Canada’s “residence-based” departure tax vs. the US “citizenship-based” Expatriation Tax – Focus on Canada’s Tax

Part I – Introduction – Not all “Exit Taxes” are the same:

Those subject to the tax jurisdiction of a country (typically because they reside in that country) are subject to tax for a variety of reasons. These include: earning income, the sale of assets, buying goods and services, etc.) People are becoming more and more mobile. In many instances, they will move from their tax jurisdiction to reside in another tax  jurisdiction. For example, a Canadian living in Toronto might decide to (1) cease residing in Canada and (2) start residing in the United States. In a practical sense he will STOP paying taxes (on his world income to Canada) and START paying taxes (on his world income) to the United States. That’s how normal people think about moving from one country to another.

That said, life in the Global World is more complicated. What might seem like a simple move to an individual, may be a more complicated move from the perspective of immigration and taxation.

The concept of the “tax resident”

In a FATCA and CRS world, the concept of “tax residency” is vitally important. In general, your “tax residence” is where you actually live. Your country of “tax residency” is the place where you are taxed on your income because you actually have a physical presence there and actually live there. For most people this is simple. For others (particularly in transition, it is possible to be considered to be a “tax resident” of more than one country. In many of these cases, tax treaties may be utilized to assign “tax residence” to one country or another.

No person should be required to be a “tax resident” of more than one country

With the exception of the United States and Eritrea, all countries assert tax jurisdiction over residents of their countries. (The United States and Eritrea assert tax jurisdiction over both residents and citizens. The consequence is that the governments of the United States and Eritrea follow their citizens to any place they move.)

In a global world it is common for people to move from one country to another. For example one could move from Canada to the Bahamas. By ceasing to become a resident of Canada, one ceases to be subject to Canadian taxes (with the exception of certain kinds of Canadian based income). As a result, Canada (like many countries) imposes a tax when one ceases to reside in Canada and is therefore no longer subject to Canadian tax laws. The theory is that Canada should have the right to impose a tax on the gains in assets that accrued when the person was a tax resident of Canada. To put it simply:

If your gains accrued while you were a tax resident of Canada,and  if you then cease to be a tax resident of Canada, you are required to pay tax on the gains that accrued while you were a tax resident of Canada. Is this fair? Is this logical? In Canada capital gains are triggered by the earliest of: sale (actual disposition), death (deemed disposition) or departure (deemed disposition).

Like it or not, that’s the theory and reality. Note that the tax is triggered by “departure” – ceasing to be a resident of Canada. The tax applies to almost all residents with exactly the same rules: regardless of citizenship, regardless of income and  regardless of wealth.

“Exit Taxes” in Europe

Historically “Exit Taxes” have been well established in Europe. The EC  Treaty has been interpreted to limit the right of countries that are subject to the treaty to impose an Exit tax when an individual moves to a treaty partner country. This was canvassed in an article by Henley Partners called:

“The End of Exit Taxes in Europe“.

The article includes:

The European Court of Justice rendered a judgment on March 11, 2004 concerning the exit tax which is imposed in France on holders of substantial participations who give up their residence and move abroad. The court ruled that the exit tax provisions of this kind restrict the freedom of movement (Article 43 of the EC Treaty). This decision will have a considerable impact on the current exit tax regimes in existence in various EU countries, for example, Germany or the Netherlands, and will probably even apply with regard to taxpayers moving to Switzerland, one of the most attractive locations for business and residence in Europe.

Although the article is written in the European context, it recognizes that “Exit Taxes” are a restriction on the freedom of movement.

The U.S. does NOT have an “Exit Tax” – It has an “Expatriation” Tax

The U.S. does NOT (with the exception of Green Card holders) impose a “change in residence” tax on U.S. citizens who move abroad. It does imposes an “Expatriation” tax on chose who relinquish citizenship. U.S. citizens abroad who “renounce” have already established residence in another country.

How is an “Expatriation Tax” like an “Exit Tax”? How is it different?

Similarity:

Both Canada’s Exit Tax and the U.S. Expatriation Tax are taxes imposed by virtue of ceasing to be a taxpayer in the country. Those who change their residence from Canada are no longer subject to Canada’s tax system. Those who cease to be U.S. citizens are no longer to the U.S. tax system. This makes senses because Canada asserts tax jurisdiction based on residence and the U.S. asserts tax jurisdiction based on citizenship.

Difference:

Canada – A tax on assets: Canada’s Exit Tax is imposed on the appreciation of assets during the period the person was a resident of Canada.

The U.S. – A tax on persons: The U.S. Expatriation Tax, as applied to U.S. citizens abroad, is NOT a tax on the appreciation of assets during the period the person was a U.S. resident. The U.S. “Expatriation Tax” is a tax imposed ON THE PERSON and the increase in the value of assets (whether connected to the U.S. or not) is used only to determine the amount of tax IMPOSED ON THE PERSON.

To put it simply:

The U.S. “Expatriation Tax” is a tax imposed on a person. The assets are relevant to determine the amount of the tax.

Canada’s “Departure Tax” is a tax imposed on assets. The tax is paid by the person.

Taxes imposed on persons:

Taxes imposed on persons have a nasty history including the German Reichsfluchsteur and the Soviet Union’s “Diploma Tax“.

My point is NOT that the U.S. Expatriation Tax is in exactly the same category as the Reichsfluchsteur or the Diploma Tax (although there are some who think it is). My point is that the U.S. Expatriation Tax is a tax directed at individuals and the tax on persons is calculated on assets that may have no U.S. connection.

The first U.S. “Expatriation Tax” was the Clinton tax of 1996. An argument for why the Clinton “Expatriation Tax” twas different from the “Soviet Diploma Tax” is here.

Expatriations and U.S. Citizenship Abroad

An unprecedented number of U.S. citizens are relinquishing their U.S. citizenship. The most common form of “relinquishment” is a formal renunciation of U.S. citizenship. Since 2008 the United States has imposed the 877A tax on those expatriating. At the risk of oversimplification, those renouncing U.S. citizenship (regardless of their reason for renouncing) hope to avoid the Expatriation Tax. (Nobody likes to pay taxes.) The Expatriation Tax applies to “Covered Expatriates”. One will be a “Covered Expatriate” if one meets any one of the following three tests:

1. Asset Test – Net worth of two million or more

2. Income Test – Determined by annual tax paid to U.S.

3. Compliance Test – Are you able to demonstrate five years of tax compliance.

Tis the season for tax reform …

American Citizens Abroad (and many individuals) argue that the time has come for the U.S. to join the rest of the world by abandoning Citizenship-based taxation (“CBT”) and adopting Residence Based Taxation (“RBT”). Will this happen? Early indications suggest that some kind of “Exit Tax” or “Expatriation Tax” will be part of the discussion.

The United States Senate Committee on Taxation is considering (in relation to U.S. citizens abroad) the position that:

IV. NON-RESIDENT U.S. CITIZENS  

1. Provide an election to citizens who are long-term nonresident citizens to be taxed as nonresident aliens if they meet certain conditions (Schneider, “The End of Taxation Without End: A New Tax Regime for U.S. Expatriates,” 2013; similar to the law in Canada)

a. Require a minimum period of residence abroad

b. Impose an exit tax on electing taxpayers where deemed to sell all assets at the time of election

2.      Repeal the foreign-earned income exclusion (H.R.2 (108th Congress), Jobs and Growth Tax Relief and Reconciliation Act of 2003, sponsored by Rep. Thomas)

Note the reference to an “exit tax” and that it being “similar to the law in Canada”. These references might mean something or they might mean nothing. That said:

They do NOT describe an “Expatriation Tax”. They describe an “Exit Tax”. Furthermore, they are referring to an idea that is “similar to the law in Canada”.

How does the “Departure Tax in Canada” work?

In a nutshell, when a tax resident of Canada ceases to reside in Canada and begins to reside in another country:

There is a “deemed disposition” of all the person’s assets, and the person is required to pay a capital gains tax on those assets. The exceptions are: Canadian real estate, Canadian pension plans, insurance policies and property used to carry on a business in Canada. Immigrants to Canada who lived in Canada for less than five years are NOT subject to the tax on assets they had when they immigrated to Canada.

Canada’s departure tax includes significant exemptions. The exemption for Canadian real estate presumably reflects the reality that real estate cannot escape the jurisdiction. Furthermore,  the intent is to keep retirement plans intact. Significantly, there is a recognition that it is inappropriate to tax assets without a significant period of Canadian residency. The U.S. Expatriation Tax does not provide an exemption for assets that cannot escape U.S. jurisdiction. Furthermore, the clear intent of the U.S. Expatriation Tax is to destroy pensions.

The devil is always in the details.

Part 2 – The Nuts and Bolts of Canada’s Departure Tax

 

Just a reminder:

Canada exercises tax jurisdiction on the basis of residence. This means residence of the person or residence of the asset. Either or both must be residents of Canada to trigger tax obligations.

There are 5 questions:

1. What is a tax resident of Canada?

2. What does it mean to cease being a resident of Canada?

3. What are the tax consequences of ceasing to be a resident of Canada?

4. What happens if you return to Canada to live?

5. When must non-residents file a Canadian Tax Return?

Answering the 5 questions …

The following page from the Government of Canada explains or links to pages that explain and answer these questions.

The Canada Departure Tax Rules apply when one ceases to be a tax resident of Canada.

1. Who or what is a tax resident of Canada?

There are two ways to be a “tax resident of Canada”

A. Actual Residency – You actually live there

Under Canada’s tax system, your liability for income tax in Canada is based on your status as a resident or non-resident of Canada. Your residence status must be established before your tax liability to Canada can be determined.

A determination of residence status can only be made after all the factors have been considered. Residence is a question of fact.

The residential ties you have or establish in Canada are a major factor in determining residence status.

Residential ties to Canada include (but are not limited to):

– a home in Canada;

– a spouse or common-law partner or dependents in Canada;

– personal property in Canada, such as a car or furniture;

– social ties in Canada; and

– economic ties in Canada.

Other ties that may be relevant include:

– a Canadian driver’s license;

– Canadian bank accounts or credit cards; and

– health insurance with a Canadian province or territory.

Residential ties that you maintain or establish in another country may also be relevant.

Note that there is no prescribed number of days of actual residence that is required to be a resident of Canada

B. Deemed residency – We are going to decide that you live there – 183 days in year rule

You are a deemed resident of Canada for tax purposes if you are in one of the following situations:

You lived outside Canada during the tax year, did not have significant residential ties, and you are a government employee, a member of the Canadian Forces including their overseas school staff, or working under a Canadian International Development Agency (CIDA) assistance program. This could also apply to the family members of an individual who is in one of these situations.
You sojourned in Canada for 183 days or more (the 183-day rule) in the tax year; do not have significant residential ties with Canada; and are not considered a resident of another country under the terms of a tax treaty between Canada and that country.

Deemed residents of Canada and actual residents of Canada have almost the same tax obligations as residents of Canada (the difference is that “deemed residents” may not reside in a province).

If you are a deemed resident of Canada for the tax year, you:

– may have to file a Canadian income tax return for that tax year;

– must report world income (income from all sources, both inside and outside Canada) for the entire tax year;

– can claim all deductions and non-refundable tax credits that apply;

– are subject to federal tax and instead of paying provincial or territorial tax, l pay a federal surtax;

– can claim all federal tax credits, but cannot claim provincial or territorial tax credits.

 

2. What does it mean to cease being a tax resident of Canada?

This is a two part test: Generally, you are an emigrant for income tax purposes if you:

(1) leave Canada to settle in another country;and

(2) sever your residential ties with Canada.

All of this is a question of fact.  Here are “some” facts used to decide whether one has severed residency in Canada:

– disposing of or giving up a home in Canada and establishing a permanent home in another country;

– having your spouse or common-law partner or dependents leave Canada; and

– disposing of personal property and breaking social ties in Canada, and acquiring or establishing them in another country.

Residency status could also be affected by the severing or not of other residential ties, such as:

– a Canadian driver’s license;

– Canadian bank accounts or credit cards; and

– health insurance with a Canadian province or territory.

3. What are the tax consequences of ceasing to be a tax resident of Canada?

A. Deemed disposition of all assets making them subject to a capital gains tax (exceptions: Canadian real estate, Canadian retirement plans, life insurance, etc.)

Note that these exemptions mean that retirement plans, life insurance policies and Canadian real estate are not subject to the deemed disposition rules).

Deemed dispositions – What does this mean?

If you cease to be a resident of Canada, you are deemed to have disposed of almost all your property at its fair market value (FMV) when you left Canada and to have reacquired it for the same amount right after. This is called a deemed disposition. It’s a “pretend sale”.

This applies to most properties. Some of the exceptions are:

– Canadian real property, Canadian resource property, and timber resource property;

– Canadian business property (including inventory) if the business is carried on through a permanent establishment in Canada;

– pensions and similar rights, including registered retirement savings plans (RRSPs), registered retirement income funds (RRIFs), registered education savings plans (RESP), registered disability savings plans (RDSP), tax-free savings accounts (TFSAs), and deferred profit-sharing plans (DPSP);

– rights to certain benefits under employee profit-sharing plans, employee benefit plans, employee trusts, employee life and health trusts, and salary deferral arrangements;

– certain rights or interests in a trust;

– property you owned when you last became a resident of Canada, or property you inherited after you last became a resident of Canada, if you were a resident of Canada for 60 months or less during the 10-year period before you emigrated;

– employee security options subject to Canadian tax; and

– interests in life insurance policies in Canada (other than segregated fund policies).

Canada’s Departure Tax contemplates the preservation of retirement plans.

If you emigrate from Canada and hold a tax-free savings account (TFSA), you can keep your TFSA and continue to benefit from the exemption from Canadian tax on investment income and withdrawals. However, no contribution will be allowed and no contribution room will accrue while you are a non-resident of Canada.

Note also that those who resided in Canada for less than 60 months of the 10 years preceding emigration will NOT be subject to the deemed disposition rules on property they arrived in Canada with or inherited.

You can provide security for the deemed dispositions. Also, the amount owing is not subject to interest! (Does this mean that by departing from Canada you can “lock in” a smaller capital gain and defer paying the tax on that gain? Hmm…)

B. No longer taxed on world income but are taxed on Canadian source income (examples: Canadian real estate, Canadian stocks, income from business located in Canada)

Part XIII Tax and Part I Tax – The two kinds of taxes paid by non-residents of Canada on Canadian source income

Part XIII Tax – this is income from Canadian property – the default Part XIII tax is 25% (subject to a tax treaty)

The most common types of Canadian income subject to Part XIII tax are:

– dividends;

– pension payments;

– old age security pension;

– Canada Pension Plan and Quebec Pension Plan benefits;

– retiring allowances;

– registered retirement savings plan payments;

– registered retirement income fund payments;

– annuity payments; and

– management fees.

Part I Tax – This is income from the following (appears to be more business/employment related)

– income from employment in Canada or from a business carried on in Canada;

– employment income from a Canadian resident for your employment in another country if, under the terms of a tax treaty between Canada and your new country of residence, the income is exempt from tax in your new country of residence;

– certain income from employment outside Canada, if you were a resident of Canada when the duties were performed;

– taxable part of Canadian scholarships, fellowships, bursaries, and research grants;

– taxable capital gains arising from the disposition of taxable Canadian property; and

– income from providing services in Canada other than in the course of regular and continuous employment.

4. What happens when you return to reside in Canada?

If you ceased to be a resident of Canada after October 1, 1996, and you later re-establish Canadian residency for income tax purposes, you can elect to make an adjustment to the deemed dispositions you reported when you emigrated from Canada. We refer to this as an election to “unwind” a previous deemed disposition.

You can make this election to unwind if you still own some or all of the property that was deemed disposed of when you emigrated. If you make this election for taxable Canadian property, you can reduce the gain reported on your tax return for the year you emigrated by an amount you specify-up to the amount of the gain you reported.

If you make this election, the amount of the gain from the deemed disposition on other than taxable Canadian property that you reported on your tax return for the year you emigrated can be reduced by the least of:

– the amount of the gain reported on your tax return for the year you emigrated;

– the fair market value (FMV) of the property on the date you returned to Canada; or

– any other amount to a maximum of the lesser of the above-noted amounts.

5. When must non-residents file a Canadian Tax Return? What kind of paperwork?

A. In the year one becomes a non-resident of Canada:

For the part of the tax year that you ARE a resident of Canada:

You have to report your world income (income from all sources, both inside and outside Canada) on your Canadian tax return.

For the part of the tax year that you are NOT a resident of Canada:

After your departure from Canada, you pay Canadian income tax only on your “Canadian source income”.

B. After one is a non-resident of Canada

.You must file a Canadian tax return if you:

– owe tax; or

– want to receive a refund because you paid too much tax in the tax year.

Special note on Part XIII Tax – This is the final Canadian tax obligation on this income. It is in general NOT refundable. But, there are two specific situations where you can elect to file a Canadian tax return to get a refund of Part XIII tax:

– when you receive Canadian rental income or timber royalties; and

– when you receive certain Canadian pension income.

If you elect to file a Canadian income tax return, you may be able to claim a refund for part or all of the Part XIII tax deducted.

Final thoughts:

Tax laws are in a constant state of change. It is your responsibility to confirm the accuracy of this information. There are significant differences between Canada’s “Departure Tax” and the U.S. “Expatriation Tax”.

This post is NOT legal advice or any other kind of advice.

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