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
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
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.
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.
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
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 countriesâ€™ 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