Tax Planning and Compliance for Canadian Residents with U.S. Connection
Canadians sometimes find themselves surprised with the fact that they are required to file a U.S. tax return. It all depends on whether they may be required to do so under the applicable U.S. tax law and the Canada-U.S. income tax treaty. The United States refers to non-U.S. persons (or more precisely, non U.S. tax resident individuals) as nonresident alien individuals. In general, a nonresident alien (NRA) is required to file a U.S. tax return when she/he performs any services in the United States or earns U.S. source income. Although there are many situations when a U.S. tax return may be required to be filed, below we outline a few key scenarios leading to a U.S. tax filing obligation that Canadians need to be aware of.
As a nonresident alien individual, you would only be required to file a U.S. return if you earned wages in excess of US $3,000 and when some other requirements are met. You would only include wages for services performed in the United States. Note that while we refer to wages and salaries, any compensation for services performed in the United States is covered under this rule. If you performed services partly within and partly without the United States, you must allocate your compensation between U.S. and non-U.S. sources to determine if any U.S. tax is owed.
In some situations, wages for services performed in the United States may be exempt under an applicable U.S. income tax treaty and, therefore, be not subject to U.S. taxation. For example, the Canada-U.S. income tax treaty indeed provides for a limited exemption from U.S. tax. If that is the case, you must file Form 8833, Treaty-Based Return Position Disclosure, along with Form 1040NR, U.S. Nonresident Alien Income Tax Return. Failure to file Form 8833, when required, could result is a penalty of US$ 1,000. But more importantly, failure to file proper IRS Forms may result in adverse U.S. tax consequences.
If you operated a business in the United States or practiced your profession as a sole proprietor in the United States, you are likely engaged in a trade or business within the United States and as such are generally subject to U.S. taxation. To the extent your business has income effectively connected with a U.S. trade or business, you may be required to report your effectively connected income and expenses on Form 1040NR and pay tax (there would be additional business tax filings for your business). For example, you would include on your tax return any income you received through your U.S. office.
If your business did not have a permanent establishment in the United States, as defined in the applicable U.S. income tax treaty (the Canada-U.S. income tax treaty provisions would apply to Canadians), it may be exempt from U.S. taxation. If that is the case, you must file Form 8833, along with Form 1040NR. Failure to file Form 8833, when required, could result in a penalty of US$ 1,000.
The rules vary depending on whether your business is a corporation or a flow-through entity.
You received the following type of income from US sources and not all of the US tax that you owe was withheld from that income:
• Gambling winnings
• Pensions and annuities and
• Other income, such as scholarship and fellowship grants
These items of income (and related withholding tax) are reported on Schedule NEC, Tax on Income Not Effectively Connected With a US Trade or Business. Gambling winnings can be offset by gambling losses, which may result in a tax refund of all or some of withholding taxes imposed at source.
In general, rents from U.S. real estate are subject to a 30 percent general withholding tax on a gross basis, unless you elect to treat the rental income as effectively connected income. With a valid election in place, you would be taxed on the rental income after the deduction of rental expenses, including tax depreciation on the rental property.
Gain or loss from the disposition of a U.S. real property is taxed as if the gain or loss were effectively connected with the conduct of a U.S. trade or business and are reported on Form 1040NR. Generally, the gain or loss on a sale of real property would be subject to a long-term capital gains rate of 20 percent (if the property was held for more than one year). If you held the property for one year or less, then ordinary income tax rates apply (they are higher than the long-term capital gains rate). You may be subject to Net Investment Income Tax (“NIIT”) of 3.8 percent and it could be added to your tax liability. Note that the U.S. taxes you paid are generally creditable in Canada, but you may need to be prove your ultimate U.S. tax liability (on a U.S. federal level, you can do it by providing the Canada Revenue Agency (“CRA”) with an IRS transcript of account).
In addition to the income tax, the sale of US real estate by a Canadian resident is generally subject to a withholding tax on the gross proceeds of the sale. That withholding is done under Foreign Investment in Real Property Tax Act (“FIRPTA”) provisions of the US Internal Revenue Code. Depending on the amount of the gross proceeds and the nature of the use of the property, the US withholding agent would withhold the amount equaling 15 percent of gross proceeds from the sale. The withholding may be only 10 percent (if certain requirements are met) or it may be further reduced if the seller and buyer follow certain IRS procedures.
For example, the amount of FIRPTA withholding may be reduced or eliminated under some circumstances if the seller applies for an IRS Withholding Certificate by filing with the IRS Form 8288-B, Withholding Certificate for Dispositions by Foreign Persons of U.S. Real Property Interests. You can claim a refund of taxes withheld in excess of the ultimate US tax liability, provided you file your US income tax return (Form 1040NR) for the tax year in which you sold the property.
Even though you may not have any US source income to report in the United States, you may be considered a US tax resident. That could happen, for example, if you meet the substantial presence test. To meet that test, you must have been physically present in the United States for at least:
• 31 days during the 2016 tax year (current year); and
• 183 days (in the aggregate) during a three-year period (in this case, 2016, 2015, and 2014).For purposes of the substantial presence test, you must count all days when you were physically present in the United States during the 2016 tax year, but only 1/3 of the number of days of physical presence in the United States in 2015 and only 1/6 of the number of days physically present in the United States in 2014.
For example, assume Brett, a Canadian citizen and resident spends lots of time in Florida, where he bought a vacation property. In 2016, Brett spent 120 days in the United States. He spent 150 days in 2015 and 120 days in 2014. Applying the above formula, we will find that Brett meets the substantial presence test as he spent more than 182 days in the United States in the aggregate over a three-year period (120 days + 50 days (150/3) + 20 days (120/6) = 190 days)). Generally, spending less than 121 days per year in the United States would not trigger the substantial presence threshold.
If you are a nonresident alien individual and you meet the closer connection exception to the substantial presence test, you may still be considered a US nonresident. In that case, you must file Form 8840, Closer Connection Exception Statement for Aliens with the IRS to establish your claim that you are a nonresident of the United States by reason of that exception.
If you do not timely file Form 8840, you will not be eligible to claim the closer connection exception and may be treated as a US resident. You will not be penalized if you can show by clear and convincing evidence that you took reasonable actions to become aware of the filing requirements and significant steps to comply with those requirements.
Finally, if both Canada and the United States claim you as a tax resident, you will need to look into the Canada-US income tax treaty tie-breaker rules to determine your residency status.
Note that in some cases, a part-time resident status applies, as well as some other exceptions from the general rules. As such, managing one’s tax residency status is important and should be done pro-actively on a continued basis. You should also pay attention to the tax residency status for US federal estate and gift tax purposes that is different from the income tax residency concept.