Prologue
This is the first of two blog posts (Part 1 and Part 2) that discuss the University of Washington Low Income Tax Clinic report referencing a dual Canada/U.S. citizen student living and working in Canada.
Part 1 (this) will discuss the report generally and how the circumstances actually trigger the Canada/U.S. tax treaty. Think of it! A few thousand dollars of summer income received by a Canadian student implicates an international tax treaty. Only in America!
Interestingly, the specific factual circumstances include an example of what happens when a U.S. citizen living outside the United States receives a U.S. inheritance that generates U.S. source income. This is a concern for many Americans abroad. It is a complicated area.
Mostly Part 1 will discuss the “LITC” Report. Specifically how the “LITC” viewed the issue. How they incorrectly tried to apply the U.S. Canada tax treaty (apparently) without regard to the “saving clause” which is included in all U.S. tax treaties.
The report seems to say that the taxpayer filed a U.S. tax return for the 2021 tax year and filed to include income which (because of information reporting) the IRS was aware of. This should be of concern to Americans abroad generally. I will discuss this aspect more fully in Part 2.
Part 2 will discuss the specific problem of a U.S. citizen abroad inheriting (or anticipating inheriting) U.S. assets (whether income producing or not). I am making this a separate post because it is a complicated topic. The most rational response to this situation is highly dependent on your factual situation.
In any case, we begin with Part 1 …
It’s worth reading the entire blog post from Tax Fairness Abroad titled “A summer job and bad advice land an American in Canada in international tax court“.
The post references a report from the University of Washington “Low Income Tax Clinic”. (Note that the “LITC” also provided assistance to Gabriel Morrow who is another American abroad who received advice from the clinic.)
The complete text of the “LITC” report AKA the drama of taxing Americans abroad
What follows are the only facts we know.
“Taxpayer is a dual US-Canada citizen; TP is a long-term resident of Canada and is employed there. TP’s father passed away in 2020 and client received an inherited retirement account in 2021 (approximately $110K). TP was misinformed by the retirement account custodian that the “taxes have been paid” (when,in reality, this was just the tax withholding from the transaction). TP believed that taxes had been reported and paid; the retirement account was not included in the 2021 tax return. TP also did not include 1099-income earned while doing a summer job in Canada for a U.S. domiciled company. TP received a notice of deficiency, and a tax court petition was filed. Unfortunately, the TP has a deficiency because the retirement account; nonetheless, IRS appeals refused to apply the LITC’s treaty claim in regard to the 1099 income and is invoking the US-Canada Treaty savings clause. The LITC will be requesting a competent authority determination on this issue (Revenue Procedure 2015-40, Section 6.04(3) and related IRM provisions). However, the TP will still have a liability because of the retirement account taxable income—this liability process will continue through appeals while the competent authority determination is submitted and a determination is received from the IRS.”
Commentary from “Tax Fairness Abroad” includes:
Cursed by U.S. citizenship
What makes this case so powerful is its source. This is not an advocacy pamphlet. It is an official report submitted to the IRS by a clinic that the IRS itself funds, written by experienced tax professionals with no axe to grind, about a taxpayer who met the program’s low-income criteria. Nobody in this story is a wealthy tax dodger hiding assets offshore. The report describes an ordinary person, misinformed by a financial institution, caught in a system that taxes people based on their passport rather than where they live.
Just as important: the IRS did not malfunction. Appeals applied the law as written. The saving clause worked exactly as designed. That is the whole point. No amount of better customer service, clearer forms, or administrative guidance can fix an outcome that the law itself commands. Only Congress can.
In other words, the gods of citizenship taxation are blessing U.S Treasury and the IRS. And yes by blessing the IRS, the gods are applying the citizenship taxation curse on Americans abroad.
Most tax disputes involve multiple issues and have multiple dimensions. The report confirms U.S. citizenship taxation. It confirms the “saving clause” which creates the presumption that Americans abroad are prohibited from enjoying the benefits of tax treaties. The most interesting aspect of the case is rooted in the fact that the taxpayer inherited a retirement plan with taxable distributions. The distributions were not reported on the return and the IRS noticed the omission. Only the United States can turn an inheritance into a source of anxiety. For Americans abroad the anxiety is particularly acute.
Introduction – What the “LITC” report tells us about taxation and Americans abroad
Yup, the U.S. citizenship taxation means that the U.S. taxes (1) the non-U.S. source income of (2) individuals who are tax residents of other countries. This is the true meaning of U.S. citizenship taxation. After all U.S. citizens who are also U.S. residents are taxed as though they are residents.
The Road To Tax Reform For Americans Abroad: Part 2 – What Is US Citizenship Taxation?
I agree with “Tax Fairness Abroad” that the story of the University of Washington “LITC” client is an exellent example of both U.S. citizenship taxation and how the “saving clause” enforces U.S. citizenship taxation. While fully agreeing with and endorsing the perspective in the post from Tax Fairness Abroad, the story flags some additional issues and raises additional questions for both compliant and noncompliant Americans abroad.
The issues include:
1. “the retirement account was not included in the 2021 tax return” – although not entirely clear, this sounds as though it was an inherited IRA. The IRS information reporting mechanisms “picked up” the fact that the distribution(s) from the IRA were not included on the return. This suggests that Americans abroad who are receiving taxable income from the United States are expected to include that income on U.S. tax returns. What if the American abroad receiving the bequest has NOT been filing U.S. tax returns? What should they do?
The issue: To be or not to be a U.S. citizen when receiving the bequest – to renounce or comply – “The Road Less Taken” (from the AMERICAN poet Robert Frost)
The Compliance Road: Is this a reason for non-compliant Americans abroad to address any issues of noncompliance before receiving an inheritance that generates U.S. taxable income? What if one (as a U.S. citizen) inherits an IRA and is NOT in U.S. tax compliance? What then?
The Renunciation Road: Should they renounce U.S. citizenship prior to receiving the inheritance and receive this taxable U.S. source income as a nonresident alien (and be taxed accordingly)?
The Lesson: The prospect of inheriting taxable U.S. source income should be considered and addressed proactively. Only the United States can turn the excitement of receiving an inheritance into a source of anxiety!
2. The “LITC” report strongly suggests that the “LITC” did NOT know about the “saving clause” in the Canada/U.S. tax treaty. Remember that U.S. citizens are taxable on their worldwide income.
Let’s unpack the U.S. taxation of the income from the summer job performed in Canada:
(i) Per Internal Revenue Code 862: Income from personal services performed outside the United States is “foreign source income”.
To be clear, from a U.S. perspective the wages ARE “foreign source” income. Because these wages are “foreign source” Canadian tax (foreign) can be used as a foreign tax credit to offset U.S. tax owing. (It could also be excluded from U.S. taxation under the section 911 “Foreign Earned Income Exclusion”.)
It is very unlikely under U.S. law that this Canadian citizen student living and working in Canada owed any U.S. tax.
The “LITC” apparently took the position that the U.S. Canada Tax Treaty meant that the United States could not tax this employment income.
(ii) What does the Canada/U.S. tax treaty say about who can tax the income?
Paragraph 1 of Article XV of the treaty says:
Income from Employment
1. Subject to the provisions of Articles XVIII (Pensions and Annuities) and XIX (Government Service), salaries, wages and other remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State. If the employment is so exercised, such remuneration as is derived therefrom may be taxed in that other State.
Presumably the LITC is trying to argue that income from the summer job could be taxed ONLY in and ONLY by Canada. This appears to be a fair and accurate reading of the treaty. Assuming that this is an accurate reading of the treaty, then ONLY Canada would have the right to tax the employment income.
What then is the problem? The problem is that the Canadian citizen student is also a U.S. citizen. The fact of U.S. citizenship allows the IRS to effectively ignore the treaty and impose U.S. tax on the Canadian student.
Let’s examine how the “saving clause” actually works.
(iii) Paragraph 2(a) of Article XXIX – the standard “saving” clause allows the United States to tax its “citizens” as though the treaty did not exist. (This paragraph does NOT impact the sourcing rule under the Internal Revenue Code.)
Here is what the “saving clause” in Article XXIX(2) of the U.S. Canada Tax Treaty says:
2.
(a) Except to the extent provided in paragraph 3, this Convention shall not affect the taxation by a Contracting State of its residents (as determined under Article IV (Residence)) and, in the case of the United States, its citizens and companies electing to be treated as domestic corporations.
In other words, the presumption is that the United States can impose U.S. tax on U.S. citizens regardless of what the treaty says. (There are some narrow exceptions to this principle that are not material to this analysis.)
The means that a U.S. citizen cannot benefit from the part of the treaty giving exclusive taxing rights to Canada!
Here is our analysis with the “saving clause” considered:
– the employment income is foreign source income because the work is performed in Canada
– Canada will impose its tax
– the United States will impose its tax because the student is a U.S. citizen
– The tax imposed by Canada can be used as a tax credit against U.S. tax under S. 901 of the Internal Revenue Code
(Note also that the student might simply exclude the income from U.S. taxable income by using the Foreign Earned Income Exclusion found in S. 911 of the Internal Revenue Code. A U.S. tax return must be filed in order to use the exclusion.)
Such is the ““dignity and glory of American citizenship,” ” – as per Justice Thomas on page 62 of Trump v. Barbara.
John Richardson – Follow me on X.com/ExpatriationLaw