U.S. Citizens in Canada: Are you sure you don’t owe U.S. income tax?
The U.S. income tax filing requirements of U.S. citizens living in Canada has seen more than its fair share of press coverage in recent times. That said, despite the onerous personal income tax filing obligations and related foreign bank and financial account disclosure requirements imposed on U.S. citizens living outside of the U.S., few of these taxpayers end up owing U.S. income tax. For many U.S. citizens living in Canada, these U.S. compliance obligations are seen only as an administrative burden representing the cost of having and retaining U.S. citizenship. Enter the Net Investment Income Tax (NIIT), a new U.S. income tax that could create a U.S. income tax liability for U.S. citizens, even those with no U.S. source income.
What is the Net Investment Income Tax?
The NIIT was introduced in 2010 as part of U.S. President Obama’s Patient Protection and Affordable Care Act and is often referred to as the Medicare surtax. The NIIT came into effect on January 1, 2013 and it applies to the first taxation year beginning on or after this date. For individual taxpayers, the NIIT will need to be considered starting with their U.S. personal tax return for the 2013 tax year. The NIIT applies a rate of 3.8% on certain net investment income.
Who is subject to the Net Investment Income Tax?
The NIIT applies to individuals who are considered U.S. persons for U.S. tax purposes, as well as U.S. estates and U.S. trusts. The definition of a U.S. person includes a U.S. citizen, a U.S. permanent resident (i.e. green card holder) and a resident alien of the U.S. (i.e. an individual who meets the Substantial Presence Test under U.S. domestic income tax law).
Generally speaking, non-resident aliens of the U.S. are not subject to the NIIT unless they have elected to be considered a resident alien of the U.S., in which case special NIIT rules are applied.
How is the NIIT calculated?
An individual will be subject to the NIIT if they meet the following two conditions:
- They have net investment income
- They have modified adjusted gross income over the following thresholds:
- Married and filing jointly: $250,000
- Married and filing separately: $125,000
- Single: $200,000
- Head of household: $200,000
- Qualifying widow: $250,000
Net investment income (NII) includes, but is not limited to interest, dividends, capital gains, rental income, royalty income and certain other passive activities. In arriving at NII, the investment income is
reduced by certain expenses that are allocable to the income. These include investment interest expenses, investment advisory and brokerage fees, expenses related to rental and royalty income, tax preparation fees and state and local taxes. The NII calculation does not focus solely on U.S. source investment income and instead includes investment income from all sources worldwide.
Modified adjusted gross income (MAGI), for the purposes of the NIIT, is generally the same as adjusted gross income as calculated on Form 1040, Line 37 on the U.S. personal tax return with certain modifications, the most common of which is adding back any income deducted under the Foreign Earned Income Exclusion, a deduction frequently claimed by U.S. citizens living in Canada.
The NIIT is based on the lesser of:
- The amount that the taxpayer’s MAGI exceeds the taxpayer’s NII threshold, and
- The taxpayer’s NII
As an example, if a taxpayer with a single filing status has $190,000 of wages and $50,000 of NII, the taxpayer’s MAGI is $240,000. The taxpayer’s MAGI exceeds the NIIT threshold of $200,000 for a single filer and as such is subject to the NIIT. The NIIT would be calculated as 3.8% of the lesser of the following amounts: $40,000, the amount that the taxpayer’s MAGI exceeds the NIIT threshold, and $50,000, the taxpayer’s NII. As such, the NIIT would be $1,520, or 3.8% of $40,000.
Can foreign tax credits reduce the NIIT?
The short answer is no – foreign tax credits cannot be used to reduce or eliminate the NIIT. The long answer is that any federal income tax credit that may be used to offset a tax liability imposed by subtitle A of the U.S. Internal Revenue Code (the Code) can be used to offset the NIIT. However, if the tax credit is allowed only against the tax imposed by chapter 1 of the Code, those credits may not be used to reduce the NIIT. Foreign tax credits are allowed as credits only against the tax imposed by chapter 1 of the Code, therefore, they cannot be used to reduce the NIIT liability. Historically, U.S. citizens residing in Canada have relied on the fact that Canadian tax rates are generally much higher than U.S. tax rates, and the foreign tax credit has been a reliable mechanism to completely eliminate any U.S. tax owing on their U.S. tax returns, assuming no U.S. source income exists. Unfortunately, the way in which the NIIT rules were drafted prohibit the use of the foreign tax credit and create a potential U.S. income tax on non-U.S. source investment income upon which significant foreign tax has already been paid.
Based on the high-level information provided above, it is clear that the NIIT will be a surprising and frustrating U.S. tax issue for many U.S. citizens living abroad, including the many Canadian residents with U.S. citizenship. There may be planning opportunities to reduce or eliminate the NIIT in some cases, but for most taxpayers that become subject to the NIIT, it will be an additional tax burden that may bring into question serious considerations about whether or not to keep their U.S. citizenship.
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