Cross-border issues for those with U.S. investments

The following is an overview of some cross-border tax considerations for Canadians. Before making U.S. investments or acquiring U.S. real estate, you should consult an expert familiar with Canadian and U.S taxation. As well, in most cases, keep in mind that in the absence of a U.S. Social Security Number (SSN), as a U.S. non-resident you will need to obtain an Individual Taxpayer Identification Number (ITIN). Before investing in the U.S., ask your accountant or investment dealer what you need to do to obtain this number.

Canadian residents earning U.S. investment income

Portfolio interest income earned from U.S. sources is no longer subject to U.S. withholding taxes. But it should still be reported as taxable income when filing your Canadian tax return.

However, if you own shares of a U.S.-based company, a 30% tax will be withheld by your investment dealer on behalf of the IRS. You can reduce this withholding rate to 15% by filing IRS form W-8Ben-E, and providing it to the withholding agent (the investment dealer).

To avoid double taxation, the U.S. withholding tax is recovered through a foreign tax credit when you file your Canadian return. The dividend tax credit available on Canadian-source dividend income does not apply to foreign dividends and therefore, the U.S. dividend should not be grossed-up. "In a nutshell, U.S. dividends are taxed at the same rate as U.S.-source interest income," says Robert Kerr, chairman of Kerr Financial Group Inc. in Montreal.

Capital gains realized on the sale of U.S. securities are not subject to U.S. withholding tax, but are taxable under Canadian capital-gains taxation rules. In other words, half of the capital gains are taxable in Canada.

Income from U.S. assets held within a registered plan (such as an RRSP or RRIF) is not subject to U.S. withholding tax. As pension assets, they are covered by an exemption under the Canada-U.S. Income Tax Treaty.

However, U.S.-source income earned within a tax-free savings account (TFSA) is not covered by a treaty exemption. Therefore, U.S. tax withholding at source will apply on such U.S.-source income and it cannot be recovered when filing your Canadian tax return.

"You should avoid holding U.S. securities through your TFSA," says Kerr. "Considering the client's optimal geographical asset allocation, U.S. securities should always be purchased through an RRSP or a taxable account to avoid any double taxation. It's also important to keep in mind that U.S. investments must be reported on the Canadian T1135 form and that this additional filing requirement also applies to U.S. rental properties."

Taxes on U.S. real estate

Canadians who own real estate in the U.S. are subject to withholding tax on any gross rental income earned and on the proceeds, should the property be sold.

In the case of a rental property, your tenant is required to withhold 30% of the rent as withholding tax and remit it to the IRS. If you elect with the IRS to be taxed on the net rental income, you can deduct all related costs such as mortgage interest, maintenance, insurance and property taxes.

For example, if you collected $12,000 of U.S. rental income for the year and your expenses totalled $7,000, you would report net rental income of $5,000. You would then be entitled to a refund of a portion of the 30% U.S. taxes withheld on the gross rental income of $12,000 because, based on your taxable income, the applicable tax rate would be considerably less than the rate used for withholding taxes. In order to avoid double taxation, the actual U.S. taxes paid will be considered as a Canadian foreign tax credit when filing your Canadian tax return.

If you elect to file on a net-rental-income basis, you can avoid the 30% withholding by providing the appropriate IRS form to your tenant.

Furthermore, when you sell a U.S. real-estate property, a withholding tax of 10% generally applies on the gross sales price. This amount is applied against your capital-gains-tax liability on proceeds of the sale when you file a U.S. tax return for that year -- or is refundable should your capital-gains taxes be less than the 10% withheld.

"Otherwise," says Kerr, "the withholding tax rate can be reduced by filing IRS form 8288-B prior to the selling date. Similar to the U.S. rental income, the actual U.S. taxes paid will be considered as a Canadian foreign tax credit when filing your Canadian income-tax return unless the Canadian principal-residence exemption eliminates such Canadian tax."

Depending on the location of the U.S. property, separate state and municipal income taxes may also apply on rental income and/or the gain from the disposition of the property, Kerr adds.

Who must file a U.S. tax return?

For most individuals who qualify as a non-resident alien in the United States, as determined by the substantial presence test and/or closer-connection rules, you will have to file a U.S. non-resident income-tax return (Form 1040NR) if you have income from the sale of real estate located in the United States, or if you are engaged in a profit-intended business there or received U.S. employment income.

You generally do not have to file a U.S. tax return if you received income only in the form of interest, dividends, rental income and annuities. However, you should file if you had too much tax withheld at source on this income in order to claim a refund of the overpaid tax.