Dual Citizen Returning to Canada

[bruce]

I am a dual citizen (US and Canadian). I used to live in Canada but emigrated to the US in 1998. I am now likely to return to Canada (perhaps permanently) and want to structure my situation appropriately. I apologize in advance for this long message but I would rather provide too much information than not enough. Here are the facts:

1) Previously when I lived in Canada, I contributed to RRSPs and declared all this income on my US tax forms. Since moving the US in 1998, I no longer file Canadian taxes; however, I understand that I will always have to file US taxes. In the US, since 1998, I have used the various revenue procedures and form 8891 to defer RRSP income. I still have the RRSPs and plan to start contributing again once I return to Canada. Because my past RRSP contributions did not defer any US tax, roughly 50% of the current value of my RRSPs is the US cost basis.

2) Until the year I emigrated, I never owed any US tax due to the Foreign Earned Income Exclusion and standard deductions & exclusions. I never needed to use foreign tax credits. Due to the recent changes to the Foreign Earned Income Exclusion (i.e. the "stacking" provision) that recently became law and the fact that I will have much more passive investment income, I will now need to use foreign tax credits to avoid/limit double taxation.

3) I expect my Canadian earned income to use up most if not all of the US Foreign Earned Income Exclusion.

4) Once I return to Canada, my income will differ significantly between my US and Canadian filings for several reasons: a) My Canadian cost basis for unsheltered investments will reset upon re-entering Canada (and therefore be much higher) so I expect to have up to $20k of additional capital gains declared on my US return vs. Canadian return. b) I have a Roth IRA that will have taxable earnings in Canada but not the US. c) my RRSP contributions will not be deductible in the US.

Here are my questions:

Q1) When I eventually withdraw from my RRSP, do I have to declare 100% of the withdrawals as income to the IRS or do I just declare the prorated amount above my cost basis (i.e. declare only earnings but not contributions)?

Q2) Since both Canada and the US have foreign tax credits, how do they interact? Should I calculate my US taxes first and collect a credit in Canada or should I start with Canada and use US tax credits? Assuming there is still some double taxation left over, should I then go back and re-calculate the first return with tax credits. Very confusing. It seems to me that this could be a highly iterative process since taxes paid to one jurisdiction impact the tax credits to the other, etc.

Q3) When I sell an investment in one country, are the capital gains considered "foreign income" in the other? For example, if I live in Canada and realize $10k by selling a mutual fund held in a US brokerage account, is that considered foreign income to Revenue Canada? How does the US treat this? (Likewise, if I sell a $US exchange traded fund (e.g. SPDRs) in my Canadian brokerage account while living in Canada, is this foreign income on my US return?

Any guidance is greatly appreciated. Thank you!

-Bruce

[nelsona]

Short answers:
1. you will declare your earnings, net of your contributions. You must continue to file 8891.

2. The tax credit in canada is limited to the tax that a NON-US citizen would pay on their income, and can only be claimed on US-sourced income. your foreign tax credit on your 1040 will be limited to Cdn income oand Cdn tax. By treaty, you do the Cdn and US tax returns without credit, then take the allowable US taxes as a credit on your Cdn return. It is now complete. Then take the final Cdn tax as the basis for your US form 1116 tax credit calculations.

The result should almost always yield no US tax owed. You will have to apportion the Cdn tax based on the types of Cdn income reported on your US return, on different 1116's.

if you have children, you will find that using the FTC rather than FEIE will net you a free $1000 per child, so you might simply want to use FTC for everything.

3. Your cap gains are condsidered to be sourced where you reside, not where the brokerage is located. Your cap gains will all be Cdn-sourced (except forany real property situated in US) once you move to canada. You will have to report these in US because of your citizenship, and claim Cdn tax as a credit on your 1116.

[bruce]

Nelsona:

Thank you very much. If I could trouble you for a couple of clarifications, it would certainly be helpful:

1. Yes, I understand that I will need to keep filing form 8891. My question was more with regards to the IRS' requirements when I ultimately make my RRSP withdrawals. Do I have to pay tax on 100% of the withdrawal (as in Canada) or only on the deferred earnings? I would think that there should not be any US tax on contributions that have already been declared to the US and technically "taxed" by the IRS. As a matter of fact, since I declared some RRSP earnings on my taxes before I moved to the states, I would guess that both these previously "taxed" earnings should also be US tax free when ultimately withdrawn. Does this make sense or is this wishful thinking on my part?

2. All my income will be from earned income, dividends, interest and capital gains. If I understand you correctly, the only "US sourced" income that I would have is from interest & dividends earned in US domiciled accounts (since all cap gains are considered Canadian sourced). Everything else (including interest & dividends in Canadian domiciled accounts) is Canadian sourced. Right?

3. If my cap gains are considered sourced where I reside (in this case Canada), what happens when there is a large discrepency between the cap gains declared on my 2 returns? I expect the gains on my US return to be significantly higher than the gains on my Canadian return. (This is simply because the stepped up cost basis on my investments when I move back to Canada would not apply to the US.) For example, I can realistically see a situation where capital gains on my Canadian return are $10k and capital gains on my US return are $30k. Since all cap gains are considered Canadian sourced, can I use the $30k figure on my US return as foreign income?

Thank you!

-Bruce

[nelsona]

1. As i said, you will owe tax on the withdrawals "net of your contributions".

There are a copule of acceptable ways of doing this calculation, and I have described these elsewhere.

The most staraigntforward way of doing this will be to, on a yearly basis, determine the % of contributions vs. overall value. EG: if you contributed, up to that point, $300,000 and your RRSP is worth $1,000,000, and you withdraw $10,000, you would report $100,000 on line 16a and $70,000 on 16b.

The next year, you would redo the calculation, with $270,000 as you 'contributed portion' (the original $300,000 minus the $30,000 you removed tax-free), and you updated total value, and determine a new taxable % for the next year.

So, every year, your non-taxable portion of your withdrawal is equivalent the % of your contributions minus any ammount previously withdrawn tax-free. That is why it is important to know exactly how much you contributed over the years, in US$ values for those years.

2. yes

3. That is the problem with being a US citizen moving to Canada, the 'step-up' doesn't really help you. Even if you could say that the gains were foreign-sourced (there is that possibility) that fact that you paid hardly any Cdn tax on that gain won't help you in US. you can't 'create' Cdn tax that isn't there.

[bruce]

1) So any earnings in my RRSP prior to my electing any RRSP deferals (even though these earnings were previously declared and taxed by the IRS) do not enter into the equation upon withdrawal? It is unfortunate if I can only net out contributions because it seems like double taxation on the earnings in the early years of my RRSP. I guess the upside is that this will seem pretty minor by the time I withdraw.

3) Since Canadian tax rates (Fed & Prov) are generally higher than US federal rates, I suppose the smart strategy would be to figure out how much extra US-only passive income I can crystalize (via capital gains) until my U.S. tax (on passive income) equals my Canadian tax. This might be possible if I can limit the difference in capital gains (due to different US & Cdn cost bases) to only $5k - $10k per year. Does this make sense as a tax planning strategy?

For the purposes of filling in a 1116 and calculating the foreign tax paid to Canada on passive income, can I use a 100% capital gains inclusion rate or do I have to use the 50% per Canadian rules? Using a simplified example, let's say I had $100k total Canadian income including $10k in capital gains and paid $30k in total Canadian taxes, is my foreign tax on the capital gains (on the 1116) $3k or $1500?

Thank you!!!!

[nelsona]

You said previously that you "declared all this income on my US tax forms".
I took this to mean only that you did not deduct the RRSP contributions you made, not that you reported all the interest and dividends that your RRSP generated year-over-year.

if you previously declared the income that those RRSPs generated (I don't know why you would have done this), then of course this counts towards your future non-taxable withdrawal. So in my previous example, if you contribut $300,000 and now have a million, and paid tax on $10,000 of produced income, then 31% of your first-year withdrawl would be tax-exempt, instead of 30%. You will in the end withdraw $310,000 tax-free.

Again, I question why you would have included your RRSP income in your US taxes, since this was never required. The IRS no longer allows one to do this on a year-by-year basis anyways, one either defers forever or doesn't. This 'cherry-picking' had some tax advantage, in that you could declare RRSP income in years when you had little other income (or in years when your foreign exclusion made you non-taxable in US. But you said this income had been declared and taxed so you obvioulsy weren't using that strategy.

---

If you live and work in canada, The only US-sourced income you will have form CRA's point of view is the US-sourced interest and US-sourced dividends, and the most you will be granted in tax credit is 10%.

---
on cap gains, The US doesn't care about inclusion rules. canada on the other hand does, so watch out for when you generate US-sourced cap gains (like on real property). CRA automatically reduces the US tax by half based on this false logic.

[bruce]

"...I question why you would have included your RRSP income in your US taxes, since this was never required..."

For what it's worth, I did this because under the old FEIE rules (pre-2006), I was able to use my standard deduction & personal exclusion to eliminate any tax due on the RRSP earnings. In effect my US tax on this income was $0. I figured if it didn't cost me anything, I might as well keep declaring the income and increase my taxed basis for the future. (As you point out, this would no longer work under current rules.)

---
"If you live and work in canada, The only US-sourced income you will have form CRA's point of view is the US-sourced interest and US-sourced dividends, and the most you will be granted in tax credit is 10%....on cap gains, The US doesn't care about inclusion rules. canada on the other hand does, so watch out for when you generate US-sourced cap gains (like on real property). CRA automatically reduces the US tax by half based on this false logic."

Yes, that makes sense; however, I was looking at this from the other direction... how much Canadian-sourced income and Canadian tax will the IRS see from the US point of view? The strategy I am contemplating is to effectively use the difference in cost basis (i.e. Cdn cost basis will be higher than US basis), to bring my US taxes on passive income up to the same level as my Canadian taxes on passive income... and then use the Canadian taxes as a credit on my US form 1116. I would essentially be crystalizing capital gains tax free by shifting some tax credit from earned income to the passive category. (This plan assumes that the Canadian taxes are high enough that there is still plenty of tax left over to cover my Canadian earned income on a separate 1116.)

[nelsona]

As I said in my previous post, the strategy of declaing your RRSP-generated income wasaa a sound one, back then and has added to your RRSP 'investment' for future tax calculations.

It was your earlier statement that you had declared and paid tax on this income that threw me.

I just wanted to clarify one thing: your US-sourced INTEREST wil NOT be eligible for a tax credit in Canada, since non-US citizens do not pay income tax on interest earned in US. you will need to use your US tax return to get any crdit under the "re-sourced" category.

The technical explanation to the treaty has some examples on how US citizens living in canada have to do hoops to get credit for tax on their US return.

Your arithmetical gymnastics I will leave to you... but all of them\ will have to be dome on your US return, largely using the "re-sourced" category, keeping in mind that IRS is planning to simplify the number of 1116 categories in the near future.

Your best tactic will involve using Article XXIV on your 1040 by the terms of para. 4, re-sourcing your US-sourced income to the extent that it equals your cdn tax.

If I might illustrate.

Say your bank in Boston pays you $100 in interest. Your US tax on that income is $10 (rememebr the tax apportioned to any type of income is dome on an 'effective' basis not a marginal rate). the tax in canada on that $1000 is $25. these two tax calculations are done before ant foreign tax credits are taken into account.

In canada, you would get no tax credit for the $10 tax you paid in US (if you were not a US citizen, you would not pay US tax). However, by the rules of Article XXIV(4) (b) (and the rules of re-sourcing outlined in the 1116 categories), you would re-source the $100 (ie make it foreign) to be able to recoup the $10 that you paid to IRS).

For each type of US-sourced income, you will have to go through this procedure. The result will be that you will pay tax at the higher rate of the 2 countries for each type of income (normal, dividend, cap gains).

[bruce]

I just wanted to clarify one thing: your US-sourced INTEREST wil NOT be eligible for a tax credit in Canada, since non-US citizens do not pay income tax on interest earned in US. you will need to use your US tax return to get any crdit under the "re-sourced" category.

I'm confused. This seems to contradict an earlier statement. On 6/26, you said that "If you live and work in canada, The only US-sourced income you will have form CRA's point of view is the US-sourced interest and US-sourced dividends, and the most you will be granted in tax credit is 10%." Can you please clarify?

For each type of US-sourced income, you will have to go through this procedure. The result will be that you will pay tax at the higher rate of the 2 countries for each type of income (normal, dividend, cap gains).

This whole notion of "re-sourcing" is new to me. Is it only relevant for US-sourced interest (since capital gains would be all Canadian and dividends would depend on where the account was domiciled)? Presumably dividends and capital gains fall in the passive income category.

Re-sourcing seems to add unnecessary complications and with the upcoming revision to the 1116, re-sourcing may not even be an option. My first thought is to structure my finances so that most of my unsheltered interest is in Canadian accounts (and therefore considered foreign by the IRS). Based on my fuzzy understanding, that would seem to eliminate the need for any re-sourcing???

Thank you!

[nelsona]

I just DID clarify: interest is NOT taxable in US for non-US citizens living abroad, so by treaty you can't get credit for it. I guess I should have used the term 'correct' rather than clarify.

You will need re-sourcing in order to avoid paying double tax. IRS knows that most treaties limit the US tax that US citizens abroad can claim on their foreign tax return. The re-sourcing remedies this. It is specifically for US citizens living abroad but earning US income like interst dividends or royalties.

Look at the examples in the technical explanation of the treaty.

www.irs.gov/pub/irs-trty/canatech.pdf

Re-sourcing will be the only way that you reduce your US tax to zero. (Because of the possibility that your cap gains rate in US is higher than in Canada, you may from time to time owe some US tax on cap gains. (not just because of the differing cost basis, but becuse of the higher short-term cap gains taxrate).



As of now, there are separate 1116 categories for most types of income. There is talk of lumping these into fewer categories, perhaps even as early as 2006 tax year. Follw the directions on 1116 to determine which bucket your income will go in, including the 're-sourced' one to get you your final tax to zero.

[bruce]

This issue of resourcing US interest raises an interesting question regarding the type of investments to hold in my Roth IRA.

I have read elsewhere on this forum your recommendation avoid a Roth IRA; however, as a US citizen it probably makes sense to keep my Roth. I figure it's better to shelter from one government (US), even if earnings are fully taxed in the other (Canada). All the money in my Roth is from after-tax contributions.

If I look at the 3 primary forms of earnings that investments inside my Roth could produce, it seems to make sense to rank them (in order of desireability) as follows: 1) capital gains, 2) dividends, and 3) interest.

Interest - This strikes me as the most problematic type of earnings. The interest would get taxed in Canada at my marginal rate (say 40%) but would be ineligible for "resourcing" on my US return for FTC purposes because Roth earnings are not taxable in the US.

Capital gains - While I still could not get any FTCs, at least it is taxed in Canada at only a 50% inclusion rate. Therefore my margin tax rate on capital gains would probably be around 20%.

Dividends - While dividends will be taxed in Canada at my marginal rate of 40%, I should be able to claim FTC on my Canadian return. Even though no actual US tax would be paid on dividends in a Roth, in the eyes of the CRA this is still taxable foreign income. Of course the tax credit will not come close to my 40% marginal rate on dividends, but I should be able to recover part of this amount. If I understood your prior comments, this FTC would be capped by CRA at 10%, so my effective marginal rate on dividend income would be 30% (i.e. 40% minus 10% FTC).

Does this analysis pass muster? In particular with respect to dividends inside the Roth, does it sound correct to claim a 10% FTC on my Canadian return? (Out of curiosity, is the 10% cap the result of the tax treaty?)

Thank you!

[nelsona]

Your best bet for Roth is to avoid yearly Cdn taxation altogether (since none of the tax will be eligible for credit in US, only as a deduction), by contacting CRA and asking permission to defer taxation until you withdraw the funds.

You analysis on dividends is incorrect, since to have a tax credit on yor Cdn tax return, you need US tax, which your roth would not have incurred. The dividend income would count as foreign income, but there would be no US tax associated with it. You could try to lump this with other taxable US income ans its tax. US didvidends do not enjoy any special tax rate in Canada.

the 10% figure was illustrative of the US tax you would pay on your interest, not the Cdn ammount. The Cdn tax credit would be capped at ZERO. If you look at the treaty expalnation you will probably see that dividend credits have a floor and not a ceiling, but I would prefer if you research this yourself, this thread is getting a little too specific to you, with little benefit to myself or others.

Contact CRA and get a tax waiver (similar to the one RRSPs get with form 8891, just not entrenched in the treaty).

I've spoken on this before.

[nelsona]

Just to recap, the only tax credits you will get on your US return, from what you have described, is from any dividends you might get (outside of nay tax favoured accounts), from income from any pension plan or IRA/401(k) you might withdraw from, or from US real property income. Everything else is either Cdn-sourced, or like interst, is zero-credited.

Other than that, it will be your 1040 that will hold all the foreign tax credit/deduction possibilities, on your Cdn income, and by re-sourcing your US-sourced income to reduce the tax to zero.

[nelsona]

Just to recap, the only tax credits you will get on your Cdn return, from what you have described, is from any dividends you might get (outside of any tax favoured accounts), from income from any pension plan or IRA/401(k) you might withdraw from, or from US real property income (sale or rental income). Everything else is either Cdn-sourced, or like interest, is zero-credited.

Other than that, it will be your 1040 that will hold all the foreign tax credit/deduction possibilities, on your Cdn income, and by re-sourcing your US-sourced income to reduce the tax to zero.

[nelsona]

By the way, thanks for pointing out the anti-stacking provisions tah thave recently been passed.

Thisis really going to complicate tax returns for USCs living in Canada and earning less than $20,000 of unearned income and less than $80,000 earned income, which, before was a no-brainer.

Although most should have switched to 1116 to get the child tax credit, now they will have little choice but to become 1116 experts.