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Minimize U.S. tax for an American spouse

U.S.-taxRegardless of where they live, U.S. citizens must file U.S. tax returns on worldwide income and comply with onerous U.S. foreign reporting requirements. U.S. citizens in Canada can reduce or eliminate U.S. taxes by applying two provisions:

  1. The foreign earned income exclusion (FEIE) on earned income up to US$100,800 (2015)
  2. Foreign tax credits (FTCs) for paying Canadian taxes; FTCs are directly applied to the same foreign-earned income

But these provisions may not be enough — especially if Americans hold certain investments.

“There’s a whole set of [vehicles] that unfortunately work really well for Canadians but don’t work well for the U.S. side,” says Matt Altro, a cross-border financial planner, and partner and chief operating officer at Altro Levy in Montreal.

If you live in Canada and you’re in a mixed marriage (one of you is Canadian, one American), don’t let the American spouse get caught in the following investment traps — or Uncle Sam will come knocking.

1. TFSAs and RESPs

The new $10,000 limit increase for TFSAs is attractive, but if you’re American, don’t even think about getting one. Same goes for an RESP. The IRS considers them foreign trusts.

“You have to pay tax on the income and [you] have to file special forms called the 3520 and the 3520-A for foreign trusts each year with the IRS. Penalties for missing [the forms] can be up to $10,000,” says Altro.

Further, the Canada Education Savings Grant is taxable on the U.S. side, so he suggests that only the Canadian spouse hold an RESP.

2. Passive income sources

Passive income includes interest, dividends and most net gains. American spouses should keep far, far away from holdings in passive foreign investment companies (PFICs), because the U.S. tax rules are punitive.

How punitive?

Upon disposal of the investment, any gain can be taxed at the highest rate over the whole lifecycle of the holding period — and interest on tax owed will be charged from the first year.

“You’ve got an enormous capital gain tax on the U.S. side that [can], in the most extreme cases, actually be 100% of the gain,” says Altro.

So American spouses should steer clear of Canadian mutual funds and ETFs, which are considered PFICs and heavily taxed outside RRSPs.

He says another tax trap results when an American spouse develops a Canadian holding company for investments: it, too, is considered a PFIC or a Controlled Foreign Corporation.

3. A capital gain on the family home

If you and your spouse sell your jointly owned home, the American spouse must claim half the capital gain for U.S. tax purposes. Capital gains over US$250,000 are subject to U.S. tax, which could be as high as 23.4%.

An American spouse could also be subject to capital gains tax in a divorce, says Veronika Chang, tax expert at Morris Kepes Winters LLP in Toronto. “If the [Canadian spouse] gets the house, then it’s considered like a sale. I actually had one client who had to pay tax on it.”

“The best plan is the American should not be on title of the principal residence,” says David Altro, Florida lawyer, Canadian legal advisor and managing partner at Altro Levy in Toronto. He says that under Ontario and Quebec laws, spouses who are not on title of the principal residence may still have rights. Generally, all assets acquired over the course of a marriage are shared equally on divorce.

If the house is fully owned and you plan to keep it long-term, David says the American spouse could begin gifting half the value of the home to the Canadian spouse according to U.S. gift tax rules. “[You] can only gift [US]$145,000 per year of value tax-free. […] The balance could be gifted under another tax exemption called lifetime gift tax exemption. […] The only downside is it reduces the estate tax exemption, called unified credit, by the same amount.”

4. The wrong life insurance

Matt says the benefit paid from any kind of life insurance policy is added to your worldwide estate, so the benefit can bring an American spouse over the estate tax exemption of US$5.43 million (2015). The policy can be shielded from U.S. tax by putting it in an irrevocable life insurance trust to keep it outside the estate.

With all the above, don’t forget about the cost of reporting, which can mean accounting fees of up to $1,000 annually. Chang says before holding an investment, an American spouse should ask, “Does this trigger another tax-filing requirement?”

Perfect for portfolios

So what can an American spouse invest in?

Thanks to the Canada-U.S. tax treaty, income within RRSPs is tax-deferred in the U.S., just as in Canada.

Matt says stocks and bonds in a non-registered account are fine, too, as is Canadian rental real estate.

Chang says to always comply with reporting requirements. All foreign bank and financial accounts (FBAR) with an aggregate value more than $10,000 must be reported — including your chequing and brokerage accounts.

For extra credit

If you want to score top grades with your portfolios, don’t ignore estate planning.

David notes he commonly helps Canadian clients with reorganization and estate freezes, which are used to transfer assets to beneficiaries while avoiding capital gains tax.

If the Canadian spouse has a holding company willed to the American spouse, upon the Canadian’s death that holding company will become a controlled foreign corporation (CFC), subject to punitive U.S. tax rules. The solution, says David, is to reorganize the holding company as an unlimited liability company (ULC) and to will the company to a cross-border spousal trust and reorganize the company while that person is still alive, not after he dies.

Chang says to review wills to ensure the American spouse stays below the estate threshold of US$5.43 million when assets are transferred. She’s seen clients with estate taxes of over $100,000 because they failed to plan.

Portfolio makeover

Anselma, a Canadian surgeon, is married to Dominik, an American university professor. They live and work in Ontario and have two children. They plan to sell their home and move closer to the children’s school.

Dominik’s Canadian/U.S. marginal tax rates are 45%/35%. If he structures his investments as shown below, and earns 5%, he’ll owe $15,625 in taxes.

Asset Amount 5% gain Taxes (Canada/U.S.) Notes
TFSA $20,000 $1,000 $450 saved/up to $350 owed = at least $100 saved Cost of filing outweighs tax-free savings
RESP $150,000 $7,500 $3,375 saved/up to $2,625 owed = at least $750 saved CESG added to Dominik’s taxable income; cost of filing outweighs tax-deferred savings
Canadian mutual funds (non-registered account) $100,000 $5,000 (capital gain) $625 owed ($2,500 × 25% for Ontario)/up to $5,000 owed IRS may also charge interest on U.S. tax
Estimated capital gain from home sale (Dominik’s half only) $300,000 N/A $0/$10,000 ($50,000 × an estimated 20%) Capital gains over $250,000 on principal residence subject to U.S. tax
Total taxes $15,625 owed; $850 saved

Dominik’s portfolio makeover: Avoid the TFSA, have Anselma hold the RESP, move the Canadian mutual funds into his RRSP, and stay off title of the family home. The result: no extra taxes owed, full tax-free savings when Anselma invests in a TFSA, and full tax-deferred savings when she invests in an RESP.

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