Each year I help over 500 clients file their Canadian and US tax returns as well as plan for both their Canadian and US investment accounts. I also regularly help new US clients plan for their move to Canada.
We file over 1,500 expat tax returns per year and we also review a significant amount of expat returns prepared by individuals and other accounting firms.
First, I would like the preface the following list with the fact that I understand honest mistakes happen and cannot be fully avoided. That being said, most individuals are not properly equipped or experienced to prepare their own Canadian and US cross-border tax returns. Also, some accounting firms venture into the cross-border tax niche when they likely should stay away until proper experience and knowledge on the subject is obtained.
The following list includes the most common mistakes we see from individuals and firms preparing expat Canadian-US income tax returns (T1 and 1040 returns). For more information on how to actually file US expat returns in Canada please visit this guide.
Not properly reporting world wide income
One of the most common and potentially the most devastating mistake one can make. Both Canadian residents and US citizens (often you can be both at the same time) are required to report their worldwide income on both their US and Canadian income tax returns.
Therefore, Americans living in Canada will need to report their worldwide income one both their T1 Canadian and US 1040 income tax return.
We often review expat tax returns that only report Canadian source income on the Canadian return and US source income on the US return. Although this will certainly help avoid double taxation, it is completely wrong.
Correctly prepared expat returns should report worldwide income on both the Canadian and US tax returns. Double tax should be controlled by calculating foreign tax credits and treaty elections between both returns.
Missing FBAR, 8938 and T1135 disclosures
Not only is this one of the most common expat return omissions, it is by far the most dangerous and potentially costly with respect to penalties. US Citizens living abroad that met a relatively low threshold of non-US financial assets (under $10,000 in aggregate) need to report these assets on form 114 (FBAR) and/or form 8938.
The reasons these forms are so important lies in the fact that the penalties for late filing these forms can be horrendous. The late filing penalty on a FBAR could be as high as $10,000 per unreported account or 50% of your total non-US financial accounts.
Form T1135, similar to the US FBAR reporting above is often missed on Canadian tax returns. Form T1135 carries a maximum penalty of $2,500 (plus interest) and is required if a Canadian taxpayer has foreign investment assets with a cost over $100,000 CAD.
RESP and TFSA reporting on US returns
RESP and TFSA internal earnings are tax deferred for Canadian purposes. This is not the case for US tax purposes. Americans who own these type of accounts will need to report the internal earnings of their TFSA and RESP in addition to other possible disclosures.
Incorrect 1116 foreign tax credit calculations
One of the reasons this form is so important to properly report and calculate is that it provides the mechanism for properly calculation US foreign tax credits. If these forms are incorrectly calculated it could result in double taxation between Canada and the US. Avoiding double taxation is one of the big reasons why individuals hire competent cross-border tax advisors.
Form 1116 is split between 4 difference pools of income, hence the high risk for potential error:
General – pension, employment, business income, etc.
Passive – interest, capital gains, rental income, etc.
Resourced – US capital gains, US interest, tax over 15% of certain types of income
GILTI – This new 1116 pool is strictly for calculating foreign tax credits related to the new GILTI rules and 962 elections.
Just a small mistake in the preparation and calculation of form 1116 can result in a huge difference in overall tax due on your 1040 and potential double tax between the Canadian and US tax return.
Also note that it’s not often enough to simply apply foreign tax credits “back and forth” between both Canadian and US returns. In some cases, as with pension income, certain rates are capped at 15%. For example, if you’re in a higher overall tax bracket and you pay 30% tax on your US pension, CRA will only give you a 15% credit on your Canadian return.
You might ask, “that’s not very fair, what happened to the other 15%, am I not getting double taxed?”. Yes, that would be true if it wasn’t for the resourced 1116 mechanics available above. By properly calculating an additional 15% US foreign tax credit you’ll be able to reduce your total US tax on this pension to proper treaty rates, e.g. 15%. See why it’s so easy to make mistakes on these kind of returns…
Incorrect Canadian foreign tax credit calculations
As with the US form 1116 above, the proper calculation is imperative to ensuring a taxpayer doesn’t pay too much Canadian tax. Not only are Canadian foreign tax credits just as complex to calculate they are highly reviewed by CRA. If you’re going to claim a foreign tax credit on your Canadian returns (from taxed paid on your 1040) make sure it’s correct. If not, there is a very good chance CRA will readjust the calculation and make you pay the difference.
A quick side note here. CRA reviews a significant amount of the T1 foreign tax credit calculation and CRA can often be wrong in their assessment. Just because CRA reviewed and changed or disallowed your foreign tax credit doesn’t necessarily mean it wrong. Have a good cross-border tax accountant review the calculation to ensure it’s correct.
Calculating correct foreign tax credits on both the Canadian and US tax return can be challenging. That’s why we always prepare both the Canadian and US income tax returns for clients at the same time. Simply preparing the Canadian return in April and waiting until June to finalize the US returns is not always possible. If the client has US source income you’ll often need to readjust the Canadian return to reflect this additional “double tax”.
Incorrect 2555 foreign income exclusion forms
We see this a lot…
Form 2555 is meant to allow US taxpayers to exclude foreign earned income up to a certain threshold. For example, a US Citizen living in Canada would be allowed to exclude up to $105,900 USD of Canadian sourced employment or business income.
We often see additional non-earned income excluded on form 2555. Such as pension income, investment income and sometimes capital gains. Of course, this is incorrect.
We also tend not to use form 2555 as much as most of the returns we see from others. This is for the simple fact that by using form 1116 to reduce US tax on this Canadian source income we are able to carry-forward any unused Canadian tax to future 1040 years when needed. Also, for high income earners form 2555 won’t help eliminate all US tax completely.
Reporting income using incorrect foreign exchange rate
How you calculate conversion on both the Canadian and US income tax returns can have a significant impact on total taxes owing. Just a 10% difference in a foreign exchange rate can result in additional tax liabilities for the client.
In general terms, for both the Canadian and US income tax returns, income is exchanged at the average US-Canadian rate and capital gains are covered at historical rates.
For example, you may have US pension income of $10,000 that needs to be reported on your Canadian return. If the actual average exchange rate for that year is 1.20 and you converted your pension income at 1.30, you’ve essentially paid tax on an additional $1,000 of income unnecessarily.
Incorrectly calculation of Canadian-US capital gains
Capital gains exchange calculations are even more involved. We often see capital gains converted incorrectly at average rates, on both Canadian and US returns. I’ll use an example to illustrate:
Let’s say you buy a US stock for $10,000 and sell it when it is worth $20,000. For US 1040 purposes you’ll have a $10,000 US dollar gain to report.
What should you report on your Canadian returns? Many will report the $10,000 US gain using an average exchange rate. In this case let’s assume that the average rate was 1.20. Would the Canadian reported gain be $12,000?
In fact, the calculation is much more involved. The correct Canadian dollar gain (to be reported on your T1 Canadian return) would be $14,000.
We calculate this amount as follows using the following assumptions:
Rate when the stock was purchased = 1.20
Rate when the stock was sold = 1.30
Stock purchased at 1.20 = $12,000 Canadian cost basis
Stock sold at 1.30 = $26,000 Canadian proceeds
Canadian capital gain = $26,000 less $12,000 = $14,000 Canadian capital gain.
You can see from the above example why it’s imperative to calculate both the historical purchase and current proceeds at actual rates.
Missing income tax treaty elections
The Canada-US income tax treaty contains many article and provisions that outline income sourcing rules and preventative double tax measures available to US-Canadian residents and taxpayers.
However, many of these tax treaty rules are not applied automatically and need to be disclosed within the tax respective tax returns.
This is especially true of US income tax return treaty elections. In many cases, in order to apply the benefits of the treaty the taxpayer need to properly disclosure the position on form 8833. The penalty for not filing this form can be high, but being disallowed a treaty election on a tax return can be much more expensive.
Incorrect reporting of social security, CPP and OAS income
Another very common expat return mistake is the incorrect reporting of CPP, OAS and US social security payments.
One would think that for cross-border returns, US social security should be first taxed in the US and CPP and OAS should be first taxed in Canada. Unfortunately this is wrong. Under the treaty US SS, CPP and OAS are only taxable in the country of residence. Therefore, US citizens that live in Canada are not taxed in the US on their US social security payments…strange isn’t it? Likely why this is often missed on expat tax returns.
Other common missing forms and calculations
Some less common but definitely noteworthy oversights:
Form 5471 is required when a taxpayers owns more than 10% of a private (often Canadian private corporation in our case) corporation. This form not only reports the existence of the corporation but also important technical tax calculations like GILTI and 965 tax.
In cases where you may take a tax position that has yet to be set as a precedent at the IRS you often want to include form 8275 and 8275-R to disclose the position.
Many US citizens living in Canada own mutual funds. Canadian mutual funds are considered Passive Foreign Investment Companies (PFIC). Americans owning PFICs are required to complete form 8621
Form T1142 – often Canadians receive distributions from US trusts and estates. In these cases form T1142 would be required. Note that this form, similar to the T1135 carries a maximum $2,500 penalty if filed late.
T1134 foreign affiliate reporting – Not as common, but just as important to file. This form is required for all Canadian residents taxpayers that own more than 10% in a non-Canadian private foreign corporation. This reporting applies to LLCs, LLLPs and LLPs in addition to US C-corps and S-Corps.
Form T2203 – In cases where Canadians earned business income in the US through a permanent establishment they are required to complete this form to properly allocate this income to foreign sources and to properly calculate non-resident surtax.
Roth IRA election – Americans often move to Canada with investments. These investments often include Roth IRAs. The internal earnings of the Roth IRA are tax deferred for US purposes. In order for the earnings and future distributions to be tax free in Canada special elections are required to be filed with CRA.
It’s not surprising how many errors we find on Canadian and US cross border returns. Especially considering the amount of experience required to fully understand Canadian taxes, US taxes and the Canada-US tax treaty.
If you need help in preparing your expat returns or simply have a question regarding your previous year filings please don’t hesitate to reach out.
I can be reach via email at email@example.com or via phone or text at 250-661-9417.