Dual US-Canada citizens, be aware of IRS!

Dual citizens of Canada and U.S. may face possible (and significant) penalties that might have been imposed upon them without their knowledge. To some people, it is difficult to comprehend that the U.S. citizens living abroad have to file U.S. tax returns even when they may not have been residing in the U.S. during the relevant tax year. The tax concerns of the U.S. citizens or dual U.S.-Canada citizens residing in Canada peaked last year when many Canadian media outlets vigorously reported on the issue. At that time, the U.S. Government’s amnesty program for missed filings was still available. The amnesty deadline passed September 9, 2011; however, a similar program reopened recently.

The tax implications of failing to file U.S. taxes can be severe for many dual citizens in Canada. These people have been diligently filing tax returns in Canada, and have no ties to the U.S. other than holding U.S. citizenship. The obligation to file U.S. taxes often takes them by surprise, since they often have had no dealings with the IRS previously.

A Diplomatic Approach
The United States has tried to assuage the fears of U.S. citizens living north of the border. “The penalties can be quite severe”, said David Jacobson, the U.S. ambassador to Canada during the speech to Canadian Club in Ottawa back in October 2011. However, Jacobson comforted anxious Canadians by saying that “We [Americans] are not unreasonable. We are not unsympathetic. We are not irresponsible.” He stated that his country will not apply the rule unreasonably. According to Jacobson, the main concern of the IRS is not Canada but countries considered tax havens. He further stated, “We have to figure out a way to do it without letting the person who is trying to evade taxes in the Cayman Islands off the hook.”

The Canadian Response
As reported in the Canadian Press, Canadian Finance Minister Jim Flaherty has called upon his U.S. counterpart to “look upon these individuals with leniency.” He acknowledges that “the majority of Canadians affected by the rule have dutifully paid their Canadian taxes and their only transgression has been in failing to file IRS paperwork they were unaware they were required to file.” More importantly, he acknowledged that most of U.S. citizens living in Canada were even unaware of such requirement. Flaherty is reported to be optimistic that the U.S. government would “move in that direction.” It is estimated that there are more than one million Canadians with dual citizenship of Canada and the U.S.

What to do?
In December 2011, the IRS provided its take on this issue. According to an IRS fact sheet (FS-2011-13, December 2011), a U.S. citizen may file his or her tax return without any penalties if they owe no tax to the IRS for the prior six tax years. The “zero” tax payable may be achieved by the application of the foreign earned income exclusion or foreign tax credits. The IRS would also consider not imposing any penalties if “a failure to file or failure to pay is due to reasonable cause.” According to the IRS, the reasonable cause may be established if a taxpayer is able to show that he or she was not aware of the fact that he or she was obliged to file returns and pay taxes. The following factors will be considered by the IRS:

1. Taxpayer’s education;
2. Whether taxpayer has previously been subject to the tax;
3. Whether taxpayer has been penalized before;
4. Whether there were recent changes in the tax forms or law that taxpayer could not reasonably be expected to know; and
5. The level of complexity of a tax or compliance issue.

Further, the IRS indicates that reasonable cause relief is generally granted “when [taxpayer] demonstrate[s] that [taxpayer] exercised ordinary business care and prudence in meeting [his or her] tax obligations but nevertheless failed to meet them.” In determining whether or not ordinary business care was used under the circumstances, the IRS will consider the reasons given for not meeting the tax obligations, compliance history, the length of time between the failure to meet tax obligations and subsequent compliance, and circumstances beyond taxpayer’s control. Finally, the IRS states that a reasonable cause for noncompliance can be proved by ignorance of the law “if a reasonable and good faith effort was made to comply with the law” or taxpayer was “unaware of the requirement and could not reasonably be expected to know of the requirement.”

Thanks to the current bilateral tax treaty between Canada and the U.S., dual U.S./Canada citizens may not end up paying taxes in both countries as Foreign Tax Credit may be provided. However, such tax treaty does not discharge U.S. citizens of the duty to file tax returns to IRS. It is highly recommended that any taxpayers concerned about this issue speak to a tax professional directly.

Min K. Kim is a tax lawyer practicing in Toronto, Ontario. Read his bio here.