How to Avoid Double Taxation of Investment Income for U.S. Citizens Living in Canada
Author: Brad Howland
First Posted: Sept. 3, 2009
U.S. citizens in Canada who earn investment income from U.S. sources can use a worksheet in IRS Publication 514 to avoid double taxation of that income.
The tax treaty between Canada and the United States (new protocol ratified Dec. 15, 2008) sets withholding tax on cross-border interest payments at 0% and dividend payments at 15%. At first glance, this would appear to be great for recipients of interest income, but in fact it magnifies a technical tax problem for many U.S. citizens.
U.S. citizens are required to file U.S. 1040 returns and report their worldwide income to the IRS regardless of where they live. If they live in Canada they also report worldwide income on their Canadian returns, including income from U.S. sources, and claim a foreign tax credit for any taxes payable to the United States. Canada Revenue Agency does not allow foreign tax credits to be claimed in excess of treaty withholding rates, which means that for interest income with a withholding rate of 0%, none of the tax liability owed to the U.S. on a 1040 return is allowed as a foreign tax credit on a Canadian return.
For many U.S. citizens living in Canada this isn't a big issue because they have little or no income from U.S. sources. However, the problem can arise when a taxpayer receives a substantial inheritance, or significant pension and investment income, from the United States.
The solution? Recharacterize the U.S. source income as foreign source, and claim additional foreign tax credits on the U.S. 1040 return using Form 1116 (see IRS Publication 514 Foreign Tax Credit for Individuals – the "Tax Treaty" section on page 21 of the 2009 version).
Calculate the additional U.S. foreign tax credit using the worksheet at the end of Publication 514, and feed the allowable amount back into the normal foreign tax credit on Form 1116. The 2008 version of the worksheet instructions told preparers to simply add the additional credit to Line 29 of Form 1116, but beginning with 2009 preparers are instructed to add it to Line 12 as well.
Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital
Original Version (Before 2007 Protocol)
Canada's New Government Signs Protocol to the Canada-U.S Tax Treaty for the Benefit of Canadians
Department of Finance Canada News Release