In most countries an individual’s tax residency is determined by their residential ties, which considers one’s own unique “facts and circumstances”. In Canada, for example, there is no statutory definition of “residency” contained in the Canadian Income Tax Act.
In the United States, however, tax residency is a more rigid process. If you are not a U.S. citizen nor a lawful permanent resident (i.e. green card holder) residency is determined by the number of days an individual is physically present in the country. For this purpose, each part of a day in the U.S. is counted as a day, whether for business or pleasure (or both). An individual who spends “too many days” in the U.S. may unintentionally become a U.S. tax resident.
Substantial Presence Test
How does the U.S. determine what is “too many days”? This is computed under the “Substantial Presence Test” or “SPT”. First the individual must have at least 31 days of physical presence in the current year. If the individual has less than 31 days in the current year, the SPT does not apply. If the individual has 31 days or more then the SPT applies the following formula:
All of the days in the current year +
1/3 of the days in the preceding year +
1/6 of the days in the second preceding year
If the result is 183 days or more, then the individual meets the SPT and will be considered a U.S. tax resident, under US domestic tax law, unless an exception applies.
Exceptions to the Substantial Presence Test
There are a few exceptions to the Substantial Presence Test. These include:
- Closer Connection to Another Country – An individual who meets the SPT but who spends less than 183 days in the U.S. in the current year and who has a closer connection to another country can claim a Closer Connection Exception. To claim this exception, an individual must file Form 8840, “Closer Connection Exception Statement for Aliens”, each year along with their U.S. tax return, or by June 15 if no U.S. tax return is required. An individual who spends more than 183 day or more in the current year cannot use the Closer Connection Exception. Those wishing to file as a U.S. nonresident, in determining any potential U.S. tax exposure, must then file under a tax treaty (see below).
- Exempt Individuals – Individuals do not have to count the days that they are in the United States as an “exempt individual”. These are defined as:
- An individual temporarily present in the U.S. as a foreign government-related individual under an “A” or “G” visa, other than individuals holding “A-3” or “G-5” class visas;
- A teacher or trainee temporarily present in the U.S. under a “J” or “Q” visa, who substantially complies with the requirements of the visa;
- A student temporarily present in the U.S. under an “F,” “J,” “M,” or “Q” visa, who substantially complies with the requirements of the visa;
- A professional athlete temporarily in the U.S. to compete in a charitable sports event.
Exempt individuals must file a Form 8843, “Statement for Exempt Individuals and Individuals with a Medical Condition” along with their U.S. tax return, or if no tax return is required by June 15, in order to claim the exemption.
- Medical Condition – Individuals who are unable to leave the United States because of a medical condition that arose while in the U.S. can exempt some of these days. To claim this exemption, the individual must file a Form 8843 along with their U.S. tax return, or by June 15 if no U.S. tax return is required.
If a Form 8840 or 8843 is not filed on time, an individual cannot claim an exemption from the Substantial Presence Test. This will not apply if the individual can prove that he took reasonable action to become aware of the filing requirements and significant steps to comply with those requirements.
Canada-United States Tax Convention (1980) aka the “Treaty”
If an individual meets the SPT and does not meet one of the exceptions listed above, he is a U.S. tax resident under U.S. domestic law. What happens, however, if the individual spends more than 183 days in the current year alone?
Individuals who are also Canadian tax residents and who maintain residential ties closer to Canada, than the U.S., can use the residency tie breaker rules, contained in Article IV, to override U.S. domestic law. This is done by filing a U.S. Form 1040NR, “U.S. Nonresident Alien Income Tax Return, by the due date along with a Form 8833, “Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b)” claiming an exception from U.S. taxes under the Treaty. If there is no U.S.-source income to report, then there is no U.S. tax to pay.
The downside of this is that the Treaty only reduces or eliminates any potential U.S. tax. It does not eliminate any filing obligations the nonresident may have. Individuals who are considered U.S. nonresidents, by way of a Treaty, are still subject to the foreign reporting requirements of a U.S. resident. Keep in mind that anything Canadian is considered “foreign” in this context. Some of these additional filings may include:
Foreign bank accounts – FinCEN 114, “Report of Foreign Bank and Financial Accounts”
Foreign corporations – Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations”
Foreign partnerships – Form 8865, “Return of U.S. Persons With Respect to Certain Foreign Partnerships
Foreign trusts – Form 3520, “Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts”
Foreign trusts – Form 3520-A, “Annual Information Return of Foreign Trust With a U.S. Owner”
Foreign mutual funds – Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund”
If an individual becomes a tax resident and is unable to claim an exception or use the Treaty, then he will be required to report his worldwide income to the U.S. and comply with all foreign reporting required of U.S. persons. While foreign tax credits may offset some or all of the U.S. tax payable, it can still be a timely and expensive process.
It’s important to keep in mind that the Substantial Presence Test, the exceptions, and the Treaty override are all related to U.S. federal tax residency rules. Each individual state has its own residency rules as well. These should be reviewed as well.
Cadesky U.S. Tax can analyze your unique situation and help you keep onside with the U.S. tax residency rules. Please contact us for an appointment to discuss your situation.