US citizens and U.S. permanent residents (green card holders) are considered tax residents of the U.S. regardless of whether they physically reside in the U.S. or not. Once a person has entered the U.S. federal tax system, they are obligated to file a U.S. tax return on all worldwide income unless they choose to expatriate from the US—and possibly pay a hefty exit tax.
However, if a U.S. person physically resides in another country and meets one or more of that country’s tax residency tests, they may be subject to that country’s tax obligations as well. The effect of being a U.S. tax resident regardless of one’s physical presence is felt most acutely when a taxpayer is located in a country with no income tax (e.g., UAE, Bermuda, Bahamas) or a lower federal income tax (e.g., Hong Kong).
But in the case of a U.S. person living who becomes a tax resident of a foreign country with higher tax rates than the U.S. (such as Canada, Australia, or the UK), the U.S. individual will pay tax at the higher applicable rate on their earned income. So what are individuals to do when they feel they satisfy different countries’ tax residency tests?
Fortunately, an individual can only be a primary tax resident of one country at a time. Therefore, when a tax treaty is in effect, the country of primary tax residence has first taxation rights to that individual’s earned income. In the event that a foreign country has a higher tax rate than the US, the taxpayer receives a foreign tax credit for what would’ve been their U.S. assessable income, thus owing nothing to the US.
Alternatively, if the taxpayer is in a lower income tax country and has taxable income that exceeds the Foreign Earned Income Exclusion (FEIE) amount ($112,000 USD in 2022), it is possible to receive a foreign tax credit for what tax they’ve paid to the foreign country, but may end up owing the U.S. for the difference between their U.S. tax assessment and what they’ve paid to the foreign country. In this situation, it may also be possible to claim a FTC on any amounts over and above the FEIE. The income must be taxed in the U.S. to be able to claim an FTC.
To understand the challenges faced by individuals when they feel they satisfy different countries’ tax residency tests, we will use a case study to illustrate. Matthew, a U.S. citizen, has decided to move to his cabin in Canada for the foreseeable future. He will continue to run the same business he owned in the US. To legally make this move, Matthew has applied for and been granted a long-term permanent residency card in Canada.
He doesn’t know exactly how long he will live in Canada, so he has retained his property in Michigan, which he is renting out to his sister’s family. However, he also owns his cabin in Toronto. As a high-income earner, Matthew knows he will need to engage in strategic tax planning to alleviate his tax burden between Canada and the US.
The U.S. maintains tax treaties with a substantial number of foreign countries (68 of them in effect at last count) to avoid or lessen the impact of double taxation. The U.S. has tax treaties with many countries, including Canada, Australia, and the UK. A full list of countries for which the U.S. maintains a tax treaty can be found here.
For today’s purposes, we are discussing income tax treaties, but the U.S. also maintains many estate tax treaties with other countries to mitigate the effects of double taxation on gifted or inherited wealth. In Matthew’s case, he and his international financial planner will need to familiarize themselves with the income tax treaty between Canada and the US.
Many tax treaties, by way of the Foreign Earned Income Exclusion and Foreign Tax Credit, allow U.S. persons to be exempt from or pay reduced taxes to the U.S. on income they earn overseas. However, according to the IRS, “most income tax treaties contain what is known as a ‘savings clause’ which prevents a citizen or resident of the United States from using the provisions of a tax treaty to avoid taxation of U.S. source income.”
For cross-border citizens, source of income refers to the physical location of where income is sourced from. For example, Brad is a UK citizen who lives in the UK and is a UK primary tax resident. Brad worked in the U.S. for three years and owned a home while he lived in Arizona. When he moved back to the UK, he decided to retain his home as a rental property in the US.
Even though he no longer lives in the U.S. or holds his U.S. visa, Brad must pay primary taxes to the U.S. federal government on all income from the rental property. This is because the income source is physically located in the US. In most cases, income derived from physical property located in any country is taxed by the country in which the physical property is located. Capital gains are typically sourced to where the individual is a tax resident whereas dividends are sourced to the country where the company paying the dividend is located. Capital gains or income of a trust are subject to trust residency tests in some jurisdictions.
Certain U.S. states may continue to tax residents regardless of whether they are physically residing there. For example, California is considered a domicile state and will continue to tax its residents if certain factors are in place to suggest that the person plans to return to California at some point in the future.
It’s always best for individuals to consult with tax professionals in their specific state to find out about any ongoing tax obligations they may have to that state. Although Michigan may not have residency rules as strict as California, Matthew should still consult with his financial advisor to determine any state filing requirements for Michigan while he is living abroad in Canada, especially if he returns to Michigan at any point during the year.
To determine which country has primary taxation rights over a resident, there are three tie-breaker provisions that can be used. The first residency tie-breaker seeks to determine the individuals’ true country of residence by evaluating where the individual maintains their permanent home.
In Matthew’s case, he kept his home in Michigan but is renting it out for the time being. He also owns his home in Toronto with no plans to sell. When he returns to Michigan to visit family, which he does often, he stays with his sister’s family at the property he owns. If the individual maintains permanent homes in both countries (or in neither country), the second tie-breaker provision applies, which Matthew may need to use to determine whether Canada or the U.S. has primary taxation rights over his income.
The second tie-breaker seeks to determine where the individual spends more time during the tax year. If they maintain permanent homes in both countries but spend more time in one country than the other, that country typically has primary taxation rights. This year, Matthew spent about six months in each country. If the individual inhabits both countries about equally, the third and final residency tie-breaker seeks to determine in which country the individual has the closest personal economic relations.
Matthew wants to claim tax residency in favor of the U.S. to offset the higher tax rates in Canada, so he can take steps to demonstrate closer personal economic relations with the US. First and foremost, Matthew has kept his home in Michigan. Additionally, his parents and siblings still live in the state. He also maintains U.S. retirement and investment accounts, which he contributes to regularly. And finally, Matthew continues to make donations to the Boys and Girls Club of America.
Because of these circumstances, Matthew may be able to claim a tie-breaker provision in favor of the U.S. as his permanent country of residence. If an individual wants the “tie” to be in favor of a specific country, they may want to take the following steps to increase their chances of a tie-breaker in their favor. These steps include, but are not limited to:
However, offsetting higher taxes shouldn’t be the only factor individuals consider when determining their primary tax residency. There are a number of irreversible consequences that could be triggered if a U.S. individual claims tax residency to a foreign country under a tax treaty.
US permanent residents (green card holders) in particular should be mindful of the consequences of claiming tax residency of a foreign country outside the US.
If a permanent resident claims residency to a foreign country under a tax treaty, they may inadvertently cancel their U.S. permanent residency and subject themselves to the U.S. exit tax under the HEART Act. They will also nullify any treaty provisions if they declare tax residency of a foreign country.
With that being said, understanding a client’s situation and knowing the factors that determine a client’s tax residency is important when conducting international or cross-border planning.
High-net-worth individuals who are relocating to or leaving the United States have much to consider in terms of their tax consequences. At Arete Wealth Strategists, we support and serve cross-border citizens. We educate on tax implications for their relocation decisions, as well as how to optimize tax mitigation strategies for clients who need them.
We specialize in providing financial advice to globally mobile individuals and families who need us, and it’s never too late to seek advice. To learn more about Arete Wealth and how we can support you, visit www.arete-wa.com or simply click here to visit our get started page.
1. While it’s beyond the scope of this blog post, there are often specific treaty provisions for business. Usually 'Permanent Establishment' and 'Business Profits' articles that might override his mere physical presence.
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