Tax tips for Americans in Canada

Recommendation No. 1: Seek advice on reporting requirements

Most countries, including Canada, do not tax on the basis of citizenship. For example, Canadian citizens who live in Canada pay tax in Canada on the taxable income they earn. If a Canadian citizen moved abroad a few years ago, with no continued ties to Canada, it is most likely this individual would be considered “non-resident” and would have no tax reporting obligation to Canada. In other words, Canadians are taxed based on residency.

The U.S. tax system is different as it treats all U.S. citizens as U.S. residents for tax purposes, no matter where they live in the world, including Canada. Many U.S. citizens live in Canada and are resident here. A U.S. citizen has to pay tax in Canada on taxable income if they are resident for Canadian tax purposes.   Canada and the U.S. have entered into various agreements (i.e. tax treaties) to address taxation differences and to largely avoid double taxation.  

The Internal Revenue Service (IRS) in the U.S. has been trying to crack down on American taxpayers using financial accounts held outside of the U.S. to evade taxes. For example, the U.S. introduced the Foreign Account Tax Compliance Act (FATCA), signed into law on March 2010, with the objective of identifying taxpayers evading taxes. To do that required co-operation from other countries to provide information.  

The U.S. effectively told Canada that if it did not comply, then all income from U.S. investments would be subject to a 30 per cent withholding tax. This threat of withholding was for both registered and non-registered investment accounts.

Previously, Canada was not required to withhold any tax on U.S. investments held in registered accounts. For non-registered accounts, the negotiated tax treaty had withholding rates on U.S. dividends at 15 per cent and nil for US interest income.

Earlier this year, Canada and the U.S. signed an Intergovernmental Agreement (IGA) regarding FATCA, in which Canada agreed to pass laws requiring that, primarily through financial institutions, that annual reports be made to the Canada Revenue Agency on specified accounts held in Canada by U.S. persons. The agreement brings Canada, via the CRA, into a reporting agreement to satisfy FACTA.

Under the agreement, the U.S. has agreed not to apply the 30 per cent withholding tax on registered accounts, such as RRSPs, TFSAs and RESPs, and to maintain the existing withholding rates for non-registered accounts.

Effective July 1, 2014, an amendment to the Canada Income Tax Act adopting Canadian tax regulations related to FATCA.   Also beginning in July 2014, financial institutions have new requirements to report to the CRA, not the IRS. Clients of financial institutions will be required to complete additional mandatory questions for all non-registered accounts. New account-opening forms will require you to state if they are a citizens of Canada, and if they are a citizen of the U.S. Another question is, “Are you a U.S. Person (Entity) for tax purposes?” Certain legal entities must answer a new classification question relating to active or passive entity.

For the purposes of FATCA, here are some examples of who is deemed a U.S. Person (Entity):

  • U.S. citizens, include persons with dual citizenship, U.S. residency,
  • Any person who meets the IRS “Substantial Presence Test of U.S. Residency,”
  • U.S. resident aliens (Green Card holders who do not have U.S. citizenship),
  • Persons born in the U.S. or who hold a U.S. Social Security Number (SSN) or U.S. Tax Identification Number (TIN) or a U.S. Place of incorporation or registration

Financial firms have a mandatory obligation to provide this information to CRA. CRA will begin sharing relevant information pertaining to the agreement with the IRS starting in 2015.

For the majority of Canadians, this is a non-issue. For the approximately one to two million people in Canada that would be deemed a U.S. Person (Entity), it reinforces the need to have all of your tax filings up to date with both the IRS and CRA.

Sharing information electronically between CRA and the IRS will enable the IRS to obtain information on U.S. Persons (Entities) that have not fulfilled their reporting obligations.

Other indicators must also be reviewed, including U.S. address (residence, mailing, in-care-of, or interested party), U.S. telephone number, standing instructions to transfer funds to an account held by the client in the U.S., a power of attorney or signatory authority granted to a person with a U.S. address.

Many snowbirds have asked me what their requirements are under FATCA. Reviewing the “Substantial Presence Test of US Residency” on the IRS website is a good starting point. A wealth advisor should have enough knowledge about FATCA to make sure your accounts are documented correctly and that they are asking you the right questions.

I recommend every client who is not sure if they have a reporting obligation to consult with an independent tax advisor to determine if they are a U.S. person for tax purposes. It is important that the accountant you approach has knowledge in these areas to be able to provide you appropriate advice.

Effective July 1, 2014, financial institutions are required by law to report annually to CRA on accounts where a client is unwilling or unable to provide documentation for FATCA, one of more U.S. owners are specified ”U.S. Persons,” undocumented account holders for FATCA purposes, and passive entity with one or more controlling persons that are specified “U.S. Persons.” The information that must be sent to CRA includes name, address, TIN/SIN and total account value.

If you are not sure if you have a reporting obligation, we encourage you to speak with your wealth advisor who should be able to communicate with your independent tax professional, and together ensure your financial accounts are documented correctly and you are fulfilling your reporting requirement, if any.  

This article is intended as a general source of information and should not be considered as personal investment, tax or pension advice. We are not tax advisors and we recommend that individuals consult with their professional tax advisor before taking any action based upon the information found in this publication.

Corporate investment accounts

Successful businesses often have a significant amount of cash sitting in a bank account earning two per cent or less – zero in some cases.  Having cash for an extended period of time can impact long-term growth, and your retirement plan.

Let’s use as an example a medical corporation with $100,000 sitting in cash earning 1.5 per cent a year.  In ten years time the compound growth amount would be $116,054.

Now compare the compound growth of $100,000 with the incremental impact of a one per cent change, if invested:

Return Value in Ten Years
2.5% $128,008
3.5% $141,060
4.5% $155,297
5.5% $170,814
6.5% $187,714

To make matters worse, the taxation of interest income in corporate bank accounts are fully taxable, with no deferral ability.  The above numbers in the table are not after tax.

Creating a deferral strategy within a corporate “investment” account can have a positive tax impact if implemented correctly.  Opening an investment account is straightforward.

It is not necessary to have your new investment account at the same place as your corporate bank account.  When the company was created, there were legal documents drawn up such as Articles of Incorporation.  Every year your company is required to pay an annual fee and you obtain a Certificate of Annual Filing, which should be filed in your corporate record book.

The record book is often kept with a lawyer who helps owners complete other documents like annual minutes.  Some people have these documents at home enabling them to avoid paying for the above services.  In these cases, it is important that you complete the required paperwork every year.

A copy of the above corporate documents is required to open an account, along with a void corporate cheque, size of company, and information about the authorized signing authorities.

Assuming you have just opened a new investment account, you can transfer funds into this account by simply writing a corporate cheque payable to the financial firm you are dealing with (include your corporate account number in the memo field and request a receipt).

If you ever require money to be moved back into your bank account, this can be done either electronically (details obtained from void cheque during account opening) or by cheque.

Prior to any investing within the corporate account it is important to establish an Investment Policy Statement.  The IPS will outline time horizon, risk tolerance, and investment objectives.

For corporate accounts we like to approach it through a visual three bucket process:

  • Bucket No. 1 is for cash and emergency purposes.  Depending on the type of business, this bucket is adjusted accordingly.  Some businesses are more cyclical than others.  Obtaining an idea of your cash flows, and how variable they are should help establish a suitable cash reserve.  The focus on this bucket should be liquidity and safety.  Suitable investment options for this bucket may be cash equivalents such as high interest savings accounts, cashable GICs, and short term fixed income.
  • Bucket No. 2 is for growth and this should be tied to  your business plan.  Every company should have at a minimum, a five year business plan.  Sharing the cash flow component of this plan with your advisor may help determine the most suitable investments.  As an example, if you have expansion plans in three years then fixed income options provide for capital preservation with a higher potential return than cash.
  • Bucket No. 3 is for portion set up for a longer period of time, such as retirement.  Depending on your IPS, this bucket may hold tax efficient type investments like preferred shares and investments set up for tax deferred growth like dividend paying common shares.   Setting up a Dividend Reinvestment Plan (DRIP) helps with long-term growth.  This bucket should be the largest of your buckets, provided you do not have growth plans and the business has stable positive cash flows.

An understanding of tax is very important in mapping out a strategy for corporate investment accounts.  Corporate tax rates on qualifying active small business income are very low in British Columbia.  The term “active” is important, and differs from how interest income, dividend income, and taxable capital gains are taxed.  Three areas that we ensure our clients understand is Part IV tax, Refundable Dividend Tax on Hand (RDTOH), and the Capital Dividend Account.

Accounting for corporate accounts is easier if you communicate to your advisor a few key items.  Let them know the fiscal year end of your company and the name of your accountant with contact information.

Similar to individuals, companies can do tax loss selling and carry net capitals losses back provided the trades settle in the fiscal year end.  Most financial advisors have the ability the save transactions in an electronic format, along with electronic monthly statements and realized gain/loss report.   This can be emailed to your accountant annually to save them time inputting each transaction.

Should business owners and professionals contribute to an RRSP?

Registered Retirement Savings Plans were initially deisgned for people who did not belong to a pension plan, including self-employed business owners. But some financial advisors and accountants encourage incorporated business owners and professional clients to avoid RRSPs because:

  • B.C.’s small business income threshold increased from $400,000 to $500,000 as of January 1, 2010. 
  • Effective March 19, 2007 the Lifetime Capital Gains Exemption increased from $500,000 to $750,000 for small business corporation shares. 
  • Effective January 1, 2010, B.C.’s small business corporate tax rate on active business income (up to $500,000) is 13.5 per cent.

Let’s take a step back in time when B.C. corporate tax rates were higher and the small business income threshold was lower. Most owner managed businesses would have regular payroll set up to pay themselves. This was an added administrative cost. It also meant remitting income tax and CPP (both employee portion and employer portion for owner managed businesses). An owner of a business would effectively be paying twice the amount into CPP, with only one half of this amount being tax deductible for the corporation. At year end, it was common to give the owner an additional management fee or a bonus to reduce taxable income in the corporation, and increase income personally.

The regular payroll/wages, plus any management fees or bonuses were all considered “earned” income. This is significant in how it relates to RRSP accounts. Your annual RRSP deduction limit is increased by multiplying your previous years earned income by 18 per cent (up to a yearly maximum). Annually it made sense for business owners to contribute to an RRSP. This effectively reduced current year income personally, and allowed business owners to tax shelter funds for retirement.

Let’s fast forward to today. With corporate tax rates so low, many accountants are advising to have the income taxed fully in the corporation and avoid paying any wages or bonuses (or at least a reduced amount). The one main exception to this would be professionals who pay an annual fee into an association that provides a matching RRSP program. As an example, doctors who pay British Columbia Medical Association dues have an RRSP matching program. In these cases we recommend that doctors take advantage of this program to make paying the dues worthwhile. This results in some wages which need to be paid in order to generate the RRSP deduction limit.

Assuming no wages, management fees, or bonuses are paid then the total net income would be taxed within the corporation. The net income after tax is added to retained earnings. If the owner/shareholder required cash then a dividend would be paid from retained earnings. Dividends are taxed at a considerably lower rate then wages.

The downside to dividends is that they are not considered “earned income” and as a result no RRSP deduction is created. The other component to factor in is that you are not paying into CPP (both employee and employer) annually when dividends are paid. The maximum employer portion of CPP is $2,163.15, and maximum employee portion of CPP is $2,163.15. Self employed business owners effectively pay a combined maximum of $4,326.30 for 2010 if earnings are $47,200 or greater.

By paying dividends, this comes with CPP saving today, but a sacrifice in the future. Unlike OAS which is based on residency, CPP is based on your reported earned income and CPP contributions. If you do not pay into CPP, then you should not expect to receive CPP at retirement. If you pay only a little into CPP, then you should expect to receive a little CPP at retirement.

Every time legislation changes people should take a pause to determine if what they have always done still makes sense. Is there a better strategy to provide for flexibility or to reduce taxes longer term?

An example of this is the introduction of the Tax Free Savings Account and Registered Education Savings Plan. Business owners can use both of these types of accounts to tax shelter income and to obtain the deferral benefit that an RRSP provides.

One of the benefits of corporate investment accounts is that investment counsel fees and interest expense, relating to the investments, may be tax deductible. These are not tax deductible within an RRSP.

Margin account agreements are not possible within an RRSP. With RRSP accounts, you are forced to begin pulling funds out at age 72. In some of these cases, this results in OAS being clawed back. With a corporate account there is no requirement to pull funds out. After going through some periods of volatility, investors should appreciate the ability to claim a loss if they have them.

Net capital losses in a corporation may be carried back up to three years or to offset taxable capital gains in the future. Losses within an RRSP cannot be claimed.

When we are talking to business owners, the number one misconception we come across is the belief that when the active business is done, the corporation is wound up at the same time. This is generally not the recommended strategy. In some cases where shares are sold, then the financial assets would typically have been moved to a holding company and only the active company is sold.

There are other reasons to have a holding company in addition to an operating company – cleansing for the lifetime capital gains exemption, income splitting, creditor protection and ease of selling. In many cases we are assisting people with the investments within the holding company as they get built up and through retirement.

Building up equity within a corporation provides flexibility and it makes sense today. There are some tax efficient ways, utilizing insurance products, to move retained earnings out during your lifetime and at death that are certainly more appealing then paying 44 per cent (or more) of your RRIF to the government on death.