Beginning January 1, 2013, some US individuals are subject to a new 3.8 percent Medicare surtax on their net investment income (NII). Several aspects of the new NII surtax affect US individual taxpayers who are resident in Canada, including those who currently pay no US taxes due to the foreign earned income exclusion and foreign tax credits.
The surtax applies to a US individual whose modified adjusted gross income (MAGI) is at least $200,000 (single filer) and $250,000 (joint filers). MAGI is defined as adjusted gross income plus statutory addbacks. The only relevant addback is for income excluded under the foreign earned income exclusion in Code section 911, an unwelcome addback for many US taxpayers in Canada.
The surtax is based on the lesser of (1) the excess MAGI over the taxpayer’s threshold and (2) the taxpayer’s NII. NII includes interest, dividends, capital gains, rental and royalty income, income from businesses involved in trading financial instruments or commodities, and income from businesses that are passive activities to the taxpayer (within the meaning of Code section 469). NII does not include wages, unemployment compensation, operating income from a non-passive business, social security benefits, alimony, self-employment income, tax-exempt interest, or distributions from certain qualified plans. The surtax is subject to the estimated tax payment rules.
To illustrate the effects of the Medicare surtax, assume that a single US citizen resides in Canada and has $180,000 of wage income and $90,000 of NII from a passive partnership interest in a Canadian partnership: her MAGI is$270,000 because there is an addback to adjusted gross income for wages that were excluded from income under the foreign earned income exclusion. The surtax applies to the lesser of the amount by which MAGI exceeds the single filer threshold of $200,000 ($70,000) and NII ($90,000); thus, the surtax is $2,660 ($70,000 × 3.8%).
In many cases, a US taxpayer resident in Canada owes little or no US federal income tax because the US tax system allows a foreign tax credit for Canadian federal and provincial taxes paid, which are often higher than the US taxes imposed. In the example above, Canadian taxes that the taxpayer paid on the $90,000 of passive partnership in- come may be otherwise sufficient to offset both the regular US taxes on the income and the NII surtax. Unfortunately, the Medicare surtax legislation as drafted does not appear to allow foreign tax credits to offset the surtax: foreign tax credits may offset a chapter 1 tax liability, but the NII surtax falls into new chapter 2A, an interpretation recently confirmed by an IRS official. Thus, the taxpayer in the example owes surtax even if she has available foreign tax credits arising from higher Canadian income taxes. It is not clear whether Congress intended this result, but the possibility of a legislative fix has not yet been raised. (The Canada-US treaty is also unlikely to override the result because of, inter alia, the last-in-time rule.)
Several aspects of the new Medicare surtax affect US individuals resident in Canada. The most significant impact arises because the surtax applies when MAGI exceeds a fairly low threshold—calculated without the foreign earned income exclusion—and foreign tax credits apparently can- not offset the NII surtax. As a result, many US taxpayers in Canada who currently pay little or no US tax will find themselves with US tax liabilities that may include quarterly estimated payments of NII surtax.