A little-known provision of the Patient Protection and Affordable Care Act —better known among friends and foes as Obamacare—came into effect on Jan. 1 that imposes a new tax on net investment income for U.S. citizens and residents. Even more unbeknownst to those potentially affected, the tax might hit Canadians in the U.S. and Americans who receive Canadian pension income.
“It’s a real bloody mess,” says Roy Berg, a U.S.-trained tax lawyer at Moodys Tax, an Alberta firm that specializes in cross-border tax issues. The new law, he told Canadian Business, might mean Canadian citizens who are U.S. residents for tax purposes are going to be taxed twice on income they receive from their RRSPs and other types of Canadian retirement plans, including the Canada Pension Plan.
It all goes back to one section of President Barack Obama’s Affordable Care Act, which introduces a 3.8% tax on investment income to help fund the costs of universal healthcare. The catch is that although U.S. pensions are exempt from the tax, foreign ones aren’t. Recipients of Canadian pensions wouldn’t even be able to use foreign tax credits to offset that, according to Berg.
Here’s what that means in practice. Suppose you receive $100 a year from your RRSP or decided to withdraw that amount from your account for whatever reason (incidentally, do not withdraw early from your RRSP — it’s generally a bad idea). If you were paying taxes in Canada and the marginal rate applicable to you was, say, 40%, you’d owe $40. Now, in the U.S., where the marginal rate is 35%, you’d owe $35 to the IRS, but you’d normally be able to deduct your Canadian taxes, which would completely offset your U.S. liability. Not so in the case of the Obamacare tax, though, says Berg. With that, you’d end up paying a total of 43.8% in tax (I’ve ignored matters of currency conversion for the sake of simplicity). Americans living in Canada and receiving U.S. pension income, on the other hand, are safe.
Not only is the discrimination against Canadian pensions rather disagreeable, it also runs counter the Canada-U.S. tax treaty, whose “principle purpose is to eliminate double taxation,” says Berg.
Admittedly, the final word on the 3.8% tax hasn’t been spoken yet. The U.S. Treasury is still in the process of drafting regulation that would interpret the provision of the Affordable Care Act and instruct the IRS on how to handle it. But the draft rules proposed so far haven’t assuaged any of Berg’s concerns. That’s why he and another Moodys Tax lawyers were invited to Washington D.C. last week to comment on the matter before Treasury officials. He is now “cautiously optimistic” that U.S. tax authorities will amend draft regulation and extend the exemption to foreign retirement income, but there are no guarantees.
What’s maddeningly confusing is that, although the Treasury hasn’t yet finalized its rules, the law has already come into effect, and it requires recipients of investment income to pay that 3.8% tax every quarter, with the first deadline coming up April 15.
Are Canadians living in the U.S. supposed to file? No one can tell for sure. Should the Treasury decide that Canadian pensions aren’t exempt, those who didn’t send the IRS a cheque every four months during 2013 might face penalties.
The convoluted tax saga also appears to be a case of bad diplomatic etiquette. The U.S., in fact, should have notified Canada that the Affordable Care Act had tax implications that would affect the Canada-U.S. treaty, but, according to Berg, it didn’t.
For many of us living south of the border, it seems, the IRS nightmare just got a little worse.
Erica Alini is a California-based reporter and a regular contributor to CanadianBusiness.com, where she covers the U.S. economy. Follow her on Twitter: @ealini.