U.S. citizens living in Canada: Time to come clean to the IRS
An estimated one million U.S. citizens living in Canada have barely four weeks to come clean to the Internal Revenue Service before facing potentially crippling fines and penalties.
The United States is the only country that requires its citizens to file a tax return and report their worldwide income, no matter where in the world they might live or how many other citizenships they might hold. While openly confessing past tax sins is a scary proposition for some, the IRS' Offshore Voluntary Disclosure Initiative that gives filers until Aug. 31 to clear up back taxes is expected to bring many out of the woodwork.
Christine Perry, a lawyer with Keel Cottrelle LLP in Toronto and a member of both the Ontario and New York bars, has been burning the midnight oil on behalf of clients anxious to clear their record before the deadline.
"Everything we are seeing from the IRS indicates that this focus on offshore disclosure and compliance is only gathering momentum," says Ms. Perry, whose practice focuses exclusively on cross-border tax and estate planning solutions.
"Tax haven abuse, whether at the individual or corporate level, is a popular issue domestically and an easy sell politically."
It is not surprising then that the U.S. might turn its tax guns on its worldwide citizens to help cope with an escalating multi-trillion dollar debt. And many people are complying. Ever since the IRS launched OVDI in February, Ms. Perry has been walking people through this tax maze and expects the rush is yet to come, even though the complex process can easily involve $15,000 to $20,000 in accounting and legal fees for a straightforward case.
OVDI is designed "to get people back into the U.S. tax system," to bring offshore money back into the country and help people with undisclosed income from hidden offshore accounts get current with their taxes, IRS Commissioner Doug Shulman said when the program was relaunched after a successful 2009 OVDI in which roughly 15,000 participants came forward.
Under the program, taxpayers must file various outstanding returns from 2003 through 2010. The first is the annual 1040 Income Tax Return to report the U.S. citizen's worldwide income, including income from Canada. It doesn't necessarily mean that you owe money -- you can generally claim a foreign tax credit for the Canadian federal and provincial tax to be applied against U.S. taxes owing -- but the obligation is that annual returns must be filed.
Filing these past tax returns can be quite burdensome especially if you own a Tax Free Savings Account or Registered Education Savings Plan. These vehicles are not recognized as tax deferred vehicles in the U.S. which views them as foreign grantor trusts requiring separate filings (IRS Form 3520/3520As). The IRS itself estimates that it would take six hours and 40 minutes to complete Form 3520.
In addition, if you have more than $10,000 in foreign (i.e. "non-U.S.") accounts, including Canadian bank, investment, RRSP and RRIF accounts, you must file a "Report of Foreign Bank and Financial Accounts" (FBAR) return listing details of each account. Note that this is under the U.S. Bank Secrecy Act and is not a tax filing.
The penalties for not filing returns can be harsh. For example, under the general rules, civil penalties for "willful" failure to file an FBAR can be as high as $100,000 or 50% of the account balance for each violation, whichever is greater. It could also result in criminal penalties of up to $500,000 and/or a prison term of up to 10 years. Even non-willful violations can trigger penalties of $10,000 per account per year.
"The magnitude of the penalty that may be imposed seems, for many taxpayers, to be totally out of proportion to the severity of their violation -- essentially the failure to file an administrative form," says Ms. Perry.
Applying under OVDI, however, can reduce penalties for late-filed FBAR returns. Instead of the regular penalties, the maximum penalty would be 25% of the highest total balance of foreign (non-U.S.) financial accounts held between 2003 and 2010; however, the IRS has indicated that the 25% penalty can be reduced to 5% for taxpayers who were unaware they were U.S. citizens or for Canadians with less than $10,000 of annual income from U.S. sources who have filed Canadian tax returns.
OVDI participants will also avoid potential criminal prosecution.
"Participation in OVDI may not be right for everyone, but the introduction of the lower 5% penalty category makes it an option worth considering," says Ms. Perry. "The one thing people want to avoid doing is burying their heads in the sand and hoping this will pass, because it won't."
What becomes especially tricky for many is that you may be a U.S. citizen charged with these reporting obligations simply by being born in the U.S. or born outside the U.S. to two U.S. parents, even if you never actually lived there. Alternately, if you have (or had) a U.S. green card, you may also have annual filing requirements.
The United States' policy of taxing its citizens' worldwide income while most countries, Canada included, choose to tax based on residency is controversial, to say the least. Under Canadian tax law, for example, if you are a Canadian resident, you pay tax on your worldwide income in Canada but if you are a Canadian citizen who is not actually resident in Canada, you generally have no worldwide income reporting obligation to Canada.
Writing in Tax Notes International last year, Reuven Avi-Yonah, a professor of law at the University of Michigan Law School, called for an end to U.S. taxation of its citizens who live abroad. "In a globalized world, citizenship-based taxation is an anachronism that should be abandoned," wrote Professor Avi-Yonah.
Earlier this month, however, Edward A. Zelinsky, an expert on U.S. tax law and a professor at Cardozo Law School in New York City, published a paper in favour of continuing citizen-based taxation concluding that the "U.S. system of citizenship-based taxation typically reaches the same results as the residence-based systems of these other nations, but reaches these results more efficiently by avoiding factually complex inquiries about domicile."
Finally, while you may be tempted to simply let the Aug. 31st deadline fade into oblivion, confident that the IRS will never actually find you north of the 49th parallel, that may soon be changing.
Starting in 2014, the U.S. Foreign Account Tax Compliance Act (FATCA) will require Canadian financial institutions to disclose information about U.S. citizens who hold Canadian financial accounts or risk punitive withholding taxes of 30% on all payments out of the U.S.
"The fact that some global financial institutions are even contemplating implementing the FATCA requirements suggests that the U.S. still has the clout to essentially strong arm foreign jurisdictions into compliance with its anti-abuse initiatives," Ms. Perry says. "I think it's clear that we are looking at a paradigm shift when we see a bank secrecy jurisdiction such as Switzerland consenting to hand over thousands of names and disclose account information to the United States."
- Jamie Golombek, CA, CPA, CFP, CLU, TEP is the Managing Director, Tax &Estate Planning with CIBC Private Wealth Management in Toronto.
By the numbers
1M Approximate number of U.S. citizens in Canada.
$70B Annual revenue loss to the United States resulting from undisclosed offshore assets, as estimated by the IRS.
$780M Fines, penalties, and interest paid to the U.S. by Switzerland's largest bank after admitting guilt on charges of conspiring to defraud the United States by impeding the IRS.
30% Potential payout under the IRS Whistleblower Program as a percent of the amount collected as a result of your tip.
$206M Amount collected under the IRS Whistleblower Program in FY 2009.
$15,000 Base estimate of legal and accounting charges to file eight years of back U.S. taxes.