U.S. expats and Obamacare

If you are a U.S. citizen living in Canada, get ready. Depending on your investment and overall income, you may be required to pay a new U.S. healthcare tax when you file your U.S. income return for the 2013 tax year.

A little background: Health care and more specifically how to fund and by extension reform it has long been a hot button political and Main Street issue in the United States. In March 2010, President Barack Obama’s The Patient Protection and Affordable Care Act was signed into law resulting in a string of new provisions and reforms that will continue to roll out over the coming years.

The Act best known as ObamaCare is based on one overriding goal: to provide affordable health insurance for all U.S. citizens and to curb ever-growing health care spending. To that end, the Act requires all insurance plans to cover preventive services. What’s more, it prohibits insurance companies from dropping plan holders when they are sick. The President’s office has reported the Act is already delivering on its promise. Americans saved $2.1 billion due to the new ObamaCare consumer protection provisions in 2012 alone.

In order to make that savings possible and help fund its many other reforms, ObamaCare has created 21 new taxes. One of these taxes came into effect on January 1, 2013. It’s called the Unearned Medicare Contribution Tax and it represents an additional tax, over and above existing U.S. income taxes. The new tax, which sits at 3.8%, tax specifically targets high income U.S. citizens wherever they live. And it will be applied to the lesser of their net investment income for the year or their modified adjusted gross income over a certain threshold (US$200,000 per year for an individual or US$250,000 for a married couple who file jointly or US$125,000 for married couples filing separately).

Net investment income subject to this tax includes interest, dividends, capital gains (including gains realized on the sale of real estate), annuities, royalties, rents, and pass-through investment income from a S-corporation or partnership that are from U.S. and foreign sources.

So, for example, if a married couple files a joint return and their adjusted gross income of US$250,000 includes employment income of US$260,000, investment income of US$50,000 and a deduction for foreign-earned income exclusion of US$60,000. That’s the starting point. The Unearned Income Medicare Contribution Tax is calculated as follows:

= 3.8% x the lesser of investment income or modified adjusted gross income over the threshold
= 3.8% x the lesser of $50,000 or $60,000 (AGI $250,000 + $60,000 –$250,000 threshold)
= 3.8% x $50,000
=$1,900.

This new tax will come into effect even if all your income comes from Canadian sources. And it’s possible because the U.S. Income Tax Act requires all U.S. citizens to file a U.S. income tax return to report their worldwide income regardless of where they reside and work. Until now, U.S. citizens living and working in Canada have typically paid no U.S. tax because they have been able to reduce their U.S. tax through the use of the foreign earned income exclusion and by applying foreign tax credits for the Canadian tax paid on the same income (because Canadian income tax rates are higher than those in the U.S. the foreign tax credit offsets any U.S. tax).

The Unearned Medicare Contribution Tax changes that because it is calculated independently and in addition to any regular U.S. income taxes. This means it will not be eligible for the foreign income exclusion and U.S. tax filers will not be able to use the foreign tax credit to offset it. As a result, for many of the tens of thousands of U.S. expats living in Canada, this may mark the first time they pay U.S. income tax.
FATCA
Since the global economic crash of 2008, the Internal Revenue Service (IRS) in the U.S. has been trying to find other ways to generate income and much needed revenue. One avenue they are pursuing aggressively involves trying to stem tax evasion by U.S. citizens who are purposely hiding their funds in offshore accounts.

According to data received by the Washington-based International Consortium of Investigative Journalists and released through newspapers around the globe, some 120,000 companies and trusts are hiding money in offshore accounts. The leak made headlines around the world this April and it reaffirmed to the IRS that it’s on the right track. In fact, the names of 4,000 Americans were on the list.

The IRS realized there are a lot of U.S. citizens living outside the country who are not reporting all their income and assets—and this goes beyond uber high net worth individuals and families. A little background: the U.S. Internal Revenue Code requires all U.S. citizens (including Green Card holders) to file a U.S. income tax return to report their worldwide income regardless where they live. They are also required to file foreign asset disclosure forms to report their worldwide assets including bank accounts, shares in foreign corporation and interests in foreign trusts.

In order to make sure they do, the U.S. government passed the Foreign Account Tax Compliance Act (FATCA), which requires U.S. citizens living abroad to file Form 8938 Statement of Specified Foreign Financial Assets along with their income tax return (which came into effect in 2011). Form 8938 is a sister form to the Report of Foreign Bank and Financial Accounts (FBAR) form, and requires that in addition to reporting all your foreign bank accounts, you also have to disclose other foreign assets. These can include all the financial bank account information you have already reported, foreign life insurance plans, stocks, securities and interest in private equity funds, for example. In effect, as a U.S. citizen living in Canada, you must now disclose any type of investment asset and interest you own that is located outside the U.S. on this form.

For single U.S. citizens living outside the U.S., the Form 8938 is required when they own specified foreign assets that had a fair market value (in aggregate) of more than US$200,000 on the last day of the tax year or more than US$300,000 at any time during the tax year.

For married U.S. citizens living outside the U.S. (who file a joint return), the Form 8938 is required when the couple own specified foreign assets that had a fair market value (in aggregate) of more than US$400,000 on the last day of the tax year or more than US$600,000 at any time during the tax year. Based on the thresholds listed above, the Form 8938 illustrates that the target group of this form is not just millionaires purposely hiding funds in offshore accounts.

If you are not complaint with Form 8938, you may face a minimum penalty of $10,000. There is also a maximum additional failure of up to $50,000 which applies if the IRS requests this form and you fail to comply. What’s more, if you underpay your tax as a result of a transaction involving an undisclosed specified foreign financial asset, you may have to pay a penalty equal to 40% of that underpayment. For criminal violations, the penalties are much steeper.

The deadline for filing is the same as your U.S. personal income tax return including extensions.

FATCA also requires foreign financial institutions to report information regarding their U.S. citizen client directly to the IRS. Foreign financial institutions that fail to comply face a 30% US tax penalty on their own total investment earnings from all of their own U.S. holdings. Foreign Financial institutions and foreign governments are uneasy about providing information about their clients and citizens and fear FATCA could hurt cross border trade. As a result, many, including Canada, have made their concerns known to the U.S. government. Still, as Canadian banks have subsidiaries and huge investments in the U.S. they are following through and making the required disclosures to the IRS. Some Canadian financial institutions even have new policies where they are not taking on any new clients that are U.S. citizens because they don’t want to deal with the U.S. flexing its muscle in Canada—where it really has no jurisdiction.

In order to encourage compliance, particularly for the majority of U.S. citizens who may not have realized they had to disclose investment assets, the IRS announced a new amnesty program. Since September 1,2012, U.S. citizens living in Canada can file delinquent U.S. income tax returns and foreign reporting forms without being assessed penalties. To qualify for the program, you must have resided outside the U.S. since January 2009; not previously filed a U.S. tax return for the 2009 tax year or later; the tax balance on each U.S. income tax return filed under the program cannot exceed US$1,500; and you must have low compliance risk. If you qualify, you will have to file delinquent U.S. income tax returns for the past three years and delinquent FBAR forms for the past six years, as well as payment for income tax owning and related interest charges. A completed questionnaire must be submitted with the tax returns and forms.

BY FRANK CASCIARO, FULLER LANDAU