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Phil Hogan, CPA, CA, CPA (CO)
Cross-Border Tax and Investment Specialist
I’ve reviewed a lot of US tax returns from new clients. Given the inherit complexity of cross-border tax returns I tend to see lots of incorrect filings and omissions. This post is not meant to point out other’s mistakes, but rather, inform those that have cross-border US and Canadian tax returns on how to improve their filings and to avoid potential harsh penalties and/or scrutiny from CRA or the IRS.
For purposes of this post I’ll be assuming that the “client” is a US citizen living in Canada filing both Canadian and US income tax returns.
Incorrect calculation of foreign tax credits
Americans in Canada often have both Canadian and US source income. If foreign tax credits (FTC) in each respective return are not properly calculated the taxpayer could end up paying double tax. Alternatively if they incorrectly over-calculated their FTC they could face significant review and scrutiny from the IRS or CRA.
For US purposes foreign tax credits are calculated on form 1116 and for Canadian purposes foreign tax credits are calculated via form T2209. Not only is a deep understanding of these forms required to properly file an FTC but a good understanding of the income sourcing rules is imperative to ensure both tax returns are accurately calculated.
Taxing US Social Security on US returns
As mentioned on previous blog posts this is one of the most common errors I encounter. Pursuant to Article XVIII (18) of the Canada-US income tax treaty social security payments made to residents of Canada will only be taxable in Canada.
Therefore, if you live in Canada and receive social security payments they will only be reportable on your Canadian T1 income tax return (after a 15% deduction) and fully excludable from your US 1040 income tax return. Don’t forget to file form 8833 to receive the treaty exclusion.
Not filing of FBARs or form 8938
In addition to filing of Canadian and US income tax returns taxpayers with assets on both sides of the border are also required to file and disclosure their foreign financial assets.
For US purpose individuals that own foreign financial assets outside of the US that total more than $10,000 (aggregate of the highest balance in each account) are required to file form 114. Or also commonly referred to as FBAR forms.
It’s common to see taxpayer that are caught up on their US returns, however they’ve neglected to file FBARs for previous years.
Also, those that have neglected to file FBAR forms are also more likely to miss form 8938 which is required to be included in the US 1040 return. Although the 8938 does have a higher filing threshold than the FBAR it’s often also required for clients.
Neglecting to file form T1135
As with the FBAR and 8938 above for US returns Canada has similar foreign financial disclosures.
If a Canadian tax resident owns foreign property with a cost basis more than $100,000 CAD they are required to file form T1135. Even through the T1 Canadian return includes a question on page 2 concerning the T1135 filing requirements it’s often missed by taxpayers.
Not reporting 100% of your worldwide income on your Canadian and US return
This is likely one of the most common mistakes I come across. Many taxpayer are not familiar with the concept of reporting worldwide income for both Canadian and US purposes.
Americans living in Canada are both Canadian tax and US tax residents. As such they are required to report their worldwide income on both returns. That doesn’t mean they will pay double tax as the treaty contains provisions to eliminate doubling up on Canadian and US tax on the same income.
I’ll often see returns from American expats where only the US income is reported on the US return and Canadian income is reported on the Canadian return. Fixing incorrect return filed this way can be quite time consuming and very expensive.
Not properly calculating cross-border capital gains
Many are under the misconception that gains on US stocks are taxable in the US and gains on Canadian stocks are taxable in Canada. In fact, gains on stocks are only taxable in your country of residence.
Therefore Americans living in Canada with stock gains on either Canadian or US securities will only be taxable on those gains in Canada.
Please note however that gains on US real estate will be taxable in the US (and possibly state tax) unlike listed securities like Canadian or US stocks.
Not properly extending your US tax returns
I get lots of requests to help in filing tax returns in July and August, well after Canadian and US filing deadlines.
For reference, Canadian T1 income tax returns are due April 30th, unless you’re self employed, then they are due June 15th.
US returns are due April 15th, however Americans in Canada receive an automatic extension to June 15th. In order to receive a further extension to October 15th a taxpayer can file an extension via form 4868.
Unfortunately no formal Canadian income tax return extension is available to taxpayers.
As an American in Canada if you feel like you won’t be able to file on time (we always recommend filing by the due date) make sure to file your 4868 extension and complete your Canadian return on time. If you feel like you can’t file your Canadian return by the deadline make sure to pay estimated taxes to avoid additional penalties. Also consider filing form T1135 to avoid the $25 a day penalty.
Not completing the questions on Schedule B
Schedule B (reporting of investment income) on the US 1040 return includes some very important questions regarding FBAR filings and 3520 foreign trust filings. Although taxpayers often complete the top section of schedule B, the bottom section (part III) with questions are often neglected.
You’ll need to answer 3 questions:
- Did you have foreign financial assets?
- Are you required to file FBARs
- Are you required to file 3520 forms
Paying SE tax to the US on business income
Similar to Canadian CPP premiums on business income earned the US levies “self-employment tax” (SE tax) on business income earned by an individual.
However, Americans living in Canada that earn business income, regardless of there the income is sourced is not subject to SE tax and only CPP on that income.
For those that complete their own US returns this can be an easy mistake to make as US software will automatically calculate SE tax on business income. If not corrected the taxpayer will be paying both SE tax and CPP on the same amount of business income.
Also note that appropriate SE tax exemption elections need to be file along side the 1040 return.
Using the wrong exchange rate for income
Very specific CAD-USD exchange rates are used to convert Canadian dollar to USD and vice versa. When completing expat tax returns worldwide income needs to be converted to appropriate currencies for each respective return.
The following USD/CAD exchange rates should be used for the following purposes:
- The average rate for income items such as pensions, business income and expenses, interest and dividends
- The year end rate for FBAR and 8938 balance conversions
- Historical rates for capital gains transactions. For example, you need to convert cost basis at the time of purchase and the sales proceeds at the time of sale.
You can view historical and current USD/CAD rates below:
Also note that in some cases if the actual amount of the converted dollars are available we can use those amounts for the respective tax returns.
Not filing from 5471 for Canadian corporate ownership
Many American expats living in Canada also own shares in private Canadian companies. Many of which they control fully. Americans that have ownership in non-US corporations are required to file form 5471 to not only disclosure the income and expensive of the corporation but also any balance sheet items.
Form 5471 can be quite time consuming and complex to complete not to mention all the adverse US tax consequences of GILTI calculations on business income and Subpart F on income earned within the company.
If you have neglected to file form 5471 make sure to engage a cross-border tax professional as penalties for late filing of form 5471 can exceed $10,000:
Incorrect reporting of K1 forms for Canadian purposes
American expats often receive US K1 reporting forms for certain investments that they own in the US. They may receive K1 forms for ownership in:
- Limited Partnerships
- Limited Liability Partnerships
- As beneficiaries of US trusts
In many cases reporting the K1 income for Canadian purposes is not as straight forward as it may seem. For US purposes the K1s can be entered just as they appear in each respective K1 information boxes. However for Canadian purposes the treatment of income may be quite different. For example:
- Income earned in an LLC will not directly flow to a Canadian resident and will certainly not retain it’s income character. For example, if an LLC earned a capital gain and then distributed out this to the shareholder in Canada it would be considered straight income and not a capital gains for Canadian purposes.
- Distributions from a foreign trust to a Canadian resident will also not retain their income character. Regardless of whether capital gains, interest or dividends are distributed to the Canadian resident by the US trust it will be treated as “foreign trust income” for Canadian purposes with no preferential tax treatment on the income.
Once again, if you have income, ownership or are a beneficiary of any of the above entities it’s wise to seek professional help.
Incorrect sourcing of W2 income
It’s not uncommon for Americans living in Canada to be employed by a US employer and receive a W2 for employment income earned in the year.
Technically speaking Canadian residents living in Canada should be paid through Canadian payroll and receive a T4 slip at year end instead of a W2. The company should also be withholding appropriate Canadian payroll withholdings and not US FICA and medicare tax withholdings.
That being said very few small US companies setup Canadian payroll for their Canadian employees. Just because you’ve received a US W2 doesn’t mean the employment income is US sourced. As mentioned above, in most cases Canadian employers of US companies will be taxable in Canada first.
If this situation applies to you make sure to have a good cross-border accountant help with the returns. For example, the income needs to be sourced to Canada and although the US tax withholdings will be available as a credit on the US return the foreign tax credit calculation on the Canadian returns is almost always complicated.
Filing a 1040NR instead of a full 1040 return
I definitely see why this mistake is made often, however it can be very time consuming and expensive to fix.
As discussed on various posts on this website, Americans living in Canada have the same tax filing requirements as US residents. As such they file full US 1040 income tax returns.
Many Americans that move to Canada file 1040NR returns when they arrive. They assume that because they no longer live in the US they should be filing a non-resident income tax return. Of course, this is incorrect and results in very difficult adjustments to correct.
As you can see from the examples above lots can go wrong with cross-border expat returns. It certainly can be “expensive” to have an accountant properly prepare your cross-border returns. However, if they are done incorrectly and need to be revised and adjusted it could be even more costly.