How to Eliminate Your US Expat Income Tax

Americans working outside of the US may be able to exclude a large portion of their foreign wages and income from US tax. In order to do so, you must qualify for the Foreign Earned Income Exclusion.

Foreign Earned Income Exclusion

Each year you can exclude an amount adjusted for inflation from your US tax return ($120,000 for 2023), as long as you meet either the bona fide residence test or physical presence test. However, if you’re working as a 1099 employee and reporting income on Schedule C, you’ll still need to pay self-employment taxes.

Physical Presence Test

If you are physically present in a foreign country for 330 days in any 12 month consecutive period, you will qualify under the physical presence test. This test does not require you to be in only one foreign location as long as you are outside of the United States; you can be living in one country and working in another. When calculating your 330 day period, note that days traveling do not count, however you are able to determine which 12 month period you would like to use to meet this test.

Bona Fide Residence Test

You are considered a bona fide resident of a foreign country if you reside in that country for an uninterrupted period that includes the full calendar year. Even if you still own property in the United States or have family here, you may be able to prove you are a bona fide resident of a foreign country as that is where your “tax home” is and where you intend to continue returning to work with no known end date.

Foreign Housing Exclusion

In addition to the foreign earned income exclusion, you may also be eligible to exclude amounts paid by your employer for certain housing expenses, whether they are paid directly to you or on your behalf. Expenses that qualify for the foreign housing exclusion include items such as rent (including rented furniture), repairs, insurance, security deposits, and utilities other than telephone.

Expenses that are considered lavish or those that could be deducted on a US tax return do not qualify, including deductible mortgage interest, property taxes, costs associated with buying property, domestic labor, improvements, purchased furniture and cable television.

The foreign earned income exclusion and foreign housing exclusion can be combined; you don’t need to choose between the two!

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Effectively Connected Income

Under most circumstances, a foreign person that engages in a trade or business in the United States will have what’s called Effectively Connected Income (ECI) with regard to all income generated from that business in the United States.

Engaging in a trade or business means any services performed within the United States. There are categories that the IRS mentions which help in determining whether one is engaged in a “trade or business”.  According to the IRS, the following will create ECI:

• Is the person engaged in providing services or selling products within the United States?
• Is this person running a business that performs services or providing products in the United States?
• Did the person at anytime during the year generate a gain or loss on the sale of real property within the United States?

While this list does not cover every scenario, certain types of income never generate ECI.  Income that is considered “fixed, determinable, annual or periodic” (FDAP) does not create ECI.  Examples of FDAP income include:

• Rents
• Royalties
• Pension income
• Interest
• Dividends

Income categorized as FDAP is always subject to a 30% tax, usually withheld by the payee.  Unlike FDAP, once a person is designated as having ECI, rather than be subjected to a fixed withholding rate of 30%, this person will be allowed to take deductions (usually ordinary and necessary expenses) and pay tax at graduated rates.

Whether a desire for warmer weather or to visit grandchildren in the United States, Canadian citizens in their retirement years have flocked to the United States.  Recent business articles on Florida property say as many as 30% of all real estate transactions in Florida since the housing market crash were perpetrated by Canadians.  Regardless of the actual number of retirees, the fact remains that there is a noticeable population of Canadians retiring in the United States.  One of the more common issues that Canadian retirees living in the United States come across is receiving a pension or retirement income from funds in Canada.

Tax on Canadian retirement funds

With retirement into the US comes retirement income that ultimately may be subject to US tax as well as Canadian tax.  To understand this better, we need to understand the retirement plans commonly used by Canadian retirees.

There are two main retirement vehicles commonly seen in Canada, the Registered Retirement Savings Plan, or “RRSP” (and a similar plan called the Registered Retirement Income Fund, or “RRIF”) and the Canadian Pension Plan (CPP).  The RRSP is a voluntary retirement vehicle in which an individual can contribute a set amount (based on their income) to a retirement fund, and have the amount deducted from current year net income.  Upon retirement, the individual is then taxed.  The CPP (as well as other smaller similar plans, the OAS and QPP) is similar to the United States Social Security system in which an individual qualifies for guaranteed income upon reaching a certain age.

When Canadian citizens choose to retire in the United States, the income provided by the retirement funds becomes taxable to the Canadian citizen in potentially two ways:

• The Canadian citizen becomes a resident of the United States through a long term visa (i.e. green card or “substantially present” residents)
• The Canadian citizen is classified as a US non-resident through a temporary visa

Under both scenarios the individual will be subjected to withholding tax on any distribution from a Canadian source investment vehicle to a US resident or non-resident.  Under the US-Canada treaty, RRSP withholding rate would be 25%, and for an RRIF, 15%. For the Canadian Pension plan, the withholding rate is 25%.

Likewise, whether a resident or non-resident, any income a Canadian citizen receives from an RRSP/RRIF or CPP will be subject to US Tax.  Any withholding amount from Canada may be used as a tax credit against a US tax liability.

Keep in mind that Canadians classified as US residents potentially have favorable tax rates and deductions on their US tax return compared to a Canadian classified as a non-resident for US tax purposes.

Things to consider – Canadian citizens

• If you have a domicile in the United States and you receive a CPP or RRSP, your withholding rate should be at 25%. To determine if the amount to withhold is correct, you should receive a Canadian Form NR4, and the amount withheld should be in box 17 or box 27 of the form.
• If you own a home in Canada and receive a CPP or RRSP, your withholding rate should be 30%, while living in the US, and should be found in box 22 of Form T4A. Keep in mind that if you were not a resident of Canada in the year of the distribution, you should receive Form NR4 instead.
• Any appreciation of pension fund value while domiciled in the United States is subject to tax deferral provided you apply the US-Canada tax treaty.
• If you reside in the United States, any RRSP/RRIF balance in aggregate of $10,000 US, will need to be reported on FinCEN Report 114, the Report of Foreign Bank and Financial Accounts (“FBAR”) as well forms 8891 and 8938 on your US tax return.

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Canadian taxes are based on residency.  If you reside in Canada and earn enough income, you will be taxed on that income.  If you reside outside Canada, but are a Canadian citizen, you normally do not have to pay Canadian tax as long as your residence is outside the Canadian borders.  But what if you are a resident of Canada (citizen or non-citizen) and decide to leave the country to live/work elsewhere?  Under certain circumstances, you may find yourself subjected to taxes solely based upon your departure.  Taxes may be due if you are determined to be an emigrant for income tax purposes.

According to the Canadian Revenue Agency (“CRA”), you are an emigrant for income tax purposes if:

• you leave Canada to live in another country; and
• You sever your “residential ties” with Canada.

Severing your residential ties with Canada means that you do not keep your main ties with Canada. This could be your case if:

• sell your home in Canada and take up permanent residence in another country
• your spouse or common-law partner or dependents leave Canada
• You dispose of personal property and break social ties in Canada, and acquire or establish them in another country.

If you leave Canada and keep residential ties in Canada, you are usually considered a “factual resident” and not an emigrant. However, if you are also considered to be a resident of another country with which Canada has a tax treaty, you may be considered a deemed non-resident of Canada. Deemed non-residents are subject to the same rules as emigrants regarding departure taxes.  If you are viewed as a “factual resident” in Canada, you may need to seek advice to protect your status.  From a US standpoint, you may not be subject to tax upon the establishment of residency in the US; however your income from that moment forward is subject to US tax.  Likewise, any investment you may have in stocks or bonds or pension funds might subject you to additional filing requirements.

What items are considered income subject to the departure tax?

When you leave Canada permanently, certain property is deemed to have been sold at fair market value and that you immediately reacquire the item at that value.  The disposition is recognized for a gain if the original basis in the property is less than fair market value.  If a gain is recognized, it is treated at capital gains rates.

Some common property that is subject to the departure tax includes gains on:

• Shares of stocks and other investments
• Jewelry
• Paintings and art collections

Also, if the fair market value of the property you own at time of departure is in excess of CAD$25,000, you are required to file Form T1161, List of Properties by an Emigrant of Canada.  Certain personal-use property (i.e. clothes and household goods) of value less than CAD $10,000 may be excluded from the Form T1161.  The form must be filed the year AFTER your departure by April 30^th.

Other Considerations

• You should always get a residency determination by filing Form NR73. Once a determination is made, you will know whether you have a tax liability and proceed to pay it.
• If you emigrated during the year, all days spent as a resident of Canada subjects you to tax on earnings during the time frame. You will be required to file a part-year resident T1 tax return.
• If you return to Canada after several years, any appreciable property (i.e. stocks, bonds) are valued at the cost when you left Canada. If you dispose of the property (i.e. sell stocks), you may be subject to additional gain on the incremental basis.
• If you had owned foreign property prior to your departure from Canada, you might need to file Form T1135

Filing requirements

• If you are an emigrant and you have property in excess of CAD $25,000, you are required to make a list and file Form T1161. If your property does not exceed CAD $25,000, no filing requirement is necessary
• In order to ensure that you are an emigrant for Canadian tax purposes, file Form NR73 prior to departure to receive a determination
• If you become an emigrant during mid-year, you are still liable for Canadian income taxes on income earned during your residency in Canada. You will be required to file form

Penalties

Penalties for non-compliance can occur, with usual penalties for failure to file form T1161 resulting in an up to $2,500 penalty.  Other penalties, such as failure to disclose property in excess of CAD $25,000 will result in a 25% penalty (similar to non-resident withholding tax).

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If you were a US citizen who has renounced citizenship, or if you are a long term resident of the United States ending your residency status for federal tax purposes, you are subject to the provisions under the Internal Revenue Code section 877A.

Section 877A is basically an exit tax.  The provision is set up to tax an individual of moderate wealth or

greater, on their appreciable assets once the individual leaves the Unitized States.  Under section 877A, property of the expatriate or long-term resident is valued at mark to market (essentially, fair market value) on the day before exit, and treated as “sold”.  All property that is valued and treated as sold is then subject to taxation on the difference of the property’s fair value less the original cost.  Any appreciation in excess of $690,000 (as of 2015) will be subject to the exit tax.  The tax calculation must be provided on Form 8854.  In 2015, you are now provided an option of a tax deferral if you appropriately enter in an agreement with the Internal Revenue Service.

General Rule – Expatriate and long-term residents

According to the Internal Revenue Service, if you expatriated on or after June 17, 2008, the Section 877A expatriation rules apply to you if any of the following statements apply.

• Your average annual net income tax for the 5 years ending before the date of expatriation or termination of residency is more than a specified amount that is adjusted for inflation ($160,000 for 2015).
• Your net worth is $2 million or more on the date of your expatriation or termination of residency.
• You fail to certify on Form 8854 that you have complied with all U.S. federal tax obligations for the 5 years preceding the date of your expatriation or termination of residency.

If any of these rules apply, you are a “covered expatriate.”

A long-term resident, as defined in IRC 7701(b) (6), ceases to be a lawful permanent resident if:

1. the individual’s status of having been lawfully accorded the privilege of residing permanently in the United States as an immigrant in accordance with immigration laws has been revoked or has been administratively or judicially determined to have been abandoned, or
2. the individual:
   • commences to be treated as a resident of a foreign country under the provisions of a tax treaty between the United States and the foreign country,
   • does not waive the benefits of the treaty applicable to residents of the foreign country, and
   • notifies the IRS of such treatment on Forms 8833 and 8854.

 Reporting requirements – what needs to be done:

If you meet the definitions and criteria mentioned above in the general rule, or will meet them shortly, your next steps should be as follows:

• File form 8854 Initial and Annual Expatriation Statement with your current year tax return and send a copy of form 8854 to the appropriate address provided in the form’s instructions. Make sure to fill out the appropriate parts based on your date of exit
• Identify the date of relinquishment of citizenship (for former US citizens)
• Determine the date you ended your long-term residency
• Identify all property you owned at date of expatriation
• Calculate the fair market value of all property owned at the date before expatriation
• If you choose to defer tax on your property upon exit, make sure you have appropriately completed all requirements the IRS provides
• Make sure you have all tax liability paid to the IRS prior to exit and that you have it appropriately certified both with records of payments as well as on form 8854. Therefore, any former US citizen or long-term resident should file a form 8854 regardless of whether they would fall under the exit tax regime

Other Considerations

Keep in mind that form 8854 might require annual statements and might require notification to Homeland Security.  It is important to know the requirements of the exit tax rules and disclosures in order to facilitate smooth transition.  Keep in mind that significant penalties of up to $10,000 may be assessed for failure to file form 8854 or to keep up with annual filing requirements.

Contact us today to help you maintain compliance and avoid significant penalties!