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