By Stephen J. Dunn
The United States taxes its citizens and resident aliens on their worldwide income. U.S. law prevents double taxation by allowing a credit for foreign tax on income which is also subject to U.S. income tax.
The U.S.-Canada Income Tax Treaty of 1980 provides process by which Canada Revenue will collect U.S. income tax obligations of U.S. citizens residing in Canada, and vice-versa.
An American citizen living and working in Canada typically has Canadian income tax withheld from his wages and remitted to the Canada Revenue Agency (“Canada Revenue”). He files an annual Canadian income tax return to determine the refund due or balance owing. But he does not file U.S. income tax returns. He may have been advised not to file U.S. income tax returns.
To attempt to assess U.S. income tax against our expatriate, the Internal Revenue Service (“IRS”) must know about him and that he has income. One way this could happen is if the expatriate moves money from a U.S. brokerage firm to another brokerage firm. The old brokerage firm will report to the IRS sale of all of the expatriate’s assets held there. If the expatriate does not file a U.S. income tax return for the year of the sale, the IRS will issue a notice of deficiency to him at his last known address for income tax on the gross sale proceeds.
The expatriate will have to petition the U.S. Tax Court to prevent the notice of deficiency from becoming a final assessment. To claim the benefit of his cost basis in the securities sold and the foreign tax credit, he will have to prepare and file a U.S. income tax return for the year of the sale. Once the IRS adjusts the proposed assessment to the actual amount, he can dismiss his Tax Court case.
The IRS will propose penalties against the expatriate for late payment of tax and late filing of the income tax return. The penalties are a percentage of the tax owing. There will also be interest on the tax and penalties finally determined to be owing.
If the expatriate cannot pay his balance owing to the IRS in a lump sum, he could enter into an installment agreement with the IRS. Instead of paying his balance owing to the IRS, the expatriate could renounce his U.S. citizenship.
The expatriate need not file a Form TD 90-22.1, Report of Foreign Bank and Financial Accounts (“FBAR”). There is no provision in the U.S.-Canada Income Tax Treaty for Canada Revenue to collect the penalty for failure to file an FBAR–$10,000 or, in the case of a willful failure, the greater of $100,000 or 50% of the highest balance in the account during the year.
Form 8938, Statement of Specified Foreign Assets, is more problematic. Internal Revenue Code § 6038D requires Form 8938 to be filed with U.S. income tax returns due beginning in 2012. The penalty for failing to file Form 8938 in $10,000 for each 30 days it is late, up to a maximum of $50,000. This likely far exceeds the amount of tax the expatriate owed on a U.S. income tax return. Because the § 6038D penalty falls under the rubric of the Internal Revenue Code, the IRS could, under the U.S.-Canada Income Tax Treaty of 1980, have Canada Revenue collect it from the expatriate’s Canadian assets. The expatriate will have to decide if retaining his U.S. citizenship is worth risking this penalty.
The U.S.-Canada Income Tax Treaty of 1980 does not provide a mechanism for the IRS to collect U.S. estate or generation-skipping transfer tax from the estate of an individual resident in Canada at the time of his death. The expatriate should take care, however, not to own any property situated in the U.S. at the time of his death. His exemption equivalent (currently $5,000,000) from U.S. estate and generation-skipping transfer tax is available if he needs it.