Tax Managed Strategy 7
There are significant differences in taxation of investments for Canadians who take up residence in the United States. To manage these differences, it’s important for individuals to properly structure their investment portfolios before they leave.
When a person is leaving Canada, questions often arise about whether their investments can continue “as is” and what the tax implications are for their portfolio. This article offers some investment strategies for individuals planning to reside in the United States.¹
Registered retirement savings plan
For U.S. tax purposes, only the income portion of withdrawals from a registered retirement savings plan (RRSP)² is taxable. The portion that represents the individual’s investment in the contract, or the capital portion, may be received tax free.
The capital portion is the lesser of:
- fair market value of plan assets at the time the individual became a U.S. citizen or resident
- sum of contributions to the plan plus the earnings in the plan at the time the individual became a U.S. citizen or resident. This doesn’t include unrealized appreciation in the plan assets.
Where the RRSP assets reflect unrealized appreciation, people should consider crystallization of plan growth before becoming a U.S. resident. By increasing the amount that’s considered to be the investment in the contract, an individual can reduce the taxable portion of their withdrawals and enjoy significant tax savings.
Making it work for an RRSP — example
Sandra’s RRSP has grown to a market value of $350,000. She crystallizes the growth in her RRSP just before leaving Canada to increase the capital portion for U.S. tax purposes to $350,000.
If Sandra cashes in her RRSP immediately after her move, the withdrawal would equal the capital portion and be exempt from U.S. tax. The full value of her RRSP would be subject to a 25 per cent withholding tax in Canada, but these taxes ($87,500) can be used as a foreign tax credit in the U.S. Compare this to cashing in the RRSP before leaving Canada: if Sandra is in a 45 per cent tax bracket, $157,500 of her RRSP is lost to taxes.
Tax-free savings account
A non-resident can continue to hold a Canadian tax-free savings account (TFSA) that will be exempt from Canadian tax on its investment income and withdrawals. However, for U.S. tax purposes, the income earned in the TFSA will be taxed each year, as there’s no treaty relief.
When leaving Canada, individuals should consider liquidating their TFSA investments and withdrawing the proceeds. Remember, the withdrawal will be added back to their unused TFSA contribution room in the following year and may be utilized in the future if they become a Canadian resident again.
Registered education savings plan
A non-resident can continue to be a subscriber of a Canadian registered education savings plan (RESP) and the funds will be exempt from Canadian tax while in the plan. However, under U.S. tax rules, the annual income earned, as well as any grant and bond money received in the year, is considered taxable income to the subscriber. Because there’s no Canadian tax payable on the RESP, there’s no offsetting foreign tax credit.
When the beneficiary draws on the RESP for post-secondary education, the accumulated income, grants, and bonds are taxed to the student, resulting in double taxation. This can be avoided by having a Canadian resident who’s not required to file a U.S. tax return as the RESP subscriber.
Trust income and capital gains
Taxable trust income (dividends and foreign income) from mutual funds and segregated fund contracts is reported to non-residents as it occurs each year. Tax withholding of 15 per cent on this income is generally paid by surrendering units from the funds. Taxes aren’t withheld on interest income or capital gains. However, there’s a deemed disposition on these types of investments when leaving Canada, making any gains or losses subject to Canadian tax laws. Because of this, the decision to hold or sell before leaving Canada isn’t usually based on Canadian tax considerations.
However, U.S. residents and citizens need to consider U.S. tax rules as well as any additional reporting requirements to U.S. authorities that may apply to holdings in Canadian trusts and corporations. For example, U.S. tax rules deem a non-registered investment in a Canadian mutual fund trust or mutual fund corporation to be an investment in a passive foreign investment company (PFIC), resulting in unfavourable U.S. tax consequences. A segregated fund contract is a variable annuity contract and the Internal Revenue Service (IRS) hasn’t indicated whether it would be subject to the same PFIC rules, but other U.S. filing and reporting requirements may be applicable.
Transaction restrictions from within the U.S.
Due to securities regulations, U.S. residents are generally limited to redemptions and otherwise prohibited from managing their Canadian investments from U.S. soil. Certain states allow brokers or dealers to apply for exemptions on registered accounts but no exemptions exist on non-registered accounts. Therefore, it’s important that individuals who are leaving Canada realign their portfolios for the long term unless they plan to return to Canada on a regular basis.
Individuals planning to take up residence in the U.S., and who hold these investments:
- non-registered mutual funds or segregated fund contracts
To help maximize the tax-efficiency of their portfolios, investors should:
- consider crystallizing unrealized growth in their RRSP assets to a new plan before leaving
- consider liquidating their TFSA investments and withdrawing the proceeds
- make sure they’re not the subscriber of an RESP
- make sure their portfolio has been structured for a long-term holding period
- consider holding their non-registered investment funds with an insurance company in a segregated fund contract, which may avoid the PFIC rules.
The different tax treatment of RRSP withdrawals from within Canada and the U.S. provides an opportunity to reduce taxes with proper planning.
Investment options with Manulife
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Before proceeding with any of these strategies, speak to a cross-border tax specialist about your personal situation.
1 The U.S. tax rules discussed apply to a “U.S. person,” which includes U.S. residents but also includes U.S. citizens (even those residing in Canada who are Canadian residents for Canadian tax purposes) and U.S. green card holders. Individuals who have to file a U.S. tax return should speak to a cross-border tax specialist about their specific situation. 2 The application of this strategy to locked-in RRSPs is uncertain at this time. Individuals should consult their tax advisor before proceeding.
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