Tax planning

Legal Ruling on Complex Disclosure Rules for US Ex-Pats

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US citizens who live outside the United States have the specter of the IRS and offshore compliance requirements over their heads, and often fear the threat of six-figure penalties and statutory fines if they are caught failing to report all their income and assets. If you have a non-US corporation, a non-US trust, invest in certain registered accounts, or have financial assets over certain thresholds, you are at increased risk.

Since 2004, the IRS has repeatedly saddled US citizens with fines in excess of $100,000 for failing to comply with foreign bank account and financial account disclosure laws. A US person who has a financial interest in non-US financial assets is required to file a Foreign Bank Account Report (currently FinCEN form 114) if the total value of their assets exceeds $10,000 at any time during the year. For willful violations of this filing requirement, the fines can be exorbitant.

U.S. v Colliot

The potential amount of these penalties has been under dispute in a court case, U.S. v Colliot. Dominique Colliot was assessed penalties for FBAR disclosure violations of $548,773 for 2007, $196,082 for 2008, and smaller penalties for 2009 and 2010. These massive penalties show the risks that US citizens face if they fail to properly disclose their foreign financial assets.

Colliot sued the U.S. government, alleging that the penalties were arbitrary and capricious, and that the IRS had incorrectly applied its own laws in calculating the penalty. The two relevant laws are 31 U.S.C. §5321(a)(5) and a related regulation, 31 C.F.R. §103.57.

§5321(a)(5) previously stated that the civil penalties in these situations could be equal to the greater of $25,000 or the balance of the unreported accounts, up to a maximum of $100,000. The related regulation, C.F.R. §103.57 agreed with the provision, using similar wording and identical numerical values.

However, in 2004, the provision in §5321 was amended by Congress and increased the maximum civil penalty which could be assessed for failing to comply with FBAR disclosure laws. The new law stated that the civil penalty for willful failure to file would be the greater of $100,000 and 50% of the balance in the unreported account.

This new provision now actually contradicted its related regulation, which continued to state that the maximum allowable penalty for a willful failure to file was $100,000. And although the IRS updated the provision for inflation and re-numbered it during a reorganization, it did not update it to align with the new §5321.

The Court therefore ruled on the side of Colliot, stating in a May 15, 2018 conclusion that the IRS cannot assess penalties in excess of the threshold set by 31 C. F. R §1010.820 (formerly 31 C.F.R §103.57). Of course, this regulation may be amended by the IRS to line up with the higher penalties in §5321, but for taxpayers who were assessed penalties between 2004 and that point, they may have a claim against the IRS to have a portion of those penalties reversed.

Despite this win for Colliot, it is important to remember that the IRS may still levy penalties of up to $100,000 per incidence of failing to properly report foreign financial assets. For US ex-pats living in Canada who have not been filing their US tax returns, this is a good opportunity to speak to a tax professional about the voluntary disclosure programs which would allow them to get up to date with their filing without the risk of incurring heavy penalties.

Tax Alert: Employment Expenses

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The CRA has made it clear that it has undertaken a new project in 2017 to carefully review employment expenses.  Many of my colleagues in the accounting profession have confirmed that they have also noticed that CRA has been more frequently asking taxpayers to support their employment expenses.

Where the employee is also an owner, we are finding that CRA is taking a tough line and denying even well-supported expenses.

CRA is basing the denial of these expenses based on the Tax Court of Canada Case, Morton Adler vs. the Queen (2010 DTC 1020), in which the burden is on the employee taxpayer to prove that there would be adverse consequences with respect to their employment if they did not use their car or home office.

In that case, the taxpayer was the spouse of the shareholder, and the court therefore took the position that there was little or no risk of the company suing the taxpayer for breach of contract if she failed to perform her duties with her car and home office. They also concluded that she would likely not suffer negative consequences of a poor performance review, and that these expenses were therefore not a requirement of employment. The expense deductions were denied.

Planning Alternatives

Wherever possible employment expenses should be paid by the employer.  For example, car expense could be accommodated by paying the employee a per kilometer amount for each supportable business kilometer driven.

Regardless of how you report the expenses, it will still be important to maintain good records.

H.R.1 The Tax Cuts and Jobs Act: Potential effects on US citizens and investors living abroad

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Individual Tax Reform

Tax rates

Tax rates for individuals and corporations are lowered across the board for individuals, but these lowered rates expire in 2025 unless there is further legislation to renew them. In conjunction with the other changes in the bill, this will result in lower taxes for some, but not all, taxpayers.

There are also new maximum tax rates for business income earned through a flow-through entity. This should replicate the lowered tax rates on corporations for individuals who conduct business through partnerships rather than corporations.

Personal exemption and standard deduction

For the years 2018 to 2025, the personal exemption is being eliminated and the standard deduction is being increased.  For non-resident individuals, this may mean a tax increase because they are not eligible to take the standard deduction.  A non-resident individual will only have specific allowable deductions to reduce their taxable income.

US 1040 filers who previously made use of the personal exemptions of their dependants, or who filed as Head of Household in order to use the larger personal exemption, may see an increase in their taxable income.

Students

The House bill contained a lot of changes relating to the treatment of student income, but most of these changes did not end up in the final bill. There is a change relating to the treatment of student loans discharged on account of death or disability. In the case of a loan being discharged due to the death or permanent disability of a student, this discharge will not be included in the gross income of the individual.

Deductions capped or removed

Foreign real property taxes may not be deducted. US citizens who own homes in a foreign country may have previously been deducting their property taxes on their non-US homes and will no longer be able to do so. Property taxes paid to the US will be capped at $10,000 for the year, or $5,000 for a married individual filing separately from their spouse.

The mortgage interest deduction is now limited to the interest paid on $750,000 worth of indebtedness secured by a qualified residence. Loans which were already in place before December 15, 2017 will not be affected by the new limitation.

The medical expense deduction floor is reduced from 10% to 7.5%.

Miscellaneous itemized deductions are suspended, as is the overall limitation on itemized deductions. This includes unreimbursed employee expenses, tax preparation fees, and certain other expenses paid to produce income, to manage or maintain income producing property, or to determine or claim a refund of tax.

These changes apply for the tax years 2018 to 2025.

Deduction for Alimony

The Bill repeals the deduction for alimony payments made, as well as the provisions requiring inclusion of alimony payments in gross income.

Elimination of shared responsibility payment

HR1 eliminates the shared responsibility payment for individuals failing to maintain essential minimum coverage. This would reduce the tax bill for people who do not have minimum essential insurance coverage or meet one of the qualifying exemptions. Most foreign nationals meet an exemption due to being out of the country, so the potential removal of this tax should not affect most US persons living outside the country.

Repatriation of earnings for Controlled Foreign Corporations

A controlled foreign corporation (CFC) is a foreign corporation in which 50% of the total combined voting power or value of all classes of stock is owned by a US person on any day of the year. Previously, there has been the opportunity for deferral of taxes on income which was not effectively connected to the US, and the income would be taxed when paid out to the US shareholder as dividends.

There were provisions in place to tax Subpart F income on the shareholder’s return, which is defined in §952 as including insurance income and foreign base company income. HR1 expands the definition of Subpart F income to include all accumulated post-1986 deferred foreign income.

This could have the effect of causing any retained earnings held in a US person’s non-US company to be taxable in the current year on the owner’s personal tax return. For many US expatriates, this is an area of significant concern since they may be running their non-US businesses out of corporations in the country in which they live.

There are some provisions included in the Bill to ease the transition to the new system, and an election which may allow the taxpayer to utilize their foreign tax credits more efficiently.

Estate and gift tax

The estate and gift tax exemption will be doubled to $10 million USD (adjusted for inflation).

Corporate Tax Reform

Lowered corporate tax rates

Despite the lowered tax rates for US C-corporations, there is still no integration between the US and Canadian tax systems, and tax rates for Canadian companies operating in the US through a US C-Corporation is still not likely to be tax efficient.

Repeal AMT

The Alternative Minimum Tax system is a taxing system applied at a lower flat rate and removes many deductions which may allow certain taxpayers to pay an “unfairly” low tax rate. HR1 repealed the AMT for corporations, and increased the limitation above which AMT would be calculated.

For those who have already paid AMT and accumulated AMT tax credits, there will be a system in place to allow those credits to be used.

Moving from deferral system to territorial system

US multinationals will have a full exemption for dividends paid from foreign subsidiaries if the US parent owns at least 10% of the subsidiary. This change works in conjunction with the above-noted requirement to include accumulated earnings and profits in Subpart F income to create what is being reported as a “territorial” tax system, rather than the “deferral” system which was in place.

Pass-through tax rate instead of being taxed at individual rates

Previous US tax law treated income earned through flow-through entities, such as partnerships, LLCs, or S Corporations, as income earned by the taxpayer who owns said entity. This means that income is included on the individual’s return and taxed at the individual’s marginal tax rate.

There are new complex rules in place to calculate the taxes for flow through entities, which includes deductions for certain business income, taking salaries into account, and different marginal rates.

Conclusion

The new US tax bill has far reaching effects, even to those not living in the United States of America. If have concerns over how the bill will affect US citizens or those investing in the US, please do not hesitate to contact us.

Taxation of Cryptocurrency Transactions

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Transaction in cryptocurrencies like Bitcoin and Litecoin are become more common every day.  There are those who are doing business, making purchases, or doing their personal transactions using Bitcoin and other cryptocurrencies, and some people are investing in the currency for speculative purposes.

CRA has taken the position that where Bitcoin is used to complete a transaction, it should be dealt with for income tax and HST purposes like a barter transaction.  The barter transaction rules have been in place for years.  If you complete this type of transaction, CRA wants you to simply value what you paid or received as if it were a cash transaction.  You would then report it for income tax or HST purposes the same way.

For the Bitcoin investor, CRA has said that while cryptocurrencies are not “money” or “currency,” they should be treated as a commodity, like gold, for Canadian tax purposes.

Buying or selling cryptocurrencies, like transactions with commodities, will trigger either a capital gain (or loss) or business income (or loss). The normal rules of whether buying or selling a commodity constitutes income or capital will apply. If you trade frequently is likely that the gains (or losses) would be business income (or loss). Conversely, if the Bitcoin was purchased a year ago, and the taxpayer never traded it, and does one trade before year end, it is virtually certain that the gain would be on capital account.

Some factors CRA will consider in determining the tax treatment include:

  1. frequency of trades,
  2. period of ownership,
  3. knowledge of matters,
  4. relationship to the taxpayer’s business, and
  5. time spent on it.

A third Bitcoin activity is mining for Bitcoins.  Mining is where you use your computer to assist in the processing of transactions for Bitcoin, and you are paid for this service in bitcoins.  Mining undertaken for profit is taxable. Mining undertaken as a personal hobby may not taxable. If are mining as a business, some of the tax consequences generally include:

  1. income from the business is included in your income at year end based on the value of your inventory (i.e., the cryptocurrencies), and
  2. any thefts or losses are deductible from your income if they are an inherent risk to carrying on the business.

If you invest in securities of offshore entities that deal in cryptocurrencies, or if you hold such cryptocurrencies directly in an offshore account, Canadian Foreign Accrued Property Income (FAPI) rules will likely apply.

 

When to file a tax return in the US

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As a person or entity who is not a US citizen and doesn’t live or work permanently in the US, you may believe that you have no obligation to file American tax reporting forms. However, according to US tax law, if a non-US entity is engaged in a trade or business in the US, it will be taxable on its income which is effectively connected with the conducting a trade or business in the United States.

The US-Canada Tax Treaty changes the burden for paying taxes in the US for Canadian entities and persons. They are only required to pay tax when the entity has a permanent establishment in the US. In order to claim these treaty benefits, a Canadian entity would have to file a protective return.

The definition of permanent establishment varies based on state, and certain states have not adopted the US-Canada Tax Treaty into law. Any time that a Canadian person or entity conducts a trade or business in the US, it is important to look at the specific states in which they are operating to determine if state-level tax obligations exist even when no federal taxes are due.

Effectively connected income

The general rule is that if an entity is engaged in a trade or business in the US, all US source income and gains is treated as effectively connected income (ECI). This does not include investment income, but does still apply to US source income earned by the entity which is not related to the trade or business carried on in the US.

Effectively connected income can be earned in a number of different circumstances. For example, certain non-immigrant visas allow people to work in the US while they are temporarily staying there. F, J M, and Q visas are in this category. The taxable part of a US scholarship or grant received by a non-resident would be considered as income connected with a trade or business in the US.

If an entity is a membership of a partnership that is engaged in a trade or business in the US, or if an entity is performing personal services in the US, this would be considered effectively connected income. If an entity is a business or owns a business that sells products or services within the US, the entity has effectively connected income.

Selling real property or real property interests within the US is considered engaging in a trade or business in the US. Income from the rental of real estate is subject to an election to allow it to be considered ECI.

Permanent establishment

Not all entities carrying on business in the US are required to pay taxes on their effectively connected income. Canadian entities earning business profits in the US have treaty protection against paying US taxes on business profits earned in the US if they did not earn those profits through a “permanent establishment.”

Article V of the Canada-US Tax Treaty defines “permanent establishment” as “a fixed place of business through which the business of a resident of [Canada] is wholly or partly carried on. The Treaty definition is fairly broad and includes a place of management, a branch, an office, a factory, a workshop, and a place of extraction of natural resources.

If a state follows the Canada-US Tax Treaty, failing to have a permanent establishment means that the entity should not have to pay income tax in that state (although franchise and licensing taxes may still apply). If the state does not follow the Canada-US Tax Treaty, state law will have to be considered to determine if the entity has nexus in that state and should therefore file a tax return and pay taxes.

Even if the entity does not have a permanent establishment, it does not automatically receive treaty protection. In order to claim treaty benefits, an entity would have to file a US return (1120-F); this return should include a treaty statement declaring that it is a Canadian entity wishing to claim the benefits of the US-Canada Tax Treaty and stating that they have no permanent establishment in the US and therefore are exempt from taxation on business profits. This is called filing a “Protective return.”

If this return is not filed, the US retains the right to issue a request to file and may claim that the treaty benefits were forfeited for failure to file. Filing this return also protects the right of the company to take deductions and credits against gross income in the event that the IRS does not agree with the entity’s determination that it does not have a permanent establishment in the US.

It is therefore very important to consult with professionals about an entity’s US tax liability, even if it only has limited activity in the US.

 

Subsection 216(1) Late-filing Policy

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A non-resident of Canada who owns real property in Canada has an obligation to report any rental income earned to the CRA. Many property owners believe that once they are no longer living in Canada, that they not required to report any of their income to the CRA. Or they may believe, that since there is no net profit on this property (i.e. expenses of owning the property are higher than the income earned from renting it), that there is no tax obligation. However, if they are earning income from real estate in Canada, that income is considered Canadian-sourced, and this income should be reported.

Non-residents earning rental income from Canadian real property are required to remit 25% of the gross income from the property to the CRA. The person who is paying the rent is the one who has the obligation to withhold this 25%, but many renters are unaware of this requirement and pay the full rent to the owner.

If the owner is also unaware of this obligation, there can be huge penalties involved. The non-resident owner will be expected to pay the outstanding 25% tax on gross income – plus interest and penalties. If there is a narrow profit margin on the rental income, this tax can often be more than the amount the owner netted on the rental.

In order to pay tax on the net income using graduated tax rates, the owner can submit an NR6 form, requesting to file a tax return to report income and expenses. However, to make this request, the non-resident must first be up-to-date on their past taxes. And the idea of paying 25% of gross income plus interest and penalties is very daunting.

The section 216(1) late filing policy at the CRA is to apply a one-time retroactive application of the NR6 election. The CRA may charge arrears interest on the full amount that should have been deducted, but if it determines that a non-resident’s circumstances warrant the one-time relief, it has an administrative policy to act as though each year’s tax return was filed on time. This means that the non-resident will only have to pay interest on the late monthly 25% remittances up to April of the following year. The CRA will then apply interest to the tax owing on the net income as reported for that year moving forward.

This policy has the potential to reduce a huge burden for non-residents who did not know or understand their Canadian tax obligations. In a recent case, over $40,000 of back taxes, interest, and penalties was reduced to approximately $2,000. This policy may allow non-residents to come forward, file their back taxes, and be onside with their taxes in the future. This is especially important for non-residents who are hoping to move back to Canada, or who would like to dispose of their Canadian real property.

If you are a non-resident who has not been properly reporting your Canadian real property income, please contact us for further information on submitting your back taxes under this policy.

Transfer Life Insurance to your Corporation

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One of the advantages of operating your medical practice or business using a corporation is the tax savings that you can have on the payment of your life insurance.

Generally most professional are paying their life insurance personally. To get the funds to pay the premium they earn a dollar, pay up to 53 cents of tax on that dollar and then pay 47 cents toward their insurance.

For example, if your life insurance premium was $4,700 you would need to earn $10,000 to cover the cost.

If you transferred your life insurance into your corporation, it would be the corporation that was paying tax on the income needed to pay your premium. Your corporation tax rate is much lower, 15% in Ontario for 2016. Your corporation would only need to earn $5,529. That is a 44.71 % savings.

An additional tax benefit might be available on the transfer of the insurance into the corporation if the fair market value of the insurance is greater than the tax cost, referred to as the Adjusted Cost Base. This topic will be discussed in a future article.

When you eventually need to collect on the life insurance, the funds are collected by your corporation and the funds can be paid out to the shareholders tax free using something called the Capital Dividend Account.

Before you make the transfer there are a few things you need to consider including:

  1. The Capital Gain Exemption – insurance could put you or your family offside when trying to claim the capital gain exemption.
  2. Tax on Death – insurance could affect the amount of tax payable on death due to the effect of the Stop Loss Rules.
  3. Creditor Protection – the proceeds of your insurance could now be exposed to the creditors of the corporation.
  4. Effect on your shareholder agreement, if you have other shareholders.

There are additional considerations where you are transferring a permanent (Whole Life or Universal Life) insurance product that will be dealt with in a future article.

Professional advice should be obtained before making any changes to your current structure.

Allowable Business Investment Loss

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When you make a good investment, CRA is very happy to tax you; however when your investment no longer has any value, getting a deduction can be difficult.
Generally a loss on the disposition of an investment, like shares or debt, is treated as a capital loss, deductible against other capital gains. As long as you have other capital gains, you will at least save a few dollars in tax.

The problem occurs when you do not have capital gains to shelter and you want to claim your loss against other income. In limited situations, CRA will allow you to claim a Business Investment Loss.
A business investment loss is basically a capital loss from a disposition of shares or debt of a small business corporation to which subsection 50(1) applies, or to an arm’s length person. One half of this loss is an allowable business investment loss (ABIL). Unlike ordinary allowable capital losses, an allowable business investment loss may be deducted from all sources of income for the taxation year in which it is recorded. Generally, an allowable business investment loss that cannot be deducted in the year it arises is treated as a non-capital loss which may be carried back three years and forward ten years, to be deducted in calculating taxable income of these other years. Any such loss that is not deducted by the end of the ten-year carry-forward period is then treated as a net capital loss which can be carried forward indefinitely to be deducted against taxable capital gains.

A detailed description of the rules related to claiming an ABIL can be found in CRA’s IT484R2r. The information is a little out of date; however the general concepts have not changed.

The rules outlined are very specific and you must fit precisely within them, otherwise you not obtain the benefit of claiming an ABIL. The other issue is that almost all ABIL claims are audited by CRA.

There are many ways to go offside and many ways to fix the problem with advance planning. For example, the corporation needs to be a Canadian Control Private Corporation (CCPC) using substantially all of its assets to carry on business in Canada within 12 months of the disposition.
If your investment does not qualify and if you have not yet disposed of the investment, you may be able to fix the problem. You may be able to make changes in order to have the corporation qualify as a CCPC; you may be able to have a non-resident operation either relocated to Canada or deemed to be resident in Canada.

The most important step is planning in advance for the disposition of the investment.

If you have an investment that has lost value and you would like to ensure that all possible steps have been taken to enable you to claim the loss in the most tax efficient manner, we can help.

15 ways to lose your ABIL deduction:

  1. 1. Investment was made to a corporation that is not a Qualified Small Business Corporation (QSBC).
  2. You waited too long to claim your write-off.
  3. The corporation did not have its assets used in Canada.
  4. The corporation did not carry on an active business within 12 months of your disposition.
  5. The investment was not made to earn income; your investment was an interest free loan to a spouse, child or their corporation.
  6. The investment was made to an individual, partnership or trust, rather than a corporation.
  7. Your section 50(1) election was not filed correctly.
  8. The disposition was not made to an arm’s length person.
  9. You honoured a loan guarantee to assist the owners of the corporation.
  10. You are found to be liable for unremitted employee withholdings.
  11. You have not disposed of all of your shares (including those owned by other family members).
  12. You have claimed a capital gains exemption in prior years.
  13. You have poor documentation or insufficient support, such as a missing loan agreement or share certificates.
  14. You are unable to provide cancelled cheques to support the original investment.
  15. You are unable to provide financial statements of the corporation.