Introduction – What is tax residency?
Tax Residency – Who is subject to taxation? Individuals who are “tax residents” of a country are subject to all forms of taxation imposed by that country.
What income are tax residents taxable on?
Most countries tax their “tax residents” on their income earned in and outside the country – “worldwide income”.
Some countries tax their “tax residents” on ONLY income earned in the country – “territorial”.
Some countries use a combination of “worldwide” and “territorial” taxation. (Did you know that the U.S. 911 “Foreign Earned Income Exclusion” is a form of “territorial taxation”?)
50 Shades Of Tax Residency – How Is Tax Residency Determined?
Most countries have multiple methods that one can meet the conditions to be a tax resident.
Method 1 – Residence or connection to the country – where do you really live?
This is usually a “facts and circumstances” test that is based on your economic/residential connection to a country. For example, Canada uses the concept of “ordinarily resident”. What this means is: considering all of the circumstances of your life, regardless of the number of days you spend in Canada, do you actually live in Canada?
Method 2 – Your citizenship or immigration status (who you are) – The United States
This is tax residency based on your status (citizenship and/or immigration status) and NOT based on your economic/residential connection to a country. For example, U.S. citizens with NO connection to the Unites States are U.S. tax residents regardless of where they live in the world.
Method 3 – Your physical presence in the country
How many days a year do you actually spend in a country? For example (without regard to other considerations):
Canada – if one spends 183 days or more in a calendar year one becomes a tax resident of Canada and is taxable by Canada on all sources of income from both inside Canada or outside Canada.
United States – If one meets the “substantial presence test” (a three year weighted average) one becomes a tax resident of the United States and is taxable by the United States on all sources of income from both inside the United States and outside the United States.
Tax residency is a big deal!! Many people work hard to avoid it. This is an important issue for Canadian snowbirds (and others) who wish to spend a significant part of the year in the United States.
Interestingly, the U.S. Internal Revenue Code has a section that allows many Canadians (and others who are not U.S. citizens) who:
1. Meet the U.S. “substantial presence” test (See Appendixes A and B below) and become U.S. tax residents; who then
2. Use a “closer connection” rule (See Appendixes C and D below) to NOT be treated as U.S. tax residents under the substantial presence test.
The “closer connection” rule is like magic!! One moment you are a tax resident of the USA and the next moment you are not!
In other words, Canadian residents who live in the United States are eligible for the “closer connection” carve out to U.S.tax residency. This means that they are not taxable by the United States on their Canadian source income, are not required to file all the penalty laden information returns and are not required to file an FBAR. (Note that this is true ONLY if the Canadian snowbird is NOT a U.S. citizen or Green Card holder. If the snowbird is a U.S. citizen or Green Card holder he he will be subject to the taxation and reporting requirements that the Canadian avoids!)
Important fact!! The “closer connection” does NOT require that one be a “tax resident” of another country!
How does the “closer connection” carve out work?
Generally, once it is established that an individual is a U.S. tax resident under the “substantial presence” test, the “Closer Connection Exemption” can be used so that the person is NOT treated as a U.S. tax resident. (Note that the “closer connection” options is NOT available if one spends more than 182 days in the USA during the calendar year. In addition, the “close connection” test is not available to those who are in the process of getting a Green Card.
Generally, (subject to the specific rules) here is how the “closer connection” carve out works:
If a person can demonstrate that he is “ordinarily resident” in another country (or countries) and has a “closer connection” to that country, then the person is NOT treated as a U.S. tax resident under the “substantial presence” test.
How the “closer connection” carve out fits into the broader picture
On the one hand the U.S. does NOT treat individuals who spend up to 182 days a year in the USA (but meet the “closer connection” test) as U.S. tax residents. The requirements for eligibility to use the “closer connection” exemption are that one generally is “ordinarily resident” in another country. Interestingly, there is evident overlap between the IRS Form 8840 (to explain the “closer connection”) and the Canada Revenue Agency form NR73 (designed to determine whether one is “ordinarily resident” in Canada). See Appendix E below.
Comparing U.S. residents who avoid U.S. tax residency by using the “closer connection” carve out to U.S. citizens living outside the USA
On the other hand the U.S. treats U.S. citizens who spend zero days in the U.S., as tax residents of the US AND taxes them on their non-U.S. source income AND requires them to file penalty laden forms. (Notably these U.S. citizens are generally “ordinarily resident” in another country.)
To put it another way, the United States exempts who are “tax residents” (because they meet the “substantial presence test”)from U.S. tax taxation non-citizens who spend up to half a year in the United States while treating U.S. citizens with no presence in the United States as subject to full U.S. taxation, forms and penalties!
An overlooked benefit of renouncing U.S. citizenship
U.S. citizens who renounce their citizenship can spend a substantial part of the year in the USA – use the “closer connection” carveout – and NOT be treated as tax residents. This is an overlooked benefit of renouncing U.S. citizenship.
It’s all explained in the appendixes on the next page.
