Being an American citizen is, for many around the world, a highly sought after position. Some might call it a gift, though I doubt the United States IRS would classify it that way. In fact, for the IRS, American citizenship is only one half of the bargain. At least, this appears to be the mindset behind how the United States has structured its income tax laws. Unfortunately, American citizens are required to file a U.S. income tax return on all worldwide income and a Foreign Bank and Financial Accounts Reporting (FBAR), regardless of where in the world they reside.
Up until recently, most U.S. citizens residing outside of the United States were unaware of this responsibility. Though this responsibility has always existed, the IRS did not take an aggressive stance on it until 2011. Since then it has issued warnings that citizens found to be out of compliance with their income tax returns and FBAR may be subject to both civil and criminal penalties, plus interest on any taxes due.
Generally, U.S. citizens in Canada are protected from double taxation under the Canada-United States Convention with Respect to Taxes on Income and on Capital, commonly referred to as the U.S.-Canada Tax Treaty. Under this Tax Treaty, U.S. citizens are granted a credit against their U.S. taxes owed for taxes paid in Canada. This does not eliminate the requirement to file yearly income tax returns with the IRS.
Complicating the matter though for U.S. citizens residing in Canada is that the IRS taxes income, whether distributed or accrued, in Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs) in the same year in which it is generated. Tax is not deferred until distribution, like in Canada, unless the beneficial owner of the RRSP or RRIF filed an IRS Form 8891 with a timely filed IRS Form 1040 income tax return. A timely filed IRS Form 1040 means that it was filed no later than any officially approved extensions. The long and short of it is that no one filing an amended 1040 right now for prior years can make the retroactive choice to defer tax on their RRSP or RRIF earnings.
What is a U.S. citizen residing in Canada to do?
When the IRS issued a statement for U.S. citizens and dual citizens residing abroad in December 2011, it stated that filing the last six years worth of income tax returns and FBARs would generally bring a U.S. citizen back into compliance. If no income tax was owed to the IRS in any of these previous six years no penalties would be levied, or if the taxpayer could show a reasonable cause for not being aware of filing requirements then no penalties would be levied even if taxes were owed. The same essentially held true for FBAR filings, which are required when a U.S. citizen’s aggregate foreign financial accounts, including accounts holding RRSPs and RRIFs, at any point during the year equaled $10,000 or more. FBAR filings had a further need to show that there was no intention to conceal income, or assets. In January 2012, the IRS re-introduced the Offshore Voluntary Disclosure Program (OVDP), through which those who are FBAR non-compliant and fear civil or criminal prosecution, may become compliant with their FBAR filings and limit exposure to any applicable civil or criminal consequences.
Positive changes are coming though.
On June 26, 2012, the U.S. IRS announced new procedures that will go into place on Sept. 1, 2012, for filing compliance. Doug Shulman, the IRS Commissioner, introduced these new procedures as, “…a series of common-sense steps to help U.S. citizens abroad get current with their tax obligations and resolve income issues.” These new procedures are aimed at tax payers who are low compliance risks. Additionally, there is new relief for U.S. citizen holders of Canadian RRSPs and RRIFs.
As of Sept. 1, 2012, U.S. citizens are only required to file delinquent tax returns for the past three years, as opposed to the previously required six years worth. Those whose tax returns show $1,500 USD or less of tax owed in each of the previous three years will not be subject to penalties or additional enforcement action. The IRS will continue to scrutinize and potentially penalize any U.S. citizens with back taxes due greater than $1,501 USD in any of the past three years. Since Canadian income tax is as a general rule higher than its American counterpart, a U.S. citizen who is compliant with his Canadian income tax filings will likely not owe additional income tax to the IRS. Therefore, most Canadian resident U.S. citizens can now become tax compliant without fear of audits or penalties by the IRS.
Another major change under these new procedures for U.S. citizens residing in Canada applies to deferral of taxes on RRSPs and RRIFs. Taxpayers are now allowed to seek relief for failure to file a timely IRS Form 8891 for their RRSPs or RRIFs. This removes the stress of having any potential taxes owed on RRSPs or RRIFs, and allows the U.S. citizen to get their retirement accounts back into compliance.
According to the IRS, in order to take advantage of this new procedure for RRSPs or RRIFs the following must be submitted:
- A request for a time extension to make an election to defer income tax on the RRSP or RRIF that includes the relevant tax treaty position;
- A Form 8891 for each tax year, along with a description of the type of retirement or savings plan; and
- A statement that explains why the taxpayer failed to previously make the election, including the events that led to the failure and the eventual discovery of said failure, as well as the name(s) and nature of work of any professional advisor(s) upon whom the taxpayer relied.
While somewhat burdensome, completing the above paperwork along with three years’ worth of amended Form 1040s may save many U.S. citizens resident in Canada from being subject to a higher tax bill and increased IRS scrutiny. By completing the above, the taxes on RRSPs and RRIFs for these three years should be deferred until the date of distribution and not counted as part of the U.S. citizen’s annual income.
The only aspect not seeing major changes under the new procedures is the FBAR. The IRS continues to require either FBARs for the prior six years, or participation in the Offshore Voluntary Disclosure Program (OVDP).
If a U.S. citizen chooses to submit FBARs for the prior six years under the new procedures then he or she is no longer eligible to take advantage of the OVDP. Any U.S. citizens concerned with potential criminal prosecution by the IRS and the Department of Justice for noncompliance with the FBAR should note that they are not protected from such prosecution if they choose to file six years of FBARs under the new procedures. Instead they should consult with a legal advisor and consider filing an OVDP.
While these new procedures still require effort and expense on the part of the taxpayer they greatly decrease the likelihood that U.S. citizens residing in Canada will be subject to large tax bills, audits, or worse, penalties by the IRS. I, for one, am pleased that the IRS has chosen to take a common-sense approach to help the average U.S. citizen living abroad come back into compliance with the IRS. Certainly Americans living in Canada should be breathing a sigh of relief over these new procedures. Now with a little help from accounting and tax professionals most U.S. citizens north of the border should be able to come back into compliance with little or no stress.
The information contained herein is for informational purposes only, and is not legal advice or a substitute for legal counsel. It is not intended to be attorney advertising or a solicitation. If you have a legal question please consult with a licensed attorney.