Cross-Border Tax Regime Timing

contributed by Nathan Gehring 

As promised in my last blog post, I am in the process of writing several pieces discussing some of the interesting nuances of cross-border financial planning. In this post, I’m going to review a particularly powerful tool in the cross-border financial planner’s arsenal, one not available in single country financial planning: tax regime timing.

Conventional Financial Planning

In conventional financial planning, it’s common practice to review when to time the recognition of different types of income. Depending on current tax law and what’s going on in a client’s life, it can be more or less advantageous to receive a certain item of income in a specific time period. One of the most obvious and common forms of this type of timing decision is choosing whether to contribute to a traditional (tax-deferred) IRA or a Roth IRA or to save assets in a taxable account. The analysis largely depends on when to time the recognition of an item of income. Is it in the client’s best interest to have income taxed today, perhaps because their income is relatively low compared to what it will be in the future? Or is it better to defer that income to be taxed in the future based on the expectations for that client?

Other common timing decisions include when to accept deferred compensation, when to exercise stock options, when and how much to distribute from IRAs or when to pay tax deductible expense among a variety of other such timing decisions. All these timing questions still apply to cross-border financial planning. However, a new and potentially extremely powerful timing decision is often introduced.

Which Tax Regime and When

At KeatsConnelly, we work predominantly with Canadians looking to spend more time in the United States or Americans heading to Canada. In most regards, the U.S. tax regime is more favorable for clients than the Canadian tax regime. In general, it’s preferable for a client to have income taxed under U.S. tax law. However, this isn’t always the case. Some items of income have more favorable treatment in Canada. Sometimes the U.S. regime plus the state of desired residency can actually result in a higher overall tax cost than some Canadian and provincial tax systems regardless of income type.

So, as cross-border financial planners, we often have to determine what items of income a client has in their future and which tax regime will result in a lower tax cost to the client. For example, in the United States the exercise of non-qualified stock options is generally treated as ordinary income and taxed according to standard income tax tables. However, in Canada, that same income may be treated as capital gain, which could provide preferable tax treatment. In this event, we might advise a client to avoid U.S. tax residency until stock options are fully exercised, particularly if the stock option income was expected to make up a large portion of the client’s gross income.

Sometimes There’s No Decision (Or It Ain’t Easy!)

While our clients often have the opportunity to reduce their taxes meaningfully by timing their tax regime, it’s not always possible or not easy to achieve. There are specific rules set out in the Canada/U.S. Tax Treaty that dictate which country gets to claim an individual as a tax resident. In order to control which tax regime applies to an individual, the rules must be applied and navigated with great care.

Sometimes a client simply does not want to wait to make a cross-border move. Different forms of income could trickle in for years, and the client might choose to pay a higher tax cost instead of waiting for all that income to be recognized in the favorable country. In this event, the client is determining that the cost to lifestyle of waiting is greater than the cost of additional taxes.

And other times, there’s no decision to be made. A U.S. citizen will be taxed under U.S. tax law regardless of tax residency. Timing tax regime doesn’t work in this event.

Tax Regime Timing…A Powerful & Tricky Tool

Tax regime timing is in many ways an extension of tax timing used in conventional planning. It can prove to be extremely powerful in the correct circumstances, and very tricky to not foul up. Using tax regime timing properly requires thorough knowledge of the tax codes of both countries involved and the tax treaty setting out the rules to determine tax residency of individuals. Done well and done right, it can offer great value to clients.

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Cross-Border Series
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