Established in 1979
Covering
U.S. Tax, Immigration, and Financial Matters Affecting Canadian Non-Resident
Aliens Of The United States*
FALL 1995/Vol. 11 No. 3
The first non-immigration question you or your Canadian employee may ask is "how will my taxes change when I work in the U.S.?"
Tax considerations can often make or break a transfer to the U.S. These tax equalization issues can come squarely within the responsibility of the HR Manager. (See a complete checklist of all HR issues relating to Canada to U.S. employee transfers.)
Richard Brunton has answered these tax questions for over twenty years. His newsletter is the best source of current information for your relocating employees.
We are pleased (and honored) to share our Web site with Mr. Brunton. This is the first time the Taxletter has been on-line.
We urge you to take out a regular subscription to the newsletter for yourself. Consider securing a subscription for each of your transferring employees. Large tax savings can result. See the home page for links to other issues of this Taxletter.
CONTENTS-BRUNTON'S TAXLETTER
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Richard Brunton holds a Masters degree in Taxation/Accounting, in which his primary interest has been international taxation. He has been a resident of Florida for the past 22 years.
Mr. Brunton's firm assists these Canadians who:
His firm also assists U.S. citizens or U.S. Green Card holders, living in Canada.
Brunton's U.S. Taxletter for Canadians is published three times per year by Tax Reports Inc. It is available for US $30 per year. Please contact Mr. Brunton's office if you wish to subscribe:
Richard Brunton, CPA
4710
NW Boca Raton Blvd. Suite 101
Boca Raton, Florida
Voice: 407.241.9991
FAX:
407.241.6332
rb@taxintl.com
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by RICHARD BRUNTON
Readers are aware Canada and the United States agreed last year to major tax treaty changes (called the "Protocol") which were subject to "ratification" by the legislative bodies of both Governments. The ratification has now occurred in the U.S. and is expected in Canada shortly. The Protocol will enter into force the day the two countries exchange "instruments of ratification". All this should happen quickly now, perhaps by the time you read this Taxletter.
However the tax changes under the Protocol do not take effect on the day the instruments of ratification are exchanged. Each tax change has its own "effective date", (i.e. the date the change takes place). Most estate tax changes are effective retroactively to deaths occurring after November 10, 1988. Many of the other changes take effect on January 1, 1996, (assuming the instruments of ratification are exchanged in 1995). For the effective date of various withholding tax rate changes please see "NEW WITHHOLDING TAX RATES".
The Protocol contains a vast array of tax changes. A few of these changes are reviewed in this Taxletter in the articles "PROTOCOL MAY REDUCE YOUR U.S. ESTATE TAX", "PROTOCOL GIVES COMPLEX ESTATE TAX RETURN OPTIONS", "CLAIMING PROTOCOL-BASED ESTATE TAX REFUND", "NEW WITHHOLDING TAX RATES", and "NEW RULES FOR U.S. GAMBLING WINNINGS".
The interrelationship between the Canadian and U.S. changes stemming from the Protocol results in an incredibly complex set of cross-border tax planning options for many Canadians. For example, see "U.S. ESTATE TAX MAY REDUCE YOUR CANADIAN INCOME TAX".
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For many Canadians, the Protocol increases the amount of U.S. property that is exempt from U.S. estate tax. You were previously entitled to a "unified tax credit" of $13,000 which had the effect of exempting $60,000 of U.S. property from estate tax. Now you have three main new benefits under the Protocol which may dramatically increase your exemption.
These benefits (which you can combine) are as follows:
1) Proportionate Unified Tax Credit,
2) Marital Tax Credit, and
3) Special Exemption for Estates not exceeding US $1.2 million.
The estates of individuals who died after November 10, 1988 may be able to claim refunds based on these new rules. However in many cases you will only have one year from the date the Protocol enters into force to make your claim.
U.S. citizens and domiciliaries receive a unified tax credit of $192,800 instead of the $13,000 credit generally available to nonresident aliens. You will now be entitled to a proportion of the $192,800 unified tax credit, depending upon the proportion of your worldwide property that is located in the United States when you die.
Example 1: Robert passes away June 1, 1996 when his Canadian and other worldwide property total US $850,000, which includes U.S. property solely owned and valued at US $170,000. Since 20% of Robert's property is located in the U.S., his estate receives a unified tax credit of $38,560 (20% of $192,800). The U.S. federal estate tax is as follows, ignoring potential deductions:
New Rules Old Rule Taxable amount 170,000 170,000 Tentative federal estate tax 45,200 45,200 Unified Credit 38,560 13,000 Net federal estate tax before other credits6,640 32,200
You can see the amount of U.S. property that is exempt from U.S. federal estate tax is indirectly dependent on the proportion of the worldwide property that is located in the United States. To determine the amount of your own U.S. property that is exempt, based on the unified credit, please refer to the second column of Table A which provides examples from the Fall, 1994 issue of the Taxletter.
If your worldwide property does not exceed US $600,000 when you die it is likely there will no U.S. federal estate tax, provided you made no prior U.S. taxable gifts.
In addition to the unified tax credit, you are potentially entitled to a marital tax credit on the portion of your U.S. property that goes to your surviving spouse, provided certain other important rules are followed. The marital tax credit can equal but not exceed the unified tax credit.
Example 2: Assume the same facts as example 1, except the U.S. property owned by Robert is jointly owned with his spouse (tenancy by the entirety) and that Robert had contributed all the purchase funds.
The estate tax computation is as follows, ignoring potential deductions:
New Rules Old Rules Taxable amount $170,000 $170,000 Tentative federal estate tax 45,200 45,200 Unified Credit 38,560 13,000 Marital Credit 38,560 ------ Total Tax Credits 77,120 13,000 Net federal estate tax before other credits 0 32,200
To determine the amount of your own U.S. property that is exempt from U.S. federal estate tax under the combined unified and marital credits, if all your U.S. property goes to your surviving spouse, please refer to the third column of Table A which provides examples from the Fall, 1994 issue of the Taxletter.
To qualify for the marital tax credit your executor must make a special election and waiver by a prescribed deadline.
If the value of your worldwide property does not exceed US $1.2 million at the date of death, and you were never a U.S. resident, you will only be subject to U.S. estate tax on U.S. real estate, certain U.S. real estate-related property including the shares of U.S. companies that are predominantly real estate companies, and certain U.S. business property.
Example 3: Michael passes away June 1, 1996 at which time his Canadian and other worldwide property total US $900,000. The U.S. property totals US $270,000, including shares in U.S. companies purchased in Canada valued at US $100,000, a U.S. boat valued at US $50,000 which always remained in the U.S., and a U.S. condominium valued at US $120,000. The U.S. companies owned no U.S. real estate.
Since Michael's estate does not exceed US $1.2 million the shares in U.S. companies and the U.S. boat are exempt. The amount subject to estate tax is as follows, ignoring potential deductions:
New Rules Old Rules Taxable amount $120,000 $270,000
Remember to include your RRSP or RRIF in your worldwide property.
TABLE A % of Your Gross "Exempt" U.S. "Exempt" U.S. Estate Located property Under Property if Both in the U.S. Unified Credit Credits Apply 7% $61,908 $110,640 10% 83,857 149,200 20% 149,200 268,588 30% 209,500 382,000 50% 325,295 600,000 100% 600,000 1,097,073
Table A shows the amount of U.S. property potentially "exempt" from U.S. federal estate tax under the proportionate unified tax credit, (and the combined proportionate unified and marital credits), based on the proportion of property located in the United States, assuming all requirements are met, there were no prior taxable gifts, and (in the case of the marital credit) all the U.S. property goes to the surviving spouse.
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Did you receive U.S. real estate rental income in past years but not report it on annual U.S. tax returns? What do you do now, since the "vise" is tightening and the various U.S. tax authorities are becoming more "nosy" about your U.S. affairs ?
Technically, you are required to file U.S. tax returns (or pay 30% withholding tax on gross rents) for all prior years you received rental income. Another section of U.S. law prevents you from deducting your expenses, and thus assesses tax on your gross rental income, if you file your tax return after a deadline. The deadline for individuals is 16 months after the due date for the return.
Up to now, in most cases the IRS seems to have been willing to let you file only the three most recent years (ignoring earlier ones) and waive the deadline for deducting expenses, provided you "allow" for all the depreciation you should have taken in all prior years. This lenient attitude may not last long. In any event, filing the prior returns will usually permit you to record losses you can carry forward to offset against future profits.
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The Protocol's estate tax rules are superimposed on top of the "old" estate tax rules without eliminating all the old rules. This will give a range of options on how your estate tax return can be prepared.
For example, suppose U.S. property is owed jointly by spouses John and Sarah (tenancy by the entirety) and John dies. Assume the property is valued at US $120,000 and 10% of John's property was located in the United States. From the third column of Table A, in the article "PROTOCOL MAY REDUCE YOUR U.S. ESTATE TAX" you can see the total value of $120,000 is exempt from U.S. estate tax because a) 10% of John's property was located in the United States and b) the U.S. property goes to Sarah since it was jointly owned, (up to $149,200 would be exempt).
However, to obtain this "exemption" John's estate must provide the U.S. Internal Revenue Service (IRS) with detailed descriptions and values of all John's Canadian property to prove the percentage of the worldwide property located in the United States. In many cases, (for example if there is an expensive Canadian residence or a Canadian business) the estate may have to obtain costly appraisals of the Canadian property and provide them to the IRS. Further, if some of the Canadian property was jointly owned with Sarah it may be necessary to prove to the IRS whether John's or Sarah's funds were used to purchase the Canadian property (the old "contribution" rule applies to Canadian property also).
Due to the cost and effort to obtain all this documentation the estate may find a different estate tax return preparation method less onerous.
For example, if John and Sarah received U.S. estate tax planning advice at the time of purchase of the U.S. property and they each issued their own check from their own funds for one-half the purchase price, John's estate is likely taxable only on one-half of the value of the property ($60,000). Since the estate is allowed to use the "old" $60,000 exemption, all the estate tax is eliminated on this simple basis, without having to disclose any of the Canadian property. Many other examples of alternative filing methods exist.
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You can potentially postpone U.S. tax on the sale of U.S. "investment" real estate if you exchange it for "like-kind" investment property. For example, you can generally exchange vacant land for other vacant land, a rental apartment building for vacant land, or vice versa.
You can even arrange for a deferred exchange in which you give up your property, but you do not immediately receive the other property (perhaps because you have not yet found acceptable replacement property). To qualify for this deferred exchange you must "identify" your replacement property within 45 days after you give up your own property, and you must receive the new property by the earlier of: a) 180 days after you gave up your property, or b) the due date for your tax return.
To "identify" the replacement property you can give written notice in a special format to another party to the transaction (other than a related party). Alternatively you can identify the property in a written agreement for the exchange of the properties. Qualifying for the deferred exchange is complex - please consult your professional tax advisor before proceeding.
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Many readers are aware a 10% U.S. withholding tax generally applies on the sale of U.S. real estate by a nonresident alien. This section reviews some of the rules.
Q: When does the 10% tax apply?
A: It generally applies whenever a non-U.S. individual or non-U.S. entity sells U.S. real estate. The withholding tax is 10% of the sales price of the real estate. Some exceptions apply.
Q: What is its purpose?
A: It is a prepayment of whatever U.S. "capital gains tax" you owe on your profit. (see the article"U.S. CAPITAL GAINS TAX ON YOUR REAL ESTATE SALE" ). If the withholding tax exceeds your U.S. capital gains tax you can obtain a refund of the excess.
Q: Is there a simple exemption from the withholding tax?
A: Yes. If the sales price is US $300,000 or less and the buyer (or certain members of the buyer's family) plan to "use the property as a residence" (and the buyer will sign an affidavit as such), there is an exemption from the withholding tax.
Q: What does "use the property as a residence" mean?
A: It means the buyer (or family) plan to reside at the property at least 50% of the time the property is used by any person during each of the first two twelve month periods following the date of sale. Vacant time is ignored.
Example: John is a semi-retired U.S. citizen living in Michigan. He is buying a Florida condo he will rent out 2 months annually and use himself three months annually. The condo will be vacant the remainder of the year. The transaction qualifies as "use as a residence" because John will use it more than 50% of the time it is occupied annually, excluding vacant time. (John will use it 60% of the time [3 months divided by 5 months total usage]).
Q: How do I arrange for this simple exemption?
A: First, determine if the buyer will use it more than 50%, then advise your closing agent. The closing agent will normally have a standard affidavit for the buyer to sign.
Q: Suppose the transaction does not qualify for the above exemption?
A: You may still qualify for a more complicated full or partial exemption. If your maximum U.S. capital gains tax on the sale is less than the 10% withholding tax you can apply to the IRS for a reduction in the withholding tax. However this takes time and probably involves some extra expense.
Example: Mary is selling her U.S. condo, which was never leased, and will receive net proceeds of $140,000 after commission and all other selling expenses. She purchased the condo in 1990. Her cost, including all relevant improvements, is $130,000. Her profit of $10,000 is subject to a maximum U.S. capital gains tax of $2,800 (i.e. 28% of $10,000, - please see the article "U.S. CAPITAL GAINS TAX ON YOUR REAL ESTATE SALE"). Since the withholding tax of $14,000 (10% of $140,000) exceeds the maximum tax of $2,800, she can apply to the IRS to reduce the withholding tax to $2,800.
For more information contact a U.S. tax advisor, or call the IRS Taxpayer Service at 1-215-516-2601, or obtain IRS Publication 515 from the IRS by calling 1-800-829-3676.
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The individual U.S. States impose their own estate tax, and tax treaties including the Canada/U.S. Protocol often do not apply to the individual States. Although the State tax is usually minimal compared with federal tax, and it can be deducted, in full or in part, from the federal tax, it could nonetheless be an unpleasant surprise if your estate expects to avoid all U.S. tax because of the Protocol, only to learn there is State tax payable.
It appears unclear what effect the new Protocol will have on State estate tax in every case. If there is federal estate tax payable despite the Protocol, it is possible all or part of any State tax will be a deduction from the federal tax. However if there is no federal tax payable due to the Protocol, will there be State tax payable? At the moment the answer appears uncertain, at least in some circumstances in some States. We contacted Florida for its opinion and we are awaiting a written response. We will report the response in the Taxletter once it is received.
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In addition to the tax treaty Protocol provisions there may be further good news for Canadians as a result of proposed estate tax changes to U.S. domestic law being considered in both the U.S. Senate and the House of Representatives.
The House of Representatives is considering an overall increase in the unified tax credit ("exemption") for all estates, including those of Canadians. The U.S. Senate is considering a change that would increase the estate tax "exemption" for family owned businesses.
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If you ever bet at a U.S. horse race, gambled at a U.S. casino, or entered a U.S. lottery, a U.S. withholding may have been deducted from your winnings. Winnings are normally subject to a 30% withholding tax (except blackjack, baccarat, craps, roulette and big-6 wheel - all of which we will call "exempt games").
But the tax treaty Protocol makes important changes. The exempt games are still exempt. However now you can deduct your losses against winnings in all other types of U.S. gambling and pay U.S. tax only on your net winnings. You can only deduct U.S. losses, and you cannot deduct losses from exempt games. This takes effect January 1, 1996 (assuming the Protocol's instruments of ratification are exchanged in 1995).
The present withholding tax of 30% will still apply when you receive your winnings. To obtain your refund you must file a U.S. tax return.
On the tax return you must be able to substantiate the losses you are deducting. Therefore you should keep an accurate record of your bets or other gambles, including the date, type, location, other persons present and, of course, details of the actual amount bet and the results.
Some specific documents to retain are:
Horse racing and dog racing: A record of the actual races, numbers, date and times, the details and results of each bet, and payment records from the racetrack.
Lotteries: The lottery name, ticket dates, unredeemed tickets, and details of each ticket including the amount paid and the result.
Slot Machines: Record the slot machine number, and keep a record of winnings by date and time.
Poker and other table games: Record the table number where you played, and casino credit card data, if applicable, indicating whether credit was issued in the pit or at the cashier's cage.
Remember: Do not destroy or throw away your tickets from losing bets. These tickets may be required to present to the IRS to obtain your refund. To the back of your U.S. tax return you should attach proof of the U.S. tax withheld, for example IRS Form 1042S.
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An annuity is an investment generally purchased from an insurance company. It can be either an "immediate" or "deferred" annuity depending on whether the payments to the beneficiary commence immediately or later at the "annuity starting date".
Is a Canadian subject to U.S. estate tax on a U.S. annuity? The Government's present attitude appears unclear. Normally U.S. securities are taxable (subject to certain treaty and other exemptions) whereas life insurance proceeds are exempt for nonresident aliens. Other investments that pay "portfolio interest" are exempt if all requirements are met. It appears a fixed income annuity without any associated "life risk" may be potentially exempt from tax under the "portfolio interest" rules if all proper paperwork is completed. However the Government has apparently not yet issued clear instructions. We will review "portfolio interest" investments in the next Taxletter.
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If you paid U.S. tax or had it withheld, and you are due a refund, you should claim it quickly. Otherwise you may forfeit the refund. This could apply, for example, if you had U.S. tax withheld on the sale of your U.S. real estate, or if you overpaid U.S. estate tax.
How quickly must you claim your refund? The rules are complex and depend partly on whether you filed an initial tax return. If you did not file an initial tax return, some U.S. tax court jurisdictions appear to suggest you must claim your refund within two years from the date the return was originally due. Another tax court jurisdiction indicates three years.
For most nonresident alien individuals on a calendar year tax basis, who do not receive U.S. wages, an income tax return is due June 15th following the end of the tax year. Thus, for many 1993 transactions, the refund deadline could be June 15, 1996.
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The tax treaty Protocol potentially creates a new tax credit for you in Canada. U.S. estate tax paid by your estate may reduce Canadian tax on your final Canadian income tax return.
For example, if you die owning U.S. real estate that has increased in value in Canadian dollars, the U.S. estate tax on the property can be used to offset your Canadian tax on gains deemed realized on the property at your death. In addition, the U.S. estate tax can be used to offset the Canadian tax on certain U.S. source income such as U.S. corporate dividends and certain U.S. wages.
For estates exceeding US $1.2 million additional benefits apply - for example the U.S. estate tax can be used to offset Canadian tax on gains from U.S. stocks deemed realized at your death.
Your affairs can also be structured so the U.S. estate tax offsets Canadian tax even in cases where your Canadian tax is deferred because your property goes to your spouse. However, picture the complexities when a deferral occurs! For example, consider the complications when the U.S. estate tax is payable immediately but the Canadian tax is deferred due to a spousal rollover, or the situation where both taxes are deferred through the use of a Qualified Domestic Trust in the U.S. and a spousal rollover in Canada, or when the tax in one or both countries is deferred but the property is sold before the death of the surviving spouse. Consult a qualified cross-border tax planning advisor!
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This section reviews some U.S. federal tax rules applying to the sale of your U.S. residential real estate that was never leased or used in business.
Q: Do I have to pay U.S. tax if I sell my U.S. residence?
A: If you sell your U.S. real estate for a profit you will likely have U.S. "capital gains" tax to pay, unless you have other qualifying deductions to offset your profit. Special rules apply for property purchased before September 27, 1980.
Q: What type of deductions qualify?
A: Certain losses carried over from a previous U.S. tax return you filed, or other current year U.S. "business" losses can be deducted. Of course you can deduct your selling expenses, and also property taxes and interest paid in the year of sale. A few other limited deductions are available.
Q: What is the tax rate?
A: The tax rate for long term capital gains (generally, but not always, property owned over one year) ranges from 26%-28% for individuals.
Q: When do I pay?
A: All or part of the tax may be withheld at the time of closing the sale. (See "REVIEW OF 10% WITHHOLDING TAX ON U.S. REAL ESTATE SALES"). If the entire tax has not been withheld you should make an immediate payment to the IRS or you may be subject to a penalty for underpayment of estimated tax. Otherwise you pay it with your U.S. tax return (see below).
Q: Anything else?
A: After the end of your tax year you must file a U.S. tax return to report the sale and pay any U.S. tax you owe. If you previously overpaid your tax you can claim a refund.
Q: Suppose I do not file the U.S. tax return or pay the U.S. tax?
A: The closing agent that handled your sale will be routinely sending IRS Form 1099-S to the IRS, giving the IRS the details of your sale including your name, Canadian address, and the sales price. The IRS can use the Form to question you if you do not file. The filing is required even if there is no profit.
Q: Suppose I already reported the sale on my Canadian tax return and paid capital gains tax to Revenue Canada.
A: The U.S. tax return is still required. You can likely reduce your Canadian tax by all or part of the U.S. tax you pay. Please consult your Canadian tax advisor concerning the Canadian tax credit.
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The estates of many Canadians who died after November 10, 1988 may be entitled to a refund of U.S. estate tax previously paid. (See "PROTOCOL MAY REDUCE YOUR U.S. ESTATE TAX").
The claim for refund can be made by filing IRS Form 843 (Claim for Refund) or by filing an amended Form 706NA (Estate Tax Return). Blank Forms can be obtained by calling the IRS at 1-800-829-3676.
Apart from your various strategic alternatives in preparing the refund claim, (please see "PROTOCOL GIVES COMPLEX ESTATE TAX RETURN OPTIONS"), you also have important procedural requirements such as:
1) The claim for refund must be filed by a deadline, which is the later of:
a) One-year from the date the two countries exchange the Protocol's instruments of ratification (the latter will likely be in the next few weeks), or
b) The normal deadline for claiming a tax refund.
It may take a year or more for the IRS to process the application and issue your refund. In the meantime, the IRS may not even acknowledge your filing. Therefore if you are constrained by the one-year requirement you may be in danger of forfeiting the refund if your claim is misplaced and a year elapses before you become aware of the problem. Or, suppose the IRS does not respond for over a year and then rejects your claim based on a technicality you can correct (e.g. lack of documentation of the value of Canadian property). If you cannot prove the claim was filed by the deadline there may be difficulty with the refund.
Hence you may wish to obtain proof of filing the claim. You can enclose a copy of your claim with the filing and request the IRS to acknowledge receipt of the copy and return it to you.
2) If you are claiming the marital tax credit (see"PROTOCOL MAY REDUCE YOUR U.S. ESTATE TAX" ) the claim must include an election and waiver of certain other rights related to the marital deduction,
3) When making a claim under the Protocol you must disclose your "treaty-based return position", (see IRS Form 8833). Otherwise a penalty of $1,000 applies for each failure to comply with the rules.
4) If you are filing an amended Form 706NA (Estate Tax Return) you should label the top of page 1 "Amended Return - Claim for Refund".
Other requirements may apply, depending on the basis for the claim.
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The tax treaty Protocol makes changes in the withholding tax rates on payments between Canada and the United States.
Some of the changes are set out below.
New Rate Old Rate Interest 1) 10% 15% Dividends 15% 15% Dividends 2) 7% for 1995 10% 6% for 1996 5% thereafter Canada Pension Plan/OAS 3) 25% 0%
1) Reduced withholding tax for interest will take effect the second month following the month the instruments of ratification are exchanged. For example, if they are exchanged in October, 1995, the change will take effect December 1, 1995.
2) Applies only to dividends paid to a corporation owning at least 10% of the voting shares of the company paying the dividend. The indicated rate commences the second month following the month the instruments of ratification are exchanged.
3) Commences January 1, 1996 assuming the instruments of ratification are exchanged in 1995.
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The next issue of the Taxletter will contain more information on the new tax treaty Protocol, including examples of tax computations and estate tax planning strategies to capitalize on the new rules. A review and update of U.S. rules on residency with the latest on Closer Connection Statements, and the taxation of U.S. financial assets including "portfolio interest" investments will also be included.
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*Applicable to residents of Canada only---addresses only U.S. Federal Issues---State and local issues may also apply. The information herein is provided for your general information. Action should not be taken on the basis of this letter. Action should only be taken on the advice of your professional advisor applying these rules to your specific situation.
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