This article was originally published on August 26 2019 by Private Wealth Canada 

We all like receiving and giving gifts. But how does tax law view the act of giving? Did you know that giving a gift could have tax implications?

In fact, depending on the value of the gift, there could be serious tax implications. And when it comes to transfers of money or property between spouses, the income tax laws in Canada and the United States are very different, which means if you’re gifting to an American or even to a Canadian who lives in the U.S., it’s best to be prepared.

By way of background, the Canada Revenue Agency employs what is known as anti-income splitting rules. The idea is to deter the practice of gifting for the purpose of income splitting between spouses. So, cash and acquired assets are traced to the spouse who earned or contributed money (in order to acquire the asset). And any future income generated by such a transaction, even including appreciation of a property, is on the record for that spouse at tax time. Even if the spouse who owns the asset wants to give their partner partial or full ownership, the one doing the gifting still gets dinged for taxes.
Is there a way around it? Yes.

To avoid this situation, the principal spouse (the one doing the gifting) can sell the asset to their spouse at fair market value and pay tax on any resulting capital gain, or the asset can be loaned to the other spouse under an ‘intra-family loan agreement’ with specific terms and rates, and that document must be signed by both parties.

When it comes to property gifting between spouses, the U.S. Internal Revenue Service (IRS) is more generous as it allows unlimited, tax-free transfers for as long as both spouses are American citizens, or green card holders, or they are treated as a U.S. domiciliary under certain provisions of the Internal Revenue Code. Most of the time, transfers between U.S. spouses have no tax implications at all since the parties tend to file their returns jointly and are taxed on the household basis and not an individual earner basis.

parties tend to file their returns jointly and are taxed on the household basis and not an individual earner basis.

Less Generous

Unfortunately, if you are U.S. citizen and your spouse is Canadian, the IRS is less generous. For example, let’s say a Canadian resident who is a U.S. citizen wants to gift money or property to their Canadian spouse who is not a U.S. citizen. If the annual market value of the gift exceeds US$155,000 (2019 rates), gift tax may result. Gift tax rates range between 18 per cent and 40 per cent of the market value of the gift. Furthermore, the same gift may end up being double-taxed – first as a deemed disposition in Canada at the rate of up to 26.76 per cent (for an Ontario resident in 2019), and then again under the U.S. gift-tax provision.

On the flip side, when a Canadian citizen gifts to a spouse who is a U.S. citizen, the IRS requires a timely disclosure if the gift exceeds a certain amount. Failure to do so could result in a penalty – US$10,000 or 25 per cent of the value of the gift, whichever is greater.

What about asset transfers resulting from divorce or separation? In Canada, the property would be transferred at the original cost unless ‘an election is made to do so at fair market value.’ In the U.S., the transfer at cost is only available if both spouses are American. If an asset goes from a separated or divorced spouse who is a U.S. citizen to a Canadian citizen, it is measured at market value and the principal spouse is subject to capital gains tax.

Overall, when dealing with multinational households, it is always best to plan in advance so you can match the value of property being gifted under the provisions of both U.S. and Canadian regimes. Also, be aware that the location of the asset may create additional tax considerations.

A wise man once said, “It is more blessed to give than to receive.” Evidently, that man wasn’t dealing with the potential tax implications of cross-border gifting! All the more reason you should consult with a tax professional who is familiar with the tax regimes and laws of any country you may be dealing with.

This article was originally published on Apr. 16 2019 by The Lawyer’s Daily (www.thelawyersdaily.ca), part of LexisNexis Canada Inc.

The 2017 Tax Reform Act (the Act) signed into law by U.S. President Donald Trump in December 2017 affects taxpayers who are getting a divorce — even if one is a Canadian resident.

Before the Act, individual taxpayers could deduct alimony or separate maintenance payments under Internal Revenue Code (IRC) s. 215. The alimony recipient was required to include the alimony as gross income under IRC sec. 61(8) and sec. 71(b) on the U.S. tax return.

A payment is considered alimony if:

  • Payment is received by (or on behalf of) a spouse under a divorce or separation instrument;
  • The divorce or separation agreement doesn’t specify that the payment is not includible in gross income of the payee spouse or is not deductible to the payor spouse;
  • The spouses/former spouses don’t live in the same household when payment is made; There is no requirement to continue making payments following the death of the recipient spouse;
  • The payment isn’t a fixed sum under the terms of the divorce or separation agreement for the support of the children.

Under the Act, alimony payments are no longer deductible on the U.S. income tax return if the separation or divorce agreement is executed after Dec. 31, 2018. On the other hand, the recipient spouse will no longer have to report alimony as taxable gross income.

However, for those agreements in place prior to Jan. 1, 2019, these changes do not apply as the original provisions are grandfathered into the agreement unless changes are made after Dec. 31, 2018, to the original agreement, in which case, new rules apply.

The bottom line? The new rules affect how alimony payments are negotiated and calculated under a divorce settlement. Prior to the Act, the recipient spouse had a bargaining chip that allowed the payor spouse to deduct alimony payments. Now, negotiations may become a drawn-out affair as divorcing parties try to reach an agreement.

What if the recipient spouse is not a U.S. person and resides in Canada, and the payor spouse resides south of the border? Under Canadian domestic law, a Canadian resident receiving alimony from the U.S. must report the income on their tax return, but the payor spouse will not have a corresponding deduction for the alimony payments. There is no longer a benefit on both sides of the border. Instead, both parties are at a disadvantage as Canadian tax is owed on the alimony income, and U.S. tax of the payor spouse is not reduced by the amount of alimony payments.

The result is more U.S. tax owing than under the old rules. However, there is relief under the U.S.- Canada Income Tax Convention (1980) (the Treaty), which allows Canadian residents receiving alimony payments from a U.S. payor to exclude the payments as taxable income if the agreement was executed in the U.S.

A U.S. citizen payor resident in Canada can deduct alimony payments on his/her Canadian tax return, but not in the U.S. However, the Canadian tax on the alimony payments can be claimed as a foreign tax credit on the U.S. tax return only on certain U.S. source income (i.e., employment income, other U.S. source private pension). Therefore, there may still be some benefit to a U.S. citizen payor who is resident in Canada.

Because alimony deductions are no longer available for U.S. tax purposes, adjustments to withholding taxes are a consideration for a payor spouse under an otherwise grandfathered divorce agreement that was revised after 2018. Under prior law, alimony payments reduced taxes withheld against the payor spouse’s wages. Under the new law, the payor spouse must increase withholdings due to the loss of the alimony deduction. The payor spouse will have to provide their employer with an updated Form W4 Employee’s Withholding Allowance Certificate.

A Canadian resident payor spouse isn’t required to withhold Canadian, non-resident tax from support payments to a former spouse who resides outside Canada and the U.S., provided certain conditions are met. On the U.S. side, the payor must withhold tax at 30 per cent, unless there is a treaty in force with the country where the payee spouse resides. Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, is required to report the alimony payments to a non-U.S. payee, whether or not the payment is subject to withholding tax or is exempt under a bilateral treaty.

Therefore, it is important that the payor spouse obtain from the payee spouse a duly completed and signed Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals). This will ascertain the residency status of the payee spouse and eligibility for treaty exemption. Otherwise, the payor spouse would be liable for any withholding taxes that are under-withheld.

The best advice for divorcing parties is to ensure that both parties work with competent cross-border divorce lawyers in tandem with a competent cross-border tax adviser. This will ensure tax compliance on both sides of the border and at the negotiating table

This article was originally published on April 4 2019 on The Financial Independence Hub (www.findependencehub.com.com)

On December 22, 2017, the largest U.S. tax reform in over 30 years was signed into law by U.S. President  Donald Trump. The new law brought with it several important changes that affect individual taxpayers who are going through, or have gone through, a divorce. As if divorce isn’t already costly enough!

Prior to the 2017 Tax Reform Act, Section 215 of the U.S. Internal Revenue Code  allowed individual taxpayers to claim alimony payments as a legitimate deduction. The deduction was permitted because section 71(a) of the IRC required the recipient spouse to include the alimony received in his/her adjusted gross income.

For tax purposes, a payment is considered alimony if all of the following criteria are met:

  • Each spouse files a separate return
  • Payment is made in cash (including check or money order)
  • Payment is made to a spouse/former spouse pursuant to a divorce or separation agreement
  • The divorce or separation agreement does not specify that the payment is “not alimony”
  • The spouses/former spouses are not living in the same household when payment is made
  • There is no requirement to continue making payments following the death of the recipient spouse
  • The payment is not treated as child support or a property settlement.

However, under the new Act alimony payments are no longer deductible on U.S. income tax returns if the separation or divorce agreement is executed after December 31, 2018. In addition, the person receiving alimony no longer has to claim these payments on their tax return as part of their gross income.

These changes are permanent, unlike other personal tax measures included in the Tax Reform Act. For those who have agreements in place prior to January 1, 2019, these changes do not apply because the original provisions are grandfathered into the agreement. But, as of January 1, if changes are made to the original agreement, the amended agreement must state that the new rules will not apply, or else they will. In other words, the parties must “opt-in” to the 2017 provisions if there is a modification of the separation or divorce instrument after 2018.

Prior to these changes, the recipient spouse had something of a bargaining chip when negotiating alimony payments. Why? The paying spouse could deduct the payments dollar-for-dollar, making the amount of the alimony payment almost a non-issue as it would come back to the party paying it in the end. Now, it is likely that negotiations will become a more drawn-out affair as divorcing couples struggle to come to an agreement as to what is fair to both parties under the new law.

With any major tax law overhaul, we can always speculate as to the rationale for certain changes. This is one of those situations where there doesn’t seem to be any real benefit to either party and, in fact, simple calculations show that these changes typically result in less after-tax income for both the payor and the payee. Perhaps, U.S. lawmakers were looking out for families by making divorce a less-attractive option in times of trouble?

Overall, these changes are quite a departure from laws that have been in place for decades, and they will bring upheaval and adjustment for divorce lawyers and divorcing taxpayers alike. That’s why it’s so important to consider all the factors, and geographies, involved when drafting up new settlement agreements.

What if recipient spouse resides in Canada?

Now let’s consider a twist to the post-marital arrangement. The spouse paying alimony is a U.S. resident, and the recipient spouse is a nonresident alien, residing in Canada. Domestic laws in Canada remain unchanged in that the Canadian resident receiving alimony from the U.S. must report the income on their Canadian tax return. The result is a situation where the alimony payment is now taxed twice – once in the U.S. where alimony is no longer deductible, and again in Canada where it is taxable income for the recipient. Fortunately, there is relief under the U.S.-Canada Income Tax Convention (1980) which we will call the Treaty.

The Treaty provides relief by allowing Canadian residents receiving alimony payments from a U.S. payor to exclude the payments as taxable income if the agreement was executed in the U.S. Conversely, a payer of alimony who is resident in Canada will not be eligible to deduct the payments in computing their Canadian tax liability if the divorce or separation agreement was executed in the U.S. The trouble here, however, is that under Canadian law the Treaty overrides the domestic law, while under U.S. law, the most recently enacted law prevails. What does this mean?

If the agreement is initiated in the U.S., it’s unlikely that the Treaty will mitigate the potential for double taxation. Remember what realtors say about the importance of “location, location, location, location”?  The same is true here. It will matter on which side of the border the separation or divorce was initiated.

Because alimony deductions are no longer available for U.S. tax purposes, you may want to consider updating your Form W4 Employee’s Withholding Allowance Certificate with your employer because tax withholding from your wages should be increased.

Is withholding required when the two parties reside in different countries?  Good question. A person who is paying alimony who is resident in Canada does not have to withhold nonresident tax from the support payment as long as certain conditions are met. But on the U.S. side the payer must withhold tax at 30%, unless there is a treaty in force with the country where the recipient lives. However, unlike Canada, the treaty exemption from withholding does not absolve the payer from the reporting obligation on Form 1042-S. Therefore, it is important that the payer obtain a current Form W-8BEN from the recipient in order to document his or her residency status.

If you’re in this boat, it is best to ensure that your divorce lawyers work closely with a knowledgeable tax advisor who knows U.S. law. That way, everyone will have compliance on both sides of the border: and at the negotiating table. In short, peace is always better than war.

CHANGES IN ALIMONY TAX TREATMENT

US Tax Reform – HR.1: Changes to the Alimony deduction

Public Law 115-97 (“HR.1”), commonly referred to as the 2017 Tax Reform Act (the “Act”), was signed into law by President Trump on December 22, 2017.  Several important changes included in HR.1 which affect individual taxpayers, including the repeal of the alimony deduction which was previously permitted under Internal Revenue Code (“IRC”) Section 215. The repeal of the alimony deduction is effective for separation and divorce instruments executed after December 31, 2018.

Pre 2017 Act

US

Currently, IRC Section 215 provides that an individual “shall be allowed as a deduction an amount equal to the alimony or separate maintenance payments paid during such individual’s taxable year.”  Payments of alimony must be reported as income on the recipient spouse’s income tax return. A payment is considered alimony if all of the following are met:

  • Spouses file separate returns from each other;
  • The payment is made in cash, including by checks or money orders;
  • The payment is to or for a spouse or former spouse made under a divorce or separation instrument;
  • The divorce or separation instrument does not designate the payment as “not alimony”;
  • The spouses are not members of the same household when the payment is made;
  • There is no liability to make the payment after death of the recipient spouse; and
  • The payment is not treated as child support or a property settlement.

If a US citizen or resident alien pays alimony to a nonresident alien spouse, there is a requirement under the domestic law to withhold 30% tax on each payment.  The 30% withholding requirement is reduced to 0% if the nonresident alien spouse is a Canadian resident.

Similarly, when payments are made by a Canadian resident payor to a US resident recipient, Canada allows for zero withholding.  The reduction of withholding from a domestic statutory rate does not waive the obligation to report the payment on Form 1042-S or Form NR4, in the US and Canada, respectively.

Amounts paid in respect of child support are not to be included in the computation of taxable income of the recipient, nor is the payer entitled to a deduction in computing taxable income.

The following example illustrates the treatment under pre 2017 Act alimony rules.

The paying spouse has income of $100,000 which before alimony deduction would attract federal tax of $18,139, assuming only the standard deduction and a single personal exemption are claimed.  By applying the “splitting of income” the overall tax cost becomes $12,113 [$8,139+$3,974], thus reducing the couples tax burden by $6,026 [$18,139-$12,113].  This means that there is more after-tax income available to the couple.

Paying Spouse and Receiving Spouse Table

Canada

Alimony payments in Canada, known as support payments, attract similar treatment as the US.  Paragraph 56(1)(b) of the Income Tax Act (“ITA”), states that “there shall be included in computing the income of a taxpayer for taxation year, the total of all amounts each of which is an amount determined by the formula A-(B+C)”, where

A = Total of all amounts received after 1996 and before the end of the year by the taxpayer from a particular person where the taxpayer and the particular person were living separate and apart at the time the amount was received,

B = Total of all amounts which is child support that became receivable by the taxpayer from the particular person under an agreement or order on or after its commencement date and before the end of the year, and

C = Total of all amounts each of which is a support amount received after 1996 by the taxpayer from the particular person and included in the taxpayer’s income for a preceding year.

Similar to the US rule, child support payments are not to be included in or deducted from income in computing taxable income.

Using the same example as above, however the couple is now resident in Canada (Ontario).  The result is a net tax savings to the couple of $8,168.

After January 1, 2019

As of January 1, 2019, alimony payments, previously deductible under IRC §215, will no longer be deductible for US tax purposes where the separation or divorce instrument was executed after December 31, 2018.  Furthermore, IRC §61(a)(8) has also been repealed to exclude such payments from the recipient’s US gross income.

Applying the same example from above, using 2018 tax rates and considering the new alimony provisions pursuant to the 2017 Act, the US resident couple will now lose $5,740 [$15,410 – (6,500+3,170)] of net tax savings as the “splitting of income” is no longer available. The overall tax burden to the couple will be $15,410 as the payor spouse will not have the benefit of the deduction and the recipient spouse will not recognize alimony into income which previously was taxed at a lower rate.

 

This situation becomes even more complicated when one of the spouses is a Canadian resident and is not a US person while the other one has a tax home in the US.  Let’s look at the same couple, but now, the paying spouse remains in the US, while the recipient spouse moves to Canada.   The domestic laws in Canada have not changed.  Therefore, the recipient of the alimony must include the payments as income on the Canadian tax return as discussed above.  This would mean that the same income is now taxed twice – once by the US where the alimony is not deductible and the second time by Canada where it is a taxable. This is not a fair result.

Does the US-Canada Income Tax Convention (1980) (“the Treaty”) provide relief? Paragraph XVIII(6) of the Treaty states the following,

“Alimony and other similar amounts (including child support payments) arising in a Contracting State and paid to a resident of the other Contracting State shall be taxable as follows:

(a) such amounts shall be taxable only in that other State;

(b) notwithstanding the provisions of subparagraph (a), the amount that would be excluded from taxable income in the first-mentioned State if the recipient were a resident thereof shall be exempt from taxation in that other State.”

Subparagraph XVIII(6)(b) provides some relief by excluding alimony payments from Canadian taxable income, if the right to receive alimony payments arose in the US, i.e., if the if the agreement was executed in the US. However, if the separation or divorce agreement was executed in Canada and therefore, the right to receive alimony arose in Canada, the support payments will remain taxable in Canada. If the payer is a US resident, a deduction for alimony payments will not be permitted in the calculation of US taxable income.

Observation

Alimony payments made pursuant to divorce or separation agreements executed before December 31, 2018 will continue to receive the pre-2017 Act tax treatment.  However, if the existing agreement is modified post December 31, 2018, the payments will no longer be deductible by the US payer.  Furthermore, it will be important to establish where the “right to alimony” arose when the recipient is a resident of Canada, otherwise the result could be punitive.

Finally, the payer of alimony should provide his or her employer with an updated Form W4 Employee’s Withholding Allowance Certificate. Tax withholding from wages will increase as the alimony deduction will no longer be available for US tax purposes.

Written by Elena Hanson, MsT (US), CPA (IL)

Sharon Conrod, CPA, CGA, EA

crossborder divorce

Everyone knows that breakdown in marriage is not only emotionally but also financially draining. Crossborder divorce for dual resident Canadian couples or Canadian couples where one spouse is a US citizen, it may also be accompanied by extreme complexities and often unfavorable immediate tax implications.

Canada and the US each has somewhat similar non-elective provisions when it comes to division of assets incident to crossborder divorce at cost basis. The transferred assets are essentially a gift without any immediate tax implications. There is also an election available under the Canada Income Tax Act for the property transferred to recipient spouse at market value instead of cost. This is typically done when the transferor spouse has unused capital loss-carryovers and would like to utilize them by harvesting gains. Suitable for Canadian spouses, this election is damaging when at least one of the Canadian spouses is also a US citizen as there is no reciprocal election available under the US Internal Revenue Code. It is important to analyze each divisible asset under both countries’ tax provisions, regulations and administrative policies to avoid immediate taxation on distribution when the intent is to structure it as a rollover. Preferably, a divorce lawyer needs to have a good rapport with a crossborder tax accountant or lawyer to reflect certain references to tax provisions in a separation agreement.

There is nothing straightforward when it comes to a breakdown of marriage between ex-couples with a Canadian citizen/resident and a US citizen/Canadian resident or when a separation agreement is drafted after a former Canadian spouse severs residential ties with Canada. In these scenarios, the division of assets loses its favorable tax-free treatment on transfer. The transferred assets are taxable to the transferor as if sold. Moreover, if the transferee is a US citizen or resident, he or she accepts them at historical or adjusted cost basis, i.e., does not receive a step-up in basis equal to the value on the date of transfer. Thus, the same asset becomes subject to second round of taxation for the entire increase in value when later sold. Furthermore, if transferor is a US citizen and transferee is not, transferor may also face US gift tax implications. Alternatively, if transferee is a US citizen and transferor is not, transferee may face punitive US tax compliance