Tax and Estate Planning Blog : Moodys LLP and SNC Law

On December 15^th and 16^th I attended the International Taxation conference sponsored by the IRS and held in Washington DC.  There were more than 700 people in attendance and the lunchtime speaker on the first day was Douglas Shulman, the Commissioner of the IRS. At the end of his prepared remarks he answered only three questions posed by the audience. The first question he answered was mine, which was the following:

“On December 2 the US Ambassador to Canada announced that, before the end of the year, the IRS would issue guidance on tax compliance and penalty relief for Canadian residents [Click here for my prior blog on that topic] and then on December 7 the IRS Issued Fact Sheet 2011-13, which doesn’t really address the relief the Ambassador alluded to, though it does provide some guidance. [Click here for my prior blog on the IRS announcement]. Is the Fact Sheet the guidance the Ambassador was alluding to, or should we expect further guidance from the IRS?

Mr. Shulman said that the Fact Sheet was the guidance the Ambassador was alluding to. Further, he said “there is a lot of misinformation out there, and we wanted to clarify [the current state of the law].”

Both my question and Mr. Shulman’s response were quoted in Tax Notes Today on December 16, 2011, which you can read by clicking here.

After he answered my question he introduced me to Rosemary Sereti, who is Director of International Individual Compliance for the IRS. Ms. Sereti is the chief architect and is in charge of the Offshore Voluntary Disclosure Initiative (OVDI). I spoke with Ms. Sereti at length at the conclusion of the lunch. Ms. Sereti was very generous with her time and provided the following insight:

• She confirmed Mr. Shulman’s comment that the Fact Sheet was the guidance the Ambassador had alluded to.
• Penalty abatement for Canadian residents participating in the OVDI is available only if the taxpayer “opts out” of the program and successfully argues that he had “reasonable cause” for failing to file the returns.
• The IRS is aware of the problems caused by including registered retirement savings plans (RRSPs) in the OVDI penalty computation.
• The IRS is on the lookout for taxpayers who attempt to bring their unfiled returns current by using “quiet disclosure” and those who attempt to resolve their filing obligations in this way will face harsh penalties.

What we can conclude from my interaction with Mr. Shulman and Ms. Sereti is the following:

• First, it is unlikely that there will be a made-in-Canada-solution for those Canadian residents who are not current on their US filing obligations.
• Second, there is the possibility of penalty abatement for participants in the OVDI provided the participant “opts out” of the program and can prove they had reasonable cause for failing to file returns.
• Third, since the IRS is aware of the problems caused by including RRSPs in the OVDI penalty computation and has not issued guidance on the matter it is reasonable to conclude that, for now, the treatment of these accounts is an open issue.
• Fourth, those who attempt to bring their filing obligations current by using “quiet disclosure” may find themselves in much more trouble than if they had used “voluntary disclosure.

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Posted by Faizal Valli CA & Brian Dennehy CPA, JD, LL.M (US TAX)

Now that the OVDI Program is over and the IRS has released its Fact Sheet on US citizens or dual citizens residing outside of the US, this is a good time to reflect on some common circumstances when US citizens resident in Canada may have additional US tax to pay.

One of the common rebuttals that we hear from US citizens residing in Canada who are not compliant with their US tax affairs is “we haven’t filed our US tax returns because the Canadian tax liability is higher than the US tax liability and therefore there is no need to file”. In many cases, it may be true that the Canadian tax liability is higher than the US tax liability but one may never know until a thorough review of all of the facts and income sources has been completed. In addition, such individuals may also need to file other US reporting forms (even when there is no income tax payable) like Form 5471, FBAR, Form 3520/3520A, 8891, etc., but such filing requirements are beyond the scope of this blog. Some common circumstances where US tax may be payable are as follows:

1.   Deferral of Income Accruing in an RRSP

The RRSP rules in Canada are conceptually straight forward...a Canadian resident individual obtains a deduction when computing taxable income for contributions to a RRSP (subject to certain limits) and any earnings accumulated inside the RRSP are automatically tax deferred. Canada does not require a taxpayer to file additional forms or schedules to obtain a deferral of income accruing in an RRSP. 

However, a US citizen must properly and timely file a Form 8891 to obtain such a deferral from his/her US taxable income.  Otherwise, RRSP income is included in the US citizen’s taxable income for the current year. In addition, a Form 8833 must be filed to claim the benefits of the Canada-US Tax Treaty to deduct the current year RRSP contribution from the calculation of US taxable income.    If a return was not filed or if it was filed late, the taxpayer must follow certain procedures to defer the income generated by the account. Simply filing the forms is not sufficient. If these procedures are not followed the taxpayer will likely owe US tax. 

2.  Capital Dividends Received By a US Citizen

Capital dividends, overly simplified, are tax free dividends paid from Canadian private corporations to the extent that the corporation has a “capital dividend account”. Very generally, the capital dividend account of a Canadian private corporation is a surplus account that accumulates tax free amounts (such as the tax free portion of a realized capital gain or life insurance proceeds) that can ultimately be paid out to the shareholders of the corporation tax free. 

The US does not recognize the concept of a “capital dividend.” Corporate distributions to its shareholders are subject to ordering rules which prescribe the characterization of such income. A “dividend” is generally defined to mean any distribution of property made by a corporation to its shareholders out of its earnings and profits.^[1] If a corporation does not have earnings and profits, a corporate distribution to its shareholders is treated as (1) a return of capital and (2) capital gain to the extent the distribution exceeds earnings and profits and the shareholder’s basis. Accordingly, capital dividends are usually fully taxable as dividends for US purposes.

3.   Canadian “Estate Freeze” Transactions

A common strategy used by shareholders of Canadian private corporations is to “freeze” their interest in the corporation and transfer the future growth to some other party. To accomplish an estate freeze one must usually exchange their existing shares for new shares on a tax-deferred basis in Canada. 

An in depth discussion of the complexities of an estate freeze that involves a US person is well beyond the scope of this blog. Simply stated, an estate freeze may result in both US gift and income tax consequences from the transfer and issuance of shares. Additional complexities and potentially harsh tax results may flow by the use of a Canadian trust in the freeze. 

4.   Stock Options

Canada generally has a preferential system to deal with the taxation of stock option benefits. In many cases, the resulting benefit is only half taxable pursuant to section 7 and paragraph 110(1)(d) of the Income Tax Act. In some cases, there may be (or may have been) opportunities available to defer recognition of the resulting stock option benefit to the year of disposition of the stock. 

For US citizens, stock options may trigger taxable compensation as well as a gain on the sale of the acquired shares. Depending on whether the options are publicly traded and other factors, the US will determine compensation as arising on either the date of grant, vest, or exercise. Subsequent tax will arise on the date of sale. Both the timing and characterization of income may result in a disparity in the foreign tax credits available to offset the US income inclusion.

5.   Use of the $750,000 Capital Gains Deduction

Astute readers of our blogs will know that Canadian residents who hold shares of a qualified small business corporation may be able to benefit (to the extent that very detailed tests are met) from the $750,000 capital gains deduction upon the disposition of such shares. 

Generally, gain from the sale of stock is treated as capital gain in the US. The US does not recognize the capital gains deduction claimed by a Canadian resident US citizen. Accordingly, any such gain would be fully taxable in the US in the year of sale. The capital gains deduction claim and reduced tax in Canada may result in insufficient Canadian tax available to offset US tax payable. 

6.   Flow-through Share Deductions

A common tax deduction for high income earning Canadian residents is flow-through share deductions. Overly simplified, a flow-through share deduction is available as a result of an investment in an oil and gas corporation (or partnership) which will renounce their ability to claim deductions on Canadian Exploration Expenses or Canadian Development Expenses in favour of the investor. This can often times reduce Canadian income tax (subject to possible alternative minimum tax). 

From a US tax perspective, deductions and credits available to a corporation cannot be shifted to its shareholders. These deductions/credits comprise a portion of the tax attributes of the corporation. If flow-through share deductions are used by a US citizen to offset his/her Canadian taxable income, he/she may lack sufficient Canadian tax payable to offset US tax payable. 

7.   Principal Residence Exemption

As many people know, Canadian residents are generally exempt from capital gains taxation on realized gains from their “principal residence”. The discussion of a principal residence is beyond the scope of this blog but generally includes a property where a person ordinarily and habitually lives. 

The US allows an individual to exclude up to US$250,000 from the sale or exchange of his/her principal residence from gross income.^[2] To qualify for the exemption, the property for which such exclusion is being claimed must have been used by the person 2 of the previous 5 years. In order to calculate the gain, a US citizen must convert the purchase and sale price into US dollars using the exchange rate in effect on the respective dates. With the rise in the value of the loonie against the US dollar, a US citizen selling his home in Canada may experience an unexpectedly large US taxable gain. 

8.   Charitable Donations

Canada has a preferential tax system for donations of “listed securities” directly to charity. To the extent that certain conditions are met, the capital gains inclusion rate on a direct donation of listed securities to charity will be zero thereby avoiding any capital gains tax that would otherwise apply. In addition, when calculating allowable charitable donations as a tax credit, Canada limits the amount of charitable donations (that are subject to the credit) in the taxation year to 75% of the taxpayer’s net income plus 25% of taxable capital gains realized on the disposition of property donated to charity and other amounts beyond the scope of this blog. Also, Canada and it provinces provide a generous tax credit equal to the highest marginal tax rate for donations over $200, which can further reduce Canadian tax paid for large donation amounts claimed.

The calculation of the tax benefit for charitable donations generally yields more favourable results in Canada than the US.  In general, the deduction for charitable donations is limited to 20%, 30%, or 50% of a taxpayer’s gross income depending on the property contributed and the classification of the charity.[3] A US tax filer must report charitable donations as an itemized deduction[4] on Schedule A of the Form 1040.  Itemized deductions are restricted in two important ways (1) they are subject to a reduction for high income earning taxpayers and (2) if claimed, must be used in lieu of the standard deduction to which the taxpayer is otherwise entitled.  In 2011, the standard deduction available to a US taxpayer is $5,700.  In other words, a taxpayer only realizes benefits from itemized deductions to the extent he/she can claim an amount in excess of $5,700.  Thus in certain circumstances, a US taxpayer may receive little or no tax benefit for charitable contributions.    

9.   Pension Income Splitting

In 2007, the Canadian Government introduced pension income splitting legislation which enables optional pension income splitting with a spouse. In some cases, this can result in significant tax savings amongst spouses. 

However, pension income earned by a US citizen is attributable and taxable to the person who earned it for US purposes. Although US citizens filing a joint return may realize a similar result, splitting pension income is simply not allowed in the US. As a result, the entire amount of pension income will be recognized by the recipient with only a portion of the tax that would otherwise have been creditable to offset the US taxable income to the extent that Canadian pension splitting is utilized. 

10.  Allowable Business Investment Losses (ABILs)

ABILs are a special type of capital loss that, if certain conditions are met, will result in the allowable loss (which is one half of the realized loss) to be utilized to reduce all other sources of Canadian taxable income. This can be beneficial given that capital losses are only deductible against capital gains. 

Unfortunately, ABILs do not have similar treatment in the US. In general, a loss from the sale of stock is treated as a capital loss. A US citizen may utilize up to $1,500 a year in capital losses to offset other types of income. However, any remaining capital loss can only be used to offset capital gains or be carried forward to another tax year. 

11.  Medical Expenses

Canada has a comprehensive medical expense tax credit regime whereby only certain medical expenses are creditable. 

When calculating US taxable income, medical expenses are deductible as an itemized deduction (as described above in discussing the deduction available for charitable donations). However, the ability to use such expenses to offset US taxable income is even more limited. Medical expenses are only available as an itemized deduction to the extent they exceed 7.5% of an individual’s adjusted gross income. Again, many US citizens may receive little or no tax benefit from incurring medical expenses. 

12.  Canadian Lottery/Gambling Winnings

In Canada, lottery/gambling winnings are generally tax free. 

In the hands of a US citizen, lottery winnings are fully taxable as ordinary income. A taxpayer’s winnings can be offset by substantiated lottery losses. However, the taxpayer must claim these losses as an itemized deduction subject to the overall limit on itemized deductions and the loss of the standard deduction. 

While the above list is not exhaustive, it should give you a flavour that the two taxation systems - Canada’s and the US’ - are not entirely consistent. Although the Canada-US Income Tax Treaty does a very good job of trying to eliminate double taxation, the treaty does not resolve the two countries’ differing tax treatment on certain sources of income and availability of deductions/credits thereby causing different taxes payable. US citizens resident in Canada need to exercise great caution in assuming that their ultimate US income tax liability may not be nil notwithstanding the fact that their Canadian tax affairs are up-to-date. Seek professional help!

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Late on December 7, 2011 the IRS issued Fact Sheet 2011-13 (“Information for U.S. Citizens or Dual Citizens Residing Outside the U.S.”), which provides important guidance on two matters for taxpayers residing outside of the U.S.: first it gives insight into the type of facts that would support a “reasonable cause” argument for the abatement of penalties. Second, it clarifies the procedure to bring current unfiled returns, thereby confirming the IRS’s disdain for “quiet disclosures.” The guidance provided by the Fact Sheet makes clear the importance of engaging a professional who is experienced in these matters.

Facts likely to support a “reasonable cause” argument for the abatement of penalties

 Many of the penalties faced by individuals who haven’t filed their U.S. returns may be reduced to zero provided the taxpayer can prove reasonable cause for not filing. Reasonable cause is a legal doctrine, the application of which is determined by all of the facts and circumstances surrounding the taxpayer’s failure to file. Particular facts that support its application are found in case law, administrative interpretations, the statutes, and the treasury regulations.[1]

The taxpayer was unaware of his U.S. filing obligations

Depending on the particular facts, one of the theories that may support a finding of reasonable cause is that the taxpayer was unaware of his filing obligations. The Fact Sheet lists several facts that the IRS will, apparently, weigh more heavily than others in determining whether being unaware is sufficient to support the “reasonable cause” argument, including:

• The taxpayer’s education;
• Whether the taxpayer has previously been subject to the tax for which the return has not been filed;
• Whether the taxpayer has been penalized before;
• Whether there were recent changes in the tax forms or law the taxpayer could not reasonably be expected to know; and
• The level of complexity of a tax or compliance issue.

The Fact Sheet then gives several examples, the facts of which support a finding of reasonable cause, the most telling of which is Example 4. Under Example 4 the IRS concludes that reasonable cause is shown based on the following facts:

·         The taxpayer complied with tax filing and payment obligations in his country of residence;

·         He was previously unaware of his U.S. filing obligations;

·         After discovering his U.S. filing obligations he filed his previously unfiled returns;

·         He attached a statement to his returns setting forth his reasonable cause argument;

·         He had a legitimate reason for maintaining non-U.S. accounts;

·         There was no indication that he had taken efforts to intentionally conceal the reporting of income or assets; and

·         There was no additional U.S. tax due.

In making the reasonable cause argument, it is critically important to analyze the facts, support the facts with affidavits or other evidence, and to make sure that the facts are supported by existing law. A U.S. lawyer who is experienced with the foregoing is an essential component to prevailing on reasonable cause argument.

Procedure to bring current unfiled returns: DO NOT ATTEMPT “QUIET DISCLOSURE”

The Fact Sheet states that if a taxpayer has not filed returns or foreign bank account reports (FBARs) he should immediately file the delinquent returns (6 years for the FBAR) and attach a statement with the filings that sets forth the reasonable cause argument. This guidance makes clear the IRS’s distain for “quiet disclosures.”

In the past many taxpayers have attempted to bring current their unfiled returns by simply filing the returns without notifying the IRS, this is what is referred to as a “quiet disclosure.” The IRS has publicly stated that it will not tolerate quiet disclosures and that those who attempt to bring their filing obligations current via quiet disclosure risk criminal prosecution. For example, in FAQ 15 of the Offshore Voluntary Disclosure Initiative (OVDI) [2] the IRS stated:

Those taxpayers making “quiet” disclosures should be aware of the risk of being examined and potentially criminally prosecuted for all applicable years.

The Fact Sheet makes clear that unfiled returns must be brought current and the IRS must be informed of the taxpayer’s actions, including his reasonable cause argument. By following these rules, the taxpayer will maximize the possibility of proving reasonable cause and thereby reducing his penalties to zero.

Other penalties may apply.

The Fact Sheet addresses only the penalties that apply for failure to file FBARs and U.S. income tax returns. However, section 3 makes clear that other failure-to-file penalties may apply for other forms that have not been filed. These other forms include:

·         Forms 3520 and 3520A, which are required for certain interests in non-U.S. trusts or estates and gifts or inheritances from non-U.S. persons;

·         Forms 5471 and 8865, which are required for certain interests in non-U.S. corporations and partnerships;

·         Forms 926 and 8865, which are required for certain transfers to non-U.S. corporations and partnerships; and

·         Form 8938, which is a new form that is required to be filed beginning in 2012. The form must be filed by certain individuals who own non-U.S. accounts (much like the FBAR). There is a $10,000 penalty for failure to file this form.

The publication of the Fact Sheet is great news for individuals living outside the U.S. who are not current on their U.S. tax filing obligations because it gives some degree of certainty as to the facts that will support a reasonable cause argument for the abatement of penalties, and it also gives guidance as to the procedure to bring delinquent filings current.

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As many regular readers of our blog or our Twitter feeds (@RoyBerg1, @Moodystax) already know, applications for the 2011 US OVDI ended on September 9, 2011. However, there has been no shortage of activity regarding non-compliant US citizens. Yesterday, our firm received some news from a highly-placed source regarding some further activity. Apparently, a very influential US body has drafted a letter that should be made public later this week. The letter advocates lenient tax treatment for US Citizens residing in Canada who are not current with their filing obligations.

Here is what we believe to be the case:

1.      The letter is addressed to President Obama, Secretary of State Clinton and Ambassador Jacobson.

·         Notably absent on the distribution list are Secretary of Treasury Geithner and IRS Commissioner Shulman.

·         We believe the omission of Geithner and Schulman indicate that the issue is being framed as a diplomatic matter and not as a tax matter.

2.      The letter purports to advocate the following relief for US Citizens residing in Canada for X years provided they are compliant with Canadian tax filing and reporting obligations:

·         Full abatement of the penalty regime under the IRS Amnesty Program;

·         Penalty relief for those who missed participation in the Amnesty Program; and

·         Ability to renounce US Citizenship without the imposition of the Exit Tax.

What we do not know is the effect, if any, the letter will have.

If the letter does manage to effectuate change to the current protocol then that would be great news. The work that practitioners have undertaken so far for their non-compliant US clients may place them in an expedient position to be compliant with their tax affairs. However, it is puzzling to think how the lobbied for changes could be implemented without causing significant other fallout. For example, if the letter effectuates change, would non-compliant US citizens be rewarded for waiting out the previous voluntary disclosure programs? Tricky issues.

We continue to monitor this space closely and will communicate any changes as they become available.

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By now many US Citizens (and holders of US green cards) living in Canada are aware that they must file US income tax returns and other forms because of their citizenship status; and that the failure to comply can have ruinous financial consequences. What many don’t know, however, is that the same individuals must also file another annual form or risk losing the tax-free growth in their registered retirement savings accounts (RRSPs).

Article XVIII(7) of the United States - Canada Income Tax Convention  (the “Treaty”) provides that an individual may defer taxation on income accumulated in RRSPs, RRIFs, registered pension plans, and deferred profit sharing plans, however, the individual must make an affirmative annual election in order to avail himself of the tax-free accumulation. The election must be made on the US form 8891 and included annually with a timely filed US income tax return. If the individual has not timely filed US returns, or if he has missed a few years, he cannot remedy this problem by simply filing the delinquent returns. A lot of Canadian residents are in this position.

Fortunately there is a solution to the problem of unfiled forms 8891 which allow the individual to retroactively elect tax-free deferral in his RRSP or other retirement account. Unfortunately, the procedure to remedy the problem is complex and granted at the discretion of the IRS, so the results are not a certainty.

Treasury Regulation 301.9100-1(c) gives the Commissioner of the IRS the discretion to grant a taxpayer a reasonable extension of time to make a regulatory election (such as the election to defer income tax on the form 8891) in certain circumstances. Treasury Regulation 301.9100-3 a) provides that the Commissioner may grant such extension provided: a) the taxpayer acted reasonably and in good faith, and b) granting the extension will not prejudice the interests of the US Government.

The process for requesting the extension under the Treasury Regulations is complex and requires the collection of facts, substantiating those facts (with affidavits and by other means), and making legal and factual arguments to support the request. Even if the taxpayer follows all of the formalities to request an extension, the request may be denied. If the request is denied, the taxpayer will have to pursue the matter in accordance with the administrative procedures established by the IRS.

On August 12, 2011 the IRS granted a taxpayer such an extension to elect tax-deferred treatment of his RRSP.   Under the facts of that ruling, in year one the taxpayer hired a Certified Public Accountant (the US equivalent of a Canadian Chartered Accountant) to prepare his US income tax return. The CPA failed to file form 8891 with the return and the omission was not detected until year two when the taxpayer hired another professional. Finally, and perhaps most importantly, at the time the taxpayer made his request for an extension the IRS had not contacted the taxpayer regarding the omitted election. The taxpayer was able to substantiate the foregoing and was granted the requested extension.

However, even considering the work involved and the uncertainty in the outcome we are advising our clients (and representing them in the process) to immediately seek an extension of the election, even if they have not filed returns for several years. If taxpayers choose to ignore the problem, it will not go away on its own and they will likely wake up one day with a substantial US income tax bill that may not be so easy to resolve.

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IRS Grants Significant Penalty Relief and Extensions Under the 2011 OVDI in Certain Circumstances

On June 2, 2011 the IRS updated the 2011 OVDI frequently asked questions webpage. FAQ 25, 51, and 52 were modified to allow an extension past the August 31, 2011 deadline and a significant reduction in penalties if certain elements are satisfied. The following is an overview of the modifications to the 2011 OVDI:

1.      FAQ 25.1 allows a taxpayer to request an extension to complete his or her submission if the taxpayer can demonstrate a good faith attempt to comply with the August 31, 2011 deadline. Requests for the 90 day extension must include a statement of missing items, the reasons why they are missing, and the steps taken to secure them. 
 

2.      FAQ 52 now provides for significant offshore penalty relief for taxpayers who have resided in a foreign country (such as Canada),  have been compliant with the tax laws in that foreign country, and have US source income of $10,000 or less per year. For these taxpayers, the 25% penalty (of the highest aggregate balance in foreign bank accounts/entities) shall not apply and will be eligible for the reduced 5% penalty. In addition, for these taxpayers only, the offshore penalty will not apply to non-financial assets, such as real property, business interests, or artworks, purchased with funds for which the taxpayer can establish that all applicable taxes have been paid, either in the US or the country of residence. This exception applies if the income tax returns filed in the foreign country included the offshore-related taxable income that was not reported on the US tax return. 
 

3.      FAQ 51.1 provides examples where a taxpayer might consider opting out of the civil settlement structure of the 2011 OVDI. These examples include (1) unreported income but no tax deficiency, (2) unreported income and failure to file FBAR, and (3) unreported controlled foreign corporation. If the taxpayer opts out, penalties are significantly reduced and if reasonable cause can be proven then there is a possibility of no FBAR penalty.  

4.      Lastly, the IRS is accepting statements from taxpayers who participated in the 2009 OVDP and whose cases have been resolved and closed with a Form 906 closing agreement who believe the facts of their case qualify them for the 5% reduced penalty. Upon receipt, the case will be re-examined and a determination will be made.  

The new provisions in the FAQs are a welcome relief to both taxpayers and practitioners. As stated in our May 27, 2011 blog, the previous penalty structure was extremely punitive for the non-willful US taxpayer. US citizens living abroad who have been non-compliant need to act quickly and take advantage of the new penalty structure. To reiterate the words of Commissioner Shulman, “As we continue to amass more information and pursue more people internationally, the risk to individuals hiding assets offshore is increasing. This new effort gives those hiding money in foreign accounts a tough, fair way to resolve their tax problems once and for all. And it gives people a chance to come in before we find them. The risk of being caught will only increase.” 

Accordingly, US citizens resident in Canada should strongly consider this new program.

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On May 19, 2011 the Department of Justice released a statement regarding United States v. Michael F. Schiavo, a case where the defendant quietly disclosed a HSBC Bermuda account. The defendant, Michael Schiavo, was a Boston venture capitalist and director at Boston Private Bank and Trust Company. From 2003 to 2008, Mr. Schiavo failed to report his HSBC Bermuda account and $99,273 of income from a partnership that invested in medical devices. As a result, Mr. Schiavo deprived the IRS of $40,624 in taxes. 

As stated in our March 2011 blog, each US person who has a financial interest in or signature or other authority over any foreign financial accounts, including bank, securities, or other types of financial accounts, in a foreign country, if the aggregate value of these financial accounts exceeds $10,000 at any time during the calendar year, must report that relationship each calendar year by filing a Report of Foreign Bank and Financial Accounts (Form TD F 90-22.1 (FBAR)). 

On October 6, 2009, Mr. Schiavo made a “quiet disclosure” to report his HSBC Bermuda account. A quiet disclosure occurs when a taxpayer amends or files previous returns and pays related taxes and penalties without notifying the IRS through the Offshore Voluntary Disclosure Initiative or the Internal Revenue Manual Voluntary Disclosure. However, Mr. Schiavo made a partial disclosure and failed to report his income from his partnership on his 2006 return. After a visit from an IRS agent on October 27, 2009, Mr. Schiavo amended his 2006 return to report the undisclosed income. 

According to the criminal information and plea agreement, Mr. Schiavo faces up to five years in prison, followed by three years of supervised release and a $250,000 fine. In addition, Mr. Schiavo agreed to pay a civil money penalty of $76,283, half the value of the highest balance of the HSBC Bermuda account for failing to file an FBAR. 

The End of Quiet Disclosures? 

Under the current Offshore Voluntary Disclosure Initiative Q&A, the IRS does not recommend taxpayers make quiet disclosures and are strongly encouraged to come forward under the OVDI. Taxpayers who make quiet disclosures run the risk of being examined and potentially criminally prosecuted for all applicable years. 

Many complaints that surround the 2011 OVDI is that the program is too punitive. In other words, the IRS is “trying to kill a mouse with an elephant gun.” Many people who are beginning to come forward are not willful tax evaders and are just learning about their US tax obligations. The Schiavo case adds another wrinkle, and taxpayers must be aware the risks of not entering the 2011 OVDI. However, it should be noted that Mr. Schiavo did not fully disclose the first time and this may be why the IRS gave Mr. Schiavo such a severe punishment.   

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As discussed in our February 9, 2011 blog, the IRS announced, on February 8, 2011, the creation of a second voluntary disclosure program for taxpayers with unreported foreign assets (OVDI). In announcing the 2011 OVDI, IRS Commissioner Douglas H. Shulman stated “The situation will just get worse in the months ahead for those hiding assets and income offshore. The new disclosure program is the last, best chance for people to get back into the system.” In 2009, the IRS offered a similar program which resulted in approximately 15,000 disclosures prior to the October 15, 2009 deadline and approximately 3,000 between then and the start of this new program. 

The following is a general description of the 2011 OVDI Rules:

Years Applicable – In order to participate in the new program, taxpayers are required to resolve any non-compliance within the eight year period from 2003-2010.

Penalties – The 2011 OVDI requires taxpayers to pay the following: (1) income tax deficiencies during the eight year period, (2) interest on the deficiencies, (3) a 25% penalty on the highest aggregate balance held within the foreign accounts during the eight year period, and (4) accuracy related penalties of 20% of the back taxes, and if applicable, 25% of back taxes for failure to timely file a return or pay tax shown on a filed return.   In addition, for smaller offshore holdings of not more than $75,000 at any time from 2003 to 2010 the penalty will be reduced to 12.5%. The rate could also be reduced to 5% if the taxpayer did not know they were U.S. citizens or if the account was inherited. 

Deadline – The 2011 OVDI terminates on August 31, 2011 and taxpayers will have to submit all of the appropriate returns to the IRS by that date. 

Benefits – Participants in the new program will generally avoid the risk of: (1) criminal prosecution, (2) civil and criminal penalties for failure to file a Report of Foreign Bank and Financial Accounts (FBAR), and (4) any taxes, interest, and penalties prior to 2003. 

Clearly, the IRS is giving all noncompliant U.S. citizens a clear warning. IRS Commissioner Shulman further stated “As we continue to amass more information and pursue more people internationally, the risk to individuals hiding assets offshore is increasing. This new effort gives those hiding money in foreign accounts a tough, fair way to resolve their tax problems once and for all. And it gives people a chance to come in before we find them. The risk of being caught will only increase.” 

Given the Commissioner’s remarks and the constant warnings from the IRS, it is well advised to come into compliance. Whether you have an undeclared foreign account or other international noncompliance, Moodys LLP Tax Advisors and Shea Nerland Calnan LLP is well placed to offer assistance. Please contact us if you have any questions. 

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As Kim recently posted, the IRS has set up a new special voluntary disclosure program for US taxpayers who have unreported income from offshore assets. Interestingly, the IRS has indicated that, as part of the program, taxpayers may file delinquent Report of Foreign Bank and Financial Accounts (“FBAR”) forms.

FBARs are required for any US person who has a financial interest in or signature authority or other authority over any financial account in a foreign country, if the aggregate value of these accounts exceeds $10,000 at any time during the calendar year. A “US person” is citizen or resident of the US, a domestic partnership, a domestic corporation, and a domestic estate or trust.  Note that Canadians who travel frequently to the US may be considered US residents.

The IRS has stated that it will not impose a penalty for failure to file a delinquent FBAR, so long as the taxpayer has already reported and paid tax on all their taxable income for prior years. Might this represent an opportunity for US citizens living in Canada or Canadian snowbirds to get current with the IRS and complete their filings without getting penalized? Anyone who qualifies should seek proper legal and tax advice.

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2010 Tax Relief Act
Last week was a monumental week for US tax practitioners. On Friday, December 17, 2010 President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (affectionately known as the “2010 Tax Relief Act” or “TRUIRJCA”). While it does not provide long-term certainty, Americans (and Canadians with permanent establishments in the US) can at least be assured that for the next two years, individual and corporate tax rates will remain at 2001 levels. Additionally, dividend rates (which were scheduled to increase to ordinary income rates) and capital gains rates (scheduled to increase to 20 percent) will likewise remain at the 15 percent 2001 rate. Other notable changes to the income tax include an increase in the exemption amount for the alternative minimum tax and a decrease to the employee share of a portion of Social Security taxes from 6.2 percent to 4.2 percent. Finally, businesses are allowed a 100 percent deduction for qualified property purchased between September 9, 2010 and December 31, 2011, that they were previously required to amortize and depreciate.

As we discussed in our previous blog on December 7, 2010, the 2010 Tax Relief Act makes major changes to the estate tax. In addition to raising the exemption amount from its 2009 level of $3.5 million to $5 million and lowering the 2009 level of tax from 45 percent to 35 percent, the new Act makes several other changes to the estate, gift and generation skipping transfer (“GST”) taxes. First, the 2011 Tax Relief Act allows estates of decedents dying in 2010 to elect out of the estate tax (with the higher exemption amounts and lower rates). Modest estates (i.e. those with net assets of less than $5 to 6 million) might benefit from paying the tax because assets in the estate would receive a step-up in basis that could be more valuable than any estate tax savings. Suppose the estate of a single decedent is worth $5.5 million, but has $5 million in unrealized capital appreciation. The estate would either owe $175,000 in estate taxes [35 percent of $500,000 net estate] and receive a $5.5 million basis or it could elect to file under the 2010 rules, in which case it would owe nothing in estate taxes. However, when the beneficiaries sell the inherited property, they may owe a combined total of $750,000 in income taxes ($5 million at 15 percent).

Second, the 2010 Tax Relief Act provides for portability of exemptions between spouses. That is, if a surviving spouse’s husband or wife dies in 2011 or 2012 and does not use his or her entire exemption amount, the unused amount will be added to the surviving spouse’s exemption amount. For example, suppose that husband and wife have a combined estate of $10 million. Suppose further that husband makes a $1 million taxable gift then dies in 2011, leaving his entire estate to his wife. Had the wife died in 2009, she would have a $9 million estate, all but $3.5 million (the 2009 exemption amount) of which would be taxable. Now, provided that wife did not remarry, she may add her husband’s unused $4 million exemption to her $5 million exemption, making the entire estate free of taxes.

Note there is a different result where one of the two spouses is not a citizen of the US. Husband’s estate would not receive a deduction for the $4 million bequest to non-citizen wife unless the property is transferred to a qualified domestic trust or wife becomes a citizen shortly after husband’s death. As written, it would appear that the surviving spouse of a non-resident, non-citizen 2011 decedent in a treaty country (like Canada) will have some ability to use the unused portion of his or her spouse’s exemption so long as an estate tax return is timely filed for the non-citizen decedent spouse.

Finally, the 2010 Tax Relief Act unifies the gift, estate, and GST tax exemptions. Thus, a US citizen making a taxable gift of $1 million uses $1 million of his unified exemption amount, leaving a $4 million exemption for his estate. The exemption for the gift tax is not available for non-resident, non-citizens.

IRS Commissioner Doug Shulman Comments on International Tax Issues
Just in case you thought the IRS has forgotten about Americans living abroad and Americans with interests in foreign entities, this should open your eyes.  In a speech given last week at the 23rd Annual Institute on Current Issues in International Taxation in Washington DC, IRS Commissioner Shulman used strong rhetoric to admonish Americans who have not been reporting income in foreign accounts and deceptively soft words to describe the IRS’s new “cooperative” approach to multinational audits.

In discussing individual offshore compliance, the Commissioner pointed to two issues:  the UBS affair and FATCA as discussed in our February 10, 2010 blog.  Shulman stated that the IRS had “made cracking down on offshore tax abuse a major priority,” and flatly stated that UBS was just the beginning.  From his comment that “this was never about one country or one bank,” I think it’s safe to expect investigations like the ones in Switzerland to proliferate throughout the globe.

Shulman named FATCA as “one of the most important projects we are working on in the international area right now.”  He stated that “FATCA provides IRS with better transparency and additional tools that [it] needs to crack down on Americans hiding assets overseas.”  The Commissioner also mentioned the “stiff penalties” that would be imposed for failure to comply and voiced his hope that all countries would develop a “unified system for information reporting”.

In discussing corporate taxpayers, Shulman discussed the new “cooperative” approach, transfer pricing and joint audits”.  The Commissioner wants to “redefine the relationship between the IRS and large corporate taxpayers.”  This seems to be a reference to the new IRS practice of requesting documents that prior to last year’s Textron decision many practitioners would have thought were not discoverable under the US work-product privilege. He also identified transfer pricing as an area on which the IRS has been focusing. 

Finally, the IRS commissioner stated that the IRS has been pushing joint audits through the OECD’s Forum on Tax Administration.  Noting that it can cost companies a considerable amount of time and money to defend its positions to multiple international jurisdictions, Shulman heralded joint audits as a method by which the IRS could “identify the issue and understand the facts quickly on a bi- or multi-lateral basis [and] adjudicate these disagreements right away and be much more efficient in reaching a resolution.”

A full copy of the IRS Commissioner’s comments can be found at http://www.irs.gov/irs/article/0,,id=232223,00.html  IR-2010-122 (December 9, 2010).

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On December 6, 2010, President Barack Obama of the United States announced a potential agreement with the opposition Republicans that would result in an extension of the Bush era tax cuts and a compromise on the US estate tax for two years which appears to commence January 1, 2011. Of major interest to clients and friends of our firm is that the US estate tax, pursuant to the terms of the deal, would have a top tax rate of 35% and a $5M exemption for US citizens. The proposed provisions of the US estate tax appear to be what the Republicans were hoping for (and better than the 2009 estate tax rate of 45% and the exemption of $3.5M) and therefore this appears to be a significant concession on the Democrat part.  It has been reported that Obama was not happy with the estate tax compromise.  In addition, long term capital gains and dividend rates are to remain at 15%.  Both rates are scheduled to rise if a deal is not reached. 

While the deal is not yet passed into law and will be subject to intense scrutiny by both the Democrats and the Republicans, it is hoped that such a deal can be put into place by December 31, 2010. To the extent that the tax deal reached on December 6, 2010 cannot be passed into law, it may still be possible that the US estate tax rate would rise to a level of 55% with a $1M dollar exemption and all of the Bush era tax cuts would expire resulting in overall tax increases.

So, for now, we will continue to watch the politicking from the sidelines and hope that the tax cut deal, or a version thereof, will ultimately get passed. As the old saying goes, “the devil is in the details” and certainly we have not yet seen the details. However, based upon the announced deal and various media reports, this certainly appears to be a good step forward in avoiding a 55% rate and a $1M exemption for the estate tax effective January 1, 2011.

For friends and clients of our firm, some instant observations come to mind:

1.      Clients and contacts who are US citizens should review their estate planning once the details are released and passed into law, to ensure it is still appropriate given the lower proposed estate tax rate and higher exemption.

2.      For non-US persons who own US-situs property, one may wish to review their estate planning as well to see if their existing structures are appropriate. Given the higher exemption level, will it be possible to avoid the US estate tax altogether? The analysis will be very fact dependent. 

3.      US tax rates on dividends and long term capital gains are proposed to remain at a 15% level which is good news for people who own, for example, US real estate. 

4.      There still appears to be uncertainty as to what will happen for 2010 decedents. While this subject is beyond the scope of this blog, it is uncertain as to whether there will be rules for decedents to opt-in to the 2009 or 2011 rules to avoid the complicated basis carry-over rules. Stay tuned.

5.      What will happen January 1, 2013 will be the subject of much speculation. Will this be a subject of debate during the 2012 Presidential election?

There are many other implications that we will certainly consider but, for now, the above are the obvious. We will continue to monitor this space….

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As you may be aware, a US person (US citizen or resident, US partnership, US corporation or US estate or trust) has an obligation to file a Report of Foreign Bank and Financial Account (FBAR) if that person has a financial interest in or signature authority (or comparable authority) in one or more accounts in a foreign country if the aggregate value of those accounts exceeds $10,000 USD at any time during the calendar year. However, what you may not know is that starting with the 2011 tax year under the Hiring Incentives to Restore Employment Act of 2010 (“HIRE Act”) and Internal Revenue Code section 6038D, there is now an additional requirement for an individual who holds an interest in a “specified foreign financial asset” to disclose information on each such asset if the aggregate value of all the individual’s specified foreign financial assets exceeds $50,000 USD. This disclosure is done on a form which will be attached to the individual’s income tax return. In addition, “individual” refers to any US entity which holds directly or indirectly non-US financial assets. Lastly, if the Secretary determines that an individual has an interest in one or more “specified foreign financial assets” but fails to provide sufficient information to determine whether the $50,000 USD threshold has been met, then the aggregate value will be assumed to be greater than the $50,000 USD threshold for purposes of assessing penalties. 

A “specified foreign financial asset” includes any financial account maintained at a non-US financial institution and any of the following assets which are not held in an account at a foreign financial institution: a stock or security issued by a person other than a US person, any financial instrument or contract held for investment that has an issuer or counterparty which is a non-US person and any interest in a foreign entity. The required information that must be disclosed is: (1) the name and address of the financial institution in which the account is maintained and the account number; (2) in the case of a stock or security the name and address of the issuer and other information such that the class or issue of the stock or security can be identified; (3) in the case of another instrument, contract or interest then such information necessary to identify the instrument and names and addresses of any issuers; and (4) the maximum value of the asset during the year. 

Under section 6038D(d), an individual who fails to provide the required information is subject to a $10,000 USD penalty. Moreover, where the failure to disclose continues for more than 90 days after the day on which the Secretary mails notice of such failure, then such person will be subject to a penalty of $10,000 USD for each 30-day period after the expiration of the initial 90-day period. The maximum penalty will be $50,000 USD. However, no penalty will be assessed where the failure to disclose the required information was due to a reasonable cause and not willful neglect. 

Sound familiar? There is much overlap with the new section 6038D reporting requirements and the FBAR reporting already in place. One notable difference is that, as mentioned above, the new reporting requirements under the HIRE Act are attached to an individual’s tax return and sent to the IRS location where the individual files his or her return whereas the FBAR is sent separate from the tax return to a different location from where returns are filed. Additionally, unlike the FBAR, the section 6038D filing requirement would apply to an individual who holds a specified foreign financial asset whether or not he or she has signature authority or other authority over the account. An example of this distinction would be an individual who is a beneficiary of a foreign trust but is not within FBAR reporting requirements because he or she holds less than a 50 percent interest and does not have the specified authority over the account but would still fall under the section 6038D reporting requirements because the $50,000 USD threshold is exceeded. 

The cross-border tax professionals at Moodys LLP would be pleased to comment on your own specific issues regarding this topic.  Please feel free to contact any one of our cross-border tax professionals.  

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By Paul R. Lebreux LLB, LLM, TEP, Ryan T. Carey CPA (US), LL.M. (US Tax) and Kristina Ash JD LLM (US Tax)

For Canadian residents spending time in the United States (“US”), it is important to ensure that the heat you receive next time you venture south is only felt from the sun, and not the Internal Revenue Service (“IRS”). 

Each year thousands of Canadians make the trek to warmer climates in an attempt to avoid Canada’s long, cold winter months.  More often than not, these winter retreats take Canadians to the US.  Whether your passion is Florida, Arizona or some other favourite southern state, such a retreat may not only put you closer to the sun, but closer to the IRS.

Depending upon the duration of your stay in the US, you may be classified as a US resident for income tax purposes and be required to complete certain tax filings.  Most Canadians who spend significant time in the US are required to file a US tax return or other filing in order to avoid paying US taxes on worldwide income.

Determination of US Tax Residency

If you visit the US on a regular basis, there are three categories into which you may fall:

1. Present in the US for 183 days or more in the current tax year.  Pursuant to the provisions of the Internal Revenue Code (“IRC” or the “Code”), if you are present in the US for 183 days or more in the current tax year, you will automatically be classified as a US resident and may be required to file a US tax return (Form 1040) in order to report your worldwide income in the US.  You may be able to claim a treaty tie breaker under the Canada-US income tax treaty in order to file a non-resident  return (Form 1040NR).

2. Present in the US for greater than 31 days, but less than 183 days during the current year and you meet the Substantial Presence Test.  If this is the category into which you fall, you will be considered a resident alien and be required to file a Form 1040 in order to report your worldwide income in the US, unless you use the treaty-tie breaker rule or you can demonstrate a closer connection to Canada than to the US (see discussion below under the heading “Substantial Presence Test”).

3. Present in the US for less than 31 days during the current year or do not meet the Substantial Presence Test as set out in category two above.  If this is your situation, you will be categorized as a non-resident alien and not be required to file a US tax return unless you have certain US source income for which adequate withholdings have not been made or you are engaged in a US trade or business (including employment within the US).   

Substantial Presence Test

In order to determine who is a US resident, the US utilizes a formula which considers the days that an individual is present in the US over a three year period.  This formula is commonly known as the Substantial Presence Test.  The test calculates the number of days actually spent in the US during the current year, plus the number of days spent in the US in the immediately preceding year multiplied by 1/3, plus the number of days spent in the US in the second preceding year multiplied by 1/6.  If the calculation totals 183 days or more, the individual meets the substantial presence test and will be classified as a resident alien.  It is important to note that for the purposes of this test, the days present in the US need not be consecutive.  You will be considered to have been present in the US on any day that you were physically in the US, whether you are present for the entire day or only part of the day.

The following example demonstrates the effect of the above formula.  Mr. and Mrs. Sunshine are residents of Canada and have a winter home in Florida.  For the past several years Mr. and Mrs. Sunshine have spent a portion of the winter months in Florida and also some time in the US during other parts of the year.

In 2008, Mr. and Mrs. Sunshine spent 3 months (91 days) in Florida during the winter and an additional 3 weeks (21 days) in the summer.  In 2009, Mr. and Mrs. Sunshine spent 4 months (122 days) in Florida during the winter and a further 2 weeks (14 days) in May.  In 2010, Mr. and Mrs. Sunshine spent 6 weeks (42 days) traveling in the US and another 11 weeks (77 days) at their home in Florida.

Based on the above, the “substantial presence” test would be applied as follows:

Years                  # of days in US                    Multiplier                    Formula Days
2008                              112                                   1/6                               18.66
2009                              136                                   1/3                                45.33
2010                              119                                     1                                119.00
                                                                                                                   183.00

Mr. and Mrs. Sunshine will therefore be deemed to have been in the US for 183 days during the current year and will meet the Substantial Presence Test.  Although this will effectively result in their being classified as resident aliens, they may be able to use an exception to avoid being liable for US income taxes on their worldwide income.

In order to avoid the requirement to file a US 1040 tax return, Mr. and Mrs. Sunshine will each be required to complete and file a “Closer Connection Exception Statement For Aliens” (Form 8840).  They must provide evidence to the IRS that they have a closer connection to Canada than to the US in order to escape US taxation.  In the event that Form 8840 is not filed on time (June 15, 2011 for the 2010 tax year), Mr. and Mrs. Sunshine would be estopped from claiming a closer connection to Canada, which could result in US taxation of their worldwide income.

You will be considered to have a closer connection to Canada if you can demonstrate that your economic and social ties to Canada are more significant than are your economic and social ties to the US.  The following are some of the indicia that the IRS considers in determining the “closer connection”:

 1. location of permanent home(s);

 2. location of personal belongings (ie. cars, furnishings);

 3.  location of banking relationships and investments;

 4.  location of drivers licenses;

 5.  countries from which you derive the majority of your income; and

 6. business and personal ties.

If you have applied for or been granted a “green card” you will not be permitted to claim a closer connection to Canada.

If you are successful in establishing a closer connection to Canada by timely filing a Form 8840, you avoid the necessity of filing a US resident tax return and possibly incurring double taxation.

Residence under the Canada-United States Income Tax Convention

Generally, if an individual fails to file a Form 8840 on time, the individual will be considered a US resident for tax purposes and be required to pay US income tax on his or her worldwide income.  Nonetheless, it may still be possible for the individual to have his or her residency status determined under Article IV of the Canada – United States Tax Convention (the “Treaty”).

The main purpose of the Treaty is to reduce the potential of an individual being taxed twice on the same income.  The treaty attempts to resolve the issue where an individual is deemed to be a resident in both the US and Canada.  You may be classified as a non-resident alien under Article IV for the purposes of calculating your US income tax liability if the following conditions are met:

 1. you are deemed to be a resident of both the US and Canada pursuant to each country’s respective tax laws; and

 2. your permanent home is in Canada and your personal and economic ties are closer to Canada than to the US.

Although relying on the Treaty may permit you to escape US taxation as a resident on worldwide income, you will still be required to file a US Form 1040NR with a “Treaty-Based Return Position Disclosure under Section 6114 or 7701(b)” (Form 8833).  These filings are far more complicated (and thus more expensive to have prepared) and intrusive than a Closer Connection Exception Statement, so most clients prefer to file a Closer Connection Exception Statement if at all possible.

Conclusion

If you are among the thousands of Canadians returning to Canada after a long cold winter, you may want to consider your potential US tax liability and filing requirements before it is too late.  If you are a Canadian who spends significant time in the US, it is imperative that you obtain professional advice to determine the extent of your tax filing and tax payment obligations.  We expect that the IRS’s increased scrutiny of taxpayers with foreign connections, combined with increasing use of technology, will cause the IRS to pay closer attention to those that are not filing required US forms and returns.

 The foregoing information is provided for general informational purposes only and readers are encouraged to consult with their professional advisors as to their specific circumstances.

U.S. Tax (IRS Circular 230): Nothing in this communication (including in any attachment) is U.S. tax or other legal advice that is intended or written to be used, and it cannot be used, by any person to
(i) avoid penalties under U.S. federal, state or local tax law, or
(ii) promote, market or recommend to any person any transaction or matter addressed herein.

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Uncle Sam Wants YOU to file US tax returns…and he has recruited foreign banks into his army to report you!  Now you will get caught if you don’t file returns and report foreign income.

Until last week, United States persons who had never earned income in the United States and had never opened a bank account in the US were generally not on the IRS’s radar screen.  With the legislation signed into law on March 18, 2010 foreign financial institutions must determine if any of their account holders are US persons, and if so, the financial institutions must report information to the IRS about those accounts.  This blog answers the most popular questions that we have received in regards to this new legislation.

My mother/father was born in the US, but I was born in Canada and have never lived or worked in the US and I do not have a US passport or Social Security number.  I have never filed a United States tax return.  Am I a US citizen and am I required to file US tax returns?

The rules surrounding citizenship are complex and depend upon when you were born.  However, if one of your parents is a US citizen and spent sufficient time living in the US, you may be a US citizen.  If both of your parents are US citizens, you are probably a US citizen regardless of whether you or they ever lived in the US.    We can help you make a preliminary determination on citizenship, then refer you to qualified immigration counsel who can give you a final legal conclusion on whether you are a US citizen.

If you meet very low income thresholds, you are likely required to file US returns and comply with US tax laws.  The good news is that in most cases, the taxes that you paid to Canada will result in foreign tax credits that will cover the taxes that you owe in the United States.  We recommend filing tax returns for the current year, and possibly filing for the past several years, in order to avoid finding yourself on the wrong side of the table with the US Internal Revenue Service! The Moodys LLP Tax Advisors team is experienced in handling these types of returns and working with the IRS.

What information is my bank in Canada required report to the IRS?

First, your bank will need to determine whether you are a United States person.  If you are a US person, your bank must report your name, address, taxpayer identification number, account number, account balance or value, and the gross receipts and gross withdrawals from the account.

I am a US person who is a minority shareholder in a private corporation.  Will this affect me or the private corporation?

Probably.  If you own more than 10 percent of the stock in a corporation, more than 10 percent of the profits interests or capital interests in a partnership or beneficially own more than 10 percent of a trust, your bank must report the above information to the IRS. If you own a sufficient interest in the entity or if there are other US persons who own part of the entity, there could be significant tax consequences.  Your company might be a Controlled Foreign Corporation (“CFC”) or a Passive Foreign Investment Company (“PFIC”).  Ownership of CFCs and PFICs can have disastrous tax consequences if your tax situation is not proactively managed.  Talk to an advisor experienced in cross-border tax planning to determine if you have any tax liability.  Moodys LLP Tax Advisors are experienced in rendering this type of advice.

I am a shareholder in a corporation, but I am not a US citizen.  Could this legislation affect me?

That depends.  Do you have any shareholders that are US persons?  If so, you may be subject to additional reporting requirements and US tax liabilities, even if you don’t conduct any business in the United States. Discuss your situation with a tax advisor experienced in cross-border planning to determine if you have US tax reporting requirements or exposure.  Moodys LLP Tax Advisors are experienced in rendering this type of advice.

I am a shareholder in a corporation that occasionally does business in the United States or that has investments in the US.  Will this legislation affect me?

Yes.  Even if you don’t have a single US shareholder and you do not have a permanent establishment in the US, if you earn any income in the US, that income may be subject to a 30 percent withholding tax unless you provide the payor with a certificate that states that no US person owns more than 10 percent of the company.

I know that I’m supposed to file a US return, but I’ve never been caught.  Why should I start filing now?

This legislation imposes a reporting requirement on foreign (including Canadian) financial institutions.  Once these institutions report information about your account to the IRS, the IRS is more likely to find you.  If you fail to disclose your assets and the aggregate value of all of those assets is greater than $50,000, the IRS could impose a penalty of $10,000.  If you receive a notice and do not provide the information after 90 days, the IRS could impose a $10,000 penalty each month up to $50,000.  Moreover, if you fail to disclose the information and the IRS determines that there was an underpayment, an additional 40 percent tax will be assessed on the amount of the underpayment.  The statute of limitations with respect to a tax return do not begin running until a return is filed!  This means the IRS may pursue you for an unlimited period of time if you do not file a required US tax return for a particular year (or years). 

The penalties imposed by this new legislation are in many instances imposed in addition to other penalties which exist under other tax law and bank secrecy law provisions.  Failing to file required returns, particularly those related to foreign assets or entities, can result in draconian penalties and criminal prosecution.  Moodys LLP Tax Advisors has an experienced team of US tax experts who can assist you with catching up past filings and finding solutions to your tax problems.
 

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This blog was authored by Kristina Ash JD (US), LL.M. (US Tax)

The US Government has required its citizens to report on their foreign bank accounts since 1970; however, its controversial revisions of October 2008 continue to cause tax practitioners, citizens and persons doing business in the US headaches.  We expect the US Government to aggressively enforce these reporting requirements since they assist the US Government in identifying abusive offshore accounts such as the UBS accounts (discussed in our blogs on September 8, 2009 and February 10, 2010).

The foreign bank account reporting requirements are promulgated under the Bank Secrecy Act,1 not the Internal Revenue Code (“IRC”).  If a US person has a financial interest in or signature authority over financial accounts in a foreign country where the aggregate value exceeds $10,000, that US person is required to file a Report of Foreign Bank and Financial Accounts (“FBAR,” Form TD F 90-22.1) on or before June 30 of the succeeding year.  The potential penalty for an inadvertent failure to file is $10,000; a wilful failure could cost as much as $100,000.  In the 2000 version of the FBAR form, the term “United States person” was defined in manner similar to that in the IRC:

United States Person. The term "United States person" means (1) a citizen or resident of the United States, (2) a domestic partnership, (3) a domestic corporation, or (4) a domestic estate or trust.2

In October of 2008, the IRS released a revised FBAR form and accompanying instructions. In the 2008 version, the definition of US persons was expanded to include foreign persons who were doing business in the US.  For example, under that definition, a Canadian salesperson from Calgary who goes to Texas once a month to, say, sell oil pumps, would probably be required to report each of his/her personal Canadian bank accounts to the US government.  This revised definition caused panic for some Canadians.

On June 5, 2009, the IRS admitted that it “received a number of questions and comments from the public concerning the new filing requirement.”3 It temporarily suspended reporting requirements for those persons who were not US citizens, residents, or domestic entities for the FBARs due on June 30, 2009, and directed the public to rely on the prior (2000) FBAR definition of a US person.  Now, the Canadian salesperson in the previous example had a reprieve from the FBAR reporting, but only for the 2008 reporting year.

On February 28, 2010, the IRS published two documents that attempted to further clarify the confusion over its 2008 FBAR form.  First, in IRS Announcement 2010-16 (Feb. 28, 2010), it continued its suspension of a filing requirement for non-US citizens, residents or entities, and expanded the suspension to FBARs which would otherwise have been required to be filed for the 2009 and earlier years.  Second, the IRS published IRS Notice 2010-23(Feb. 28, 2010) that changed its rules for some filers with signatory authority and some people with foreign hedge funds or private equity funds.  The Notice temporarily suspended reporting requirements for persons who have signature authority over, but no financial interest in, foreign accounts until June 30, 2011. Note that the temporary suspension for the signature authority only covers those persons who do not have any other interest in foreign accounts. The Notice also provided relief for persons with an interest in or signature authority over foreign hedge funds or private equity funds.  Relief was not extended to persons with interests in foreign mutual funds.

The end result of this additional IRS guidance issued in 2010 is that foreign persons who are not US citizens residents or domestic entities are generally not required to file an FBAR form.  This is generally great news for Canadians!  Additionally, US persons with interests in foreign hedge funds or foreign private equity funds are not required to report such interests to the US Government.  US persons who hold separate interests, joint interests or signature authority over foreign financial accounts (so long as that is not their only foreign account) are still required to deliver Form TD F 90-22.1 to the US Treasury by June 30, 2010.  To determine whether you have a reporting requirement under FBAR, feel free to contact our US tax group.

1 31 USC §§5311–5331.
2 IRS Announcement 2010-16 (Feb. 28, 2010) (quoting the July 2000 version of the FBAR instructions).
3 IRS Announcement 2009-51 (June 5, 2009).

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Apologies in advance ... this is lengthy and a little technical but it's a complex topic!

Notwithstanding the recent weakening of the Canadian dollar, the decline in the value of US real estate may still present some attractive buying opportunities for Canadians.

The acquisition of US real estate by a Canadian resident not only has Canadian tax implications, but may also create US income, gift and estate tax consequences.

The sale or rental of US real estate by a Canadian resident requires that the Canadian have or obtain a US Individual Taxpayer Identification Number ("ITIN") and is required to be obtained prior to the US tax reporting of the income. The application for an ITIN is IRS Form W-7.

There are a number of alternatives in which US real estate may be acquired and owned; each resulting in specific tax consequences and benefits. These alternative forms of ownership include individual, joint, trust, partnership and corporation.

A Canadian resident who is not a US citizen and is not domiciled in the US is subject to US estate tax on the fair market value of “US-situs” assets held by the individual at the date of death. A Canadian resident may become a US resident for US income tax purposes if he or she obtains a US green card or if the "substantial presence" test is met. The substantial presence test is met where a person is physically present in the US on at least 31 days in the current year AND 183 days during the 3-year period that includes the current year and the 2 immediately preceding years counting:

                   All the days you were in the US in the current year, and
                   One-third of the days you were in the US in the first preceding year, and 
                   One-sixth of the days you were in the US in the second preceding year.

However, the "closer connection" exception may be available to a non-resident of the US who meets the substantial presence test (IRS form 8840), as long as he or she (1) maintains a tax home in a foreign country, (2) has a closer connection to a foreign country, and (3) is present in the US for fewer than 183 days during the current calendar year.

With respect to Canadian residents who are neither US citizens nor US domiciliaries, their US estate tax exposure is isolated to their “US-situs” assets, including US real estate held personally. Therefore, where US real estate is held directly by a Canadian individual, US estate tax exposure may exist.

The Canada - US Treaty may exempt the Canadian individual from US estate tax through the "prorated unified credit" provided that the fair market value of his or her worldwide gross estate is less than US$2 million for 2008 and US$3.5 million for 2009. Furthermore, if the Canadian individual is married and the US situs assets pass to a surviving Canadian spouse, the US$2 million (or US$3.5 million for 2009) threshold is increased to approximately US$4 million (or US$7 million for 2009) under the Treaty.

Notwithstanding that a foreign tax credit in Canada may be available with respect to US estate tax paid, the utilization of a foreign tax credit will be limited or unavailable if there is little or no US source income in the year of death reported on the Canadian tax return of the decedent. The current maximum US estate tax rate is 45% on taxable estates greater than US$2 million in 2008 (or US$3.5 million for 2009).

Using the example of a single Canadian with a US vacation home worth US$500,000 and worldwide assets (including the US vacation home) with a fair market value US$5 million, US estate tax exposure is approximately US$80,000 (using 2008 rates). Using the example above, but assuming that the Canadian resident is married to another Canadian resident (and leaves the property to the spouse), US estate tax would be nil (through the utilization of the Treaty prorated unified credit and the Treaty marital credit).

Joint ownership is a common form of real estate ownership between spouses and family members. Notwithstanding that joint tenancy simplifies the transfer of real estate upon death it is not an effective form of ownership for US estate tax purposes. The common misconception with respect to 50/50 joint ownership (between spouses for example), is that only the decedent's 50% interest in the US real estate forms part of their US gross estate. However, for foreign individuals, this is only the case if the surviving joint owner can establish that he or she contributed his or her own funds with respect to the purchase price of the US real estate.

The use of a non-recourse mortgage on the acquisition of US real estate may result in the deduction of the mortgage from the fair market value of the US real estate for US estate tax purposes. However, obtaining such a mortgage might be difficult, and there are the higher interest costs to consider.

Some structures utilized to own US real estate and mitigate US estate taxes include certain Canadian corporations, trusts and partnerships. Such structures also carry increased administrative and compliance costs. Where a Canadian corporation is used and the US real estate is used personally by the shareholder, a taxable shareholder benefit may result in Canada, and the US may look through the corporate structure for purposes of applying US estate tax. This will often, if not always, eliminate the Canadian corporate alternative. In addition, any net rental income, or capital gains on the sale of the US real estate will result in additional layer of taxation at the corporate level. These tax rates are generally higher than if the US real estate was held personally.

An alternative to a Canadian corporate vehicle is a Canadian partnership. However, where the US real estate is to be utilized solely for personal use, a partnership may cease to exist under Canadian law on the basis that the endeavor is non-commercial in nature. The partners and not the partnership will be subject to tax, thereby accessing the personal tax rates. Also, the shareholder benefit rules should not apply to the Canadian partnership. For US purposes, the partnership may be treated as either a partnership or corporation depending on whether a "check the box" election is made. In this regard, it may be possible to retroactively "check the box" to elect to treat the partnership as a corporation prior to the death of a partner in an effort to mitigate US estate tax exposure.

Another structure that can be used to mitigate US estate tax involves purchasing the US real estate through a Canadian resident discretionary trust. The trust would be created and funded by a family member for the benefit of his or her spouse and family. Sufficient cash would be contributed to the trust (by the settling/contributing family member) to facilitate the trust's purchase of the US real estate. In order for this structure to work, the settling/contributing family member cannot be a trustee, or beneficiary of the trust, nor can he/she enjoy any of the financial benefits of the trust or affect the enjoyment of any of the beneficiaries.

As Canadian residents, we are taxed on worldwide income for Canadian tax purposes. Therefore, if you rent out US real estate, the net rental income will be subject to tax in Canada. In addition to the Canadian tax on US source rental income, the US will also tax the rental income either as a 30% withholding tax on gross rents, or on net rental income through the filing of a US non-resident income tax return. Where the US real estate generates positive net rental income, a US state income tax return may also be required.

When selling US real estate, Canadians are not only subject to Canadian tax on the gain, but subject to US federal, and state if applicable, income tax. The disposition of US real estate often triggers a US tax return filing requirement regardless if there was no gain or profit on the sale. Foreign exchange gains and losses, as applicable, would also be factored into the computation of the gain or loss on the sale of the US real estate.

The sale of US real estate may also result in US federal and state withholding tax being withheld on the gross sale proceeds. The withholding tax can be used to offset any US tax liability triggered on the sale, and is claimed when filing the US tax returns.

As can be seen from the discussion above, the attractiveness of taking advantage of the depressed US real estate market, or escaping the Canadian winters, needs to be balanced with a full understanding of the related Canadian and US tax consequences. We would be pleased to discuss the tax implications of the various alternative structures available with respect to the acquisition and ownership of US real estate with you.
 

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