Canada/US Tax

In February 2014, Canada and the US announced they had signed an intergovernmental agreement (IGA) that exponentially expands the sharing of tax-related information between the countries.

“What the IGA means is that the Canada Revenue Agency [CRA] will now exchange financial information about Americans living in Canada with the Internal Revenue Service [IRS],” says Veronika Chang, a foreign legal consultant with Toronto-based tax boutique Morris Kepes Winters LLP.

In the process, however, the IGA amends the reporting and withholding obligations of “foreign financial institutions” (FFIs) and others who make payments to a “US person” as those terms are defined under the US Foreign Account Tax Compliance Act (FATCA). But the FFI designation can be misleading.

“Any entity, both financial and non-financial, must consider whether it is subject to FATCA, because FATCA is not limited in scope to the financial services industry,” says Roanne Bratz of Stikeman Elliott LLP’s Montréal office.

All FFIs must report the financial activities of their American clients to the Internal Revenue Service and withhold funds in appropriate circumstances. But the IGA allows Canadian institutions to report to the Canada Revenue Agency instead. This aligns the reporting obligations of financial institutions under US and Canadian law.

This aspect of the IGA is, however, a double-edged sword.

“On the one hand, the fact that the legislation requires Canadian institutions to flag their US accounts to the Canada Revenue Agency rather than the Internal Revenue Service removes some pressure from Canadian banks in terms of their privacy obligations under Canadian law,” says Roy Berg, Director, US Tax Law at Calgary-based Moodys Gartner Tax Law LLP. “On the other hand, it changes the landscape for any entities characterized as foreign financial institutions by imposing an obligation on them to figure out who their US account holders are.”

The upshot is that the IGA has major implications for Americans living in Canada and others defined as “US persons” under FATCA. Indeed, FATCA’s main purpose is to track down Americans who are avoiding their obligations to pay tax on their worldwide income.

“The reason for FATCA’s creation was that many American citizens, including those not residing in the US, were not reporting their worldwide income,” says Bratz. “But instead of going directly after the non-reporters, the US approach appears to be to have the world police the situation for them.”

Still, these developments might come as a surprise to a significant number of US ex-pats.

“Many Americans living in Canada and elsewhere don’t understand that the US is one of only two countries in the world that requires its citizens to file tax returns no matter where they are living,” Berg says.

It’s a gap in understanding that could be costly.

“Even US citizens who have lived most of their life in Canada can be considered to have tax obligations under US law, and could face heavy penalties of up to $10,000 for each year they have failed to file tax returns,” Chang says. “It’s even possible that a person born in Canada who has an American parent could be affected.”

What’s not widely known about the IGA, however, is that the US, by way of reciprocity, has committed to providing the CRA with information on the accounts of Canadian residents in US financial institutions, including insurance companies.

This has the effect of imposing obligations on US institutions. The obligations are narrower than those imposed on Canadian FFIs: for example, Canadian FFIs must provide information on all US entities and residents, while the obligations of US institutions relate only to the accounts of individual US residents. Also, while Canadian FFIs must provide information on gross interest, dividends and other income generated in the account, US institutions will only be required to provide information on US-source dividends and other US-source income that is currently collected under the requirements of US domestic law.

But the gap between obligations may only be temporary. Under the IGA, the US has agreed to pursue “the adoption of regulations and advocating and supporting relevant legislation” to achieve “equivalent levels of reciprocal automatic information exchange.”

What it all means is that the IGA is certainly worthy of the attention of individuals and institutions on both sides of the border.

To comply with FATCA, Canadian FFIs (including subsidiaries of US parents) must use due diligence in searching for “US Indicia” that will identify US accounts, and report specified information about these accounts to the CRA, which will share such information with the IRS on an automated basis.

The task is daunting, all the more so because Canada’s implementing draft legislation, which was released simultaneously with the IGA, provides for significant penalties for non-compliance. “Regardless of the method Canadian banks use to identify US account holders, they will be undertaking a monumental project that is ongoing and not time-limited,” Chang says.

Indeed, Chang suggests that FATCA projects will likely involve a significant internal restructuring for many organizations.

“The restructuring will be aimed at better aligning an institution’s tax function and its operating structure with the aim of improving communication between in-house counsel, the tax department, and the client relationship department and its managers,” she says.

In-house counsel will have to start by familiarizing themselves with the IGA’s 47 pages as well as the more than 500 pages that constitute the US Treasury’s regulations under FATCA.

“These regulations are extremely complex and generally lacking in guidance,” Chang says. “They’re almost impossible to get through.”

All of this will be very expensive. “Canadian banks have been spending multimillions of dollars preparing to be in compliance with the rules,” Bratz says.

To make matters worse, implementing draft legislation appears to be fraught with problems. Some prominent tax lawyers, for example, believe that the proposed federal legislation “eviscerates” the IGA.

“The US Treasury Department may view the legislation, if passed in its current form, as an invalid implementation of the IGA and may therefore not afford Canadian financial institutions the benefit of the agreement,” Berg says. “What’s proposed is kind of a mess, although the Parliamentary Joint Committee on Taxation is putting together a paper to fix it.”

Meanwhile, close scrutiny of the draft shows that the proposed Canadian definition of “financial institution” is considerably narrower than the definition contained in the IGA, in US Treasury regulations, in intergovernmental agreements executed by other jurisdictions, and in guidance notes issued by the UK and Ireland.

“The result is that many entities that would be classified as ‘financial institutions,’ such as private trusts and private holding companies, would not be so classified in Canada,” Berg says.

 Should the US regard the final Canadian legislation as an invalid implementation of the IGA, Canadian institutions would face the dilemma of complying with Canadian law and suffering the consequences under FATCA, or complying with FATCA and suffering the consequences under Canadian law.

As well, Canadian institutions not classified as financial institutions under Canadian law but so classified under US law would likely face unnecessary withholding rules for which they would have to seek refunds directly from the IRS.

Finally, inconsistent definitions among jurisdictions that have executed IGAs with the US will cause increased compliance costs and uncertainty in the marketplace. “The UK realized this risk early on and has taken the lead in developing its domestic legislation to avoid this result,” Berg says.

But even if the Canadian legislation is fixed to the satisfaction of the US, a constitutional challenge may be looming. Peter Hogg, a leading constitutional law scholar who is Professor Emeritus at Osgoode Hall Law School and a scholar-in-residence in Blake, Cassels & Graydon LLP’s Toronto office, has warned that the legislation may violate Canada’s Charter of Rights.

However that may be, the IGA will take effect when Canada notifies the US that it has completed its internal obligations under the agreement. In the meantime, the US will deem the IGA to be in effect, making Canadian financial institutions immediately eligible to register on the FATCA website.

Canadian financial institutions that did not register by the recommended deadline of April 24, 2014, could find themselves subject to the 30 per cent FATCA withholding tax on US source income paid on or after July 1, 2014. That’s when US authorities will begin scrutinizing IRS compliance lists: if a Canadian financial institution is not on that list, the US will apply the withholding tax.

As it turns out, US authorities have recently added another tool that will help them keep track of the comings and goings of US citizens and others crossing the US-Canada border, and perhaps assist in identifying US citizens who are residents of Canada or have financial dealings there.

As of June 30, 2014, travelers have been required to swipe passports both when they enter and depart each country, with the two countries sharing the information that the new practice provides. These changes, part of the Entry-Exit Initiative and the Perimeter Security and Economic Competitiveness Action Plan, fall under a larger cooperative effort announced in February 2011.

Previously, each country counted individuals only when they entered the country but not when they left. Because even that limited information was rarely shared, typically neither country knew how long someone had been within its borders.

“Now both countries will be able, for the first time and in real time, to independently determine the number of days spent in each country,” Berg says.

Julius Melnitzer is a legal affairs writer in Toronto.