corporation and may be classified as a passive foreign investment company (PFIC) for US tax purposes. A PFIC is defined under Code section 1297(a) as a foreign corporation for which 75 percent of its annual taxable income is passive income (dividend, royalty rent, capital gain, and annuity income) or at least 50 percent of its assets produce passive income. Owning an interest in a PFIC entails complex reporting requirements and exposes the US-person owner to punitive tax consequences, including: 1) the distribution or gain on sale may be required to be spread over the years the investor held  the investment; 2) the amounts allocated to years before the current taxable year are taxed at the highest ordinary income rates in effect for those years (currently 39.6% plus any state and local taxes); and 3) the IRS collects interest as though these amounts had actually been taxed in the prior years and the taxpayer simply failed to pay the tax until the year in which the excess distribution or sale occurs. A mutual fund manager may be able to, and in light of the potential fiduciary duty owed by the fund to its investors probably should, elect to treat a Canadian mutual fund trust as a partnership for US tax purposes and thus eliminate the risk that it is a PFIC

        Is a Canadian mutual fund a corporation for US tax purposes? A Canadian mutual fund is clearly a foreign (non-US) entity for US tax purposes. There are two different types of Canadian mutual funds:  mutual fund corporations and mutual fund trusts. Under the Income Tax Act, a Canadian mutual fund corporation is incorporated as a Canadian public corporation. Under Treasury regulation section 301.7701-2(a)(8), a Canadian corporation is a per se corporation for US tax purposes. Although the PFIC determination is made fund by fund, a mutual fund generally earns a great deal of passive income from the securities that it holds and owns a high percentage of assets that produce passive income, and is thus likely to be a PFIC.

        Most Canadian mutual funds are mutual fund trusts for Canadian tax purposes and their US tax classification is less straightforward than it is for a mutual fund corporation. The US entity classification regime is complex, but generally an entity may elect its classification if it is not a trust for US tax purposes, does not meet one of the seven definitions of a corporation, and is not specifically addressed elsewhere in the Code and regulations. A Canadian mutual fund trust is not a trust for US tax purposes because it has a profit motive, the trust interests are transferrable, and the trustee can vary the trust investments. Moreover, a Canadian mutual fund trust does not meet any of the seven definitions of a corporation and is not specifically addressed in the Code or regulations. Thus a Canadian mutual fund trust is probably a “foreign eligible entity” as defined in Treasury regulation section 301.7701-3(a) and can elect to be a partnership or a corporation for US tax purposes, commonly known as a check-the-box election. In the private letter ruling PLR 200752029, the IRS accepted that a mutual fund trust from an unnamed jurisdiction was classified as a “foreign eligible entity” that could elect to be treated as a partnership or corporation for US tax purposes. The PLR is not on all fours because it does not identify the mutual fund trust’s country of origin, but it does corroborate the conclusion that a mutual fund trust generally falls into the regulatory definition of “foreign eligible entity”. Electing to be treated as a partnership for US tax purposes eliminates the potential exposure to the PFIC rules for a US investor in a Canadian mutual fund trust. 

        In the absence of a check-the-box election, the default classification of a Canadian mutual fund trust is likely to be as a corporation for US tax purposes. In Chief Counsel Advice 201003013, the IRS concluded that a Canadian mutual fund trust was a corporation for US tax purposes. Under Treasury regulation section 301.7701-3(b)(2)(i), unless it elects otherwise a foreign entity that has two or more owners – all of which have limited liability – is classified as a corporation for US tax purposes. A Canadian mutual fund trust is a foreign entity that has more than two owners – it generally has many investors – all of which may have limited liability:  many mutual fund trusts are organized in Ontario and under the Ontario Trust Beneficiaries’ Liability Act the beneficiaries of a trust that is a reporting issuer under the Securities Act (such as a Canadian mutual fund trust) is not liable for an obligation or debt of the trust. Thus unless the fund itself elects to treat the mutual fund trust as a partnership for US tax purposes, a Canadian mutual fund trust is most likely to be a PFIC and its US-person investors are exposed to negative US tax consequences.

        Under the Income Tax Act a mutual fund trust must be an inter vivos trust resident in Canada. The mutual fund manager acts as a trustee and owes a fiduciary duty to the beneficiary investors of the trust that it administers, just like an ordinary trustee. (See Dobbie v. Arctic Glacier Income Fund et al  2011 ONSC 25 at para. 55 , and the Ontario Securities Act section 116; Mackenzie Financial Corporation (Re), 2008 CanLII 66161 (ON SEC); and Fischer v. IG Investment Management Ltd. [2010] OJ No. 112, which was overturned but not on this point in Fischer v. IG Investment Management Ltd. 2011 ONSC 292.) Owing a fiduciary duty means that the manager must act in the trust beneficiaries’ best interests, which may encompass informing the US-person investor of the potential US tax risk associated with the investment and electing to treat the mutual fund trust as a partnership for US tax purposes to eliminate the risk of a PFIC classification.

        Currently FATCA appears to enhance a mutual fund manager’s liability risks for breach of fiduciary duty and makes the risk-reduction issue even more urgent. A Canadian mutual fund is a Canadian financial institution under the Canada-US FATCA intergovernmental agreement and thus must report information on US account holders to the CRA, which in turn must pass the information on to the IRS. Legally and economically, a mutual fund manager has little choice but to comply with FATCA. By providing the IRS with information about US account holders, a mutual fund manager increases the risk of IRS enforcement against its investors because, for the first time, the IRS may have knowledge of an investor’s holdings. The increased chance of IRS enforcement due to FATCA disclosure may increase the investors’ US tax risk, and the Canadian mutual fund manager should be aware of the risks. Regardless of a legal obligation to do so, in the current environment a mutual fund trust may wish to elect to classify itself as a partnership for US tax purposes in order to relieve its existing US person investors of an expensive tax problem and make the fund more attractive to US investors. The PFIC problems for these US-person investors in Canadian mutual fund trusts can and should be solved with an election.

        TFSA: US Tax Classification

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          Written by Max Reed

          The TFSA allows savings to earn tax-free investment income (section 146.2(1)), but causes issues for the estimated 1 million US persons in Canada who must report TFSA income on their US tax returns and pay any related tax. Unlike for the RRSP, there is no official IRS guidance on the TFSA and the IRS has not responded to requests for clarification on proper reporting procedures for TFSAs; other advisors indicate that the IRS will not issue a private letter ruling on the matter.

          A TFSA is generally assumed – incorrectly – to be a foreign trust for US tax purposes that requires the filing of a form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, and a form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner. Arguably, a TFSA is not an entity separate from its owner for US federal tax purposes and no additional reporting is necessary. Even if a TFSA is a separate entity, it should be treated as a disregarded entity for US tax purposes and a form 8858 filed.

          Not an RRSP. The conventional wisdom that a TFSA is a foreign trust is based on an analogy to the IRS tax treatment of an RRSP. Without the substantiation of legal concepts, in notice 2003-75 the IRS classified an RRSP as a foreign trust. The IRS position on an RRSP and a RRIF does not automatically apply to a TFSA, which is created under different statutory and contractual arrangements. A TFSA functions more like a normal bank account, and less like a trust, than an RRSP does. Withdrawals from and contributions to a TFSA are almost instantaneous compared to the financial institution’s involvement in RRSP transactions. Unlike a TFSA, tax is withheld on RRSP withdrawals and receipts are issued by the financial institution for most RRSP transactions.

          Not a separate entity. The Code’s entity classification regime under regulation 301.7701-1 to -4 only applies to entities that are separate from their owners. One indicator of this separation is the existence of a contractual arrangement under which the participants carry on a trade, business, financial operation, or venture and divide the resulting profits. A TFSA is a contractual arrangement between two parties, but the TFSA holder does not divide the TFSA returns (profits) with the sponsoring financial institution.

          The IRS has issued rulings on whether an entity is separate from its owners. Rev. Rul. 2004-86 says: “Generally, when participants in a venture form a state law entity and avail themselves of the benefits of that entity for a valid business purpose, such as investment or profit, and not for tax avoidance, the entity will be recognized for federal tax purposes.”A TFSA does not have a business purpose: its only purpose is to minimize Canadian tax. In ASA Investerings Partnership (201 F. 3d 505) the DC Circuit said that “the absence of a non-tax business purpose is fatal” to the classification of an entity for US federal tax purposes.

          Revenue ruling 2004-86 also identifies characteristics that make a Delaware statutory trust (DST) an entity separate from its owners, characteristics not all shared by a TFSA: (1) Unlike the DST, it is unclear whether under local (Canadian) law a TFSA is recognized as separate from its owners. (2) Creditors of the DST owners may not assert claims directly against the property held by the entity: a TFSA’s property is not protected from claims by the owner’s creditors. (3) Unlike a TFSA, a DST may sue or be sued and is subject to attachment and execution as if it were a corporation; only the TFSA’s sponsoring financial institution or its holder may be sued. (4) The DST’s beneficial owners have the same limitation of liability as corporate shareholders, a limited liability that does not inure to a TFSA holder. (5) The DST can merge or consolidate with or into other entities. Property can be transferred from one TFSA to another, but it is unclear whether a TFSA can be merged or consolidated with another TFSA; moreover, a TFSA cannot be merged with a non-TFSA.

          If a separate entity, not a trust. If an entity is separate from its owner, it is subject to the entity classification regime unless it is specifically classified in the Code or regulations: the TFSA is not. A TFSA also does not meet the definition of a trust for US tax purposes. A foreign trust is defined in Code section 7701(a)(31)(B) as any trust that is not domestic. A trust is defined in regulation 301.7701-4(a) as an arrangement in which the trustee “take[s] title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts”. A bank does not take title to property deposited into a TFSA. A statutory pre-condition to the establishment of a TFSA (ITA section 146.2(2)(e)) is that at the customer’s direction the financial institution “shall transfer all or any part of the property held in connection with the arrangement (or an amount equal to its value) to another TFSA of the holder”,  a right that assumes that the customer retains title to the property.

          Moreover, Rev. Rul. 2013-14 said that a Mexican land trust (MLT) arrangement was not a trust under regulation 301.7701-4(a) because the beneficiary retains control over the property and is obliged to pay any related taxes. The same is true of the TFSA and it is thus not a trust: even if the financial institution takes title to the property, the TFSA holder retains control over the property and is obliged to pay any related (US) taxes.

          Possibly a disregarded entity. Classification of a TFSA involves further steps. (1) A non-trust’s classification is determined by reference to the number of members: with two or more members, it is a partnership or a corporation; otherwise it is an association that is taxable as a corporation or is a disregarded entity. The term member is not defined, but it generally means owner. A TFSA has one member; jointly held TFSAs are not allowed. Thus, a TFSA is a corporation or is a disregarded entity for US tax purposes. (2) If an entity meets any of seven definitions of a corporation, it is automatically treated as a corporation: a TFSA meets none of these definitions. (3) A TFSA, which is organized under Canadian law, is a foreign entity because it is not domestic. (4) If an entity does not meet one of the set definitions of a corporation, it is an eligible entity and the owner may elect that it be classified as a corporation or a disregarded entity for US tax purposes. (5) In the absence of an election, the default classification of a foreign eligible entity that has one member is as an association if that member has limited liability, and the entity is disregarded if that member does not have limited liability (that is, the member is personally liable for any of the entity’s debts even if he/she is indemnified for therefor). Because a TFSA owner is not insulated from any personal liability generated by assets held in the TFSA that lead to a cause of action, a TFSA by default is classified as a foreign disregarded entity for US tax purposes. A US person who has an interest in a foreign disregarded entity must file form 8858 every year.

          In summary, the precise classification of a TFSA is not certain, but a TFSA is not a foreign trust because it is not an entity separate from its owner; thus the entity classification rules do not apply and no special reporting of the TFSA is required. Even if the entity classification rules apply, the default classification of a TFSA is as a disregarded entity for US tax purposes and a form 8858 must be filed annually. It is hoped that the IRS will clarify the issue once and for all.

          In the interim, the safest option for a US citizen in Canada may be to file form 8858 annually. Alternatively, a taxpayer may write to the IRS, describe the nature of a TFSA, and request reporting guidance. Although the IRS has not yet replied to any such requests, this disclosure is simpler than a full form 8858 and may make the taxpayer compliant with his or her obligations.