“Financial Checkup” is an ongoing series that discusses financial planning options. In this issue, Investment Executive speaks with registered financial planners Derek Moran, president of Smarter Financial Planning Ltd. in Kelowna, B.C., and Terry Ritchie, partner with Transition Financial Advisors Group Inc. , which has offices in Calgary and Phoenix. (All figures are in Canadian dollars.)

The Scenario: a 65-year-old woman, who is a U.S. citizen resident in Canada, has no children and lives with her very healthy 94-year-old mother, who is a Canadian citizen and resident. They spend half the year — 184 days — in Alberta and the rest of the time, including the winter, in Palm Springs, Calif.

The daughter has a sister, also a U.S. citizen, who lives in Alberta and is not well off financially.

The daughter-client owns two residences, which are mortgage-free. The Alberta home is worth $700,000 and the Palm Springs home is worth $300,000. Her annual income from old-age security, the Canada Pension Plan and U.S. Social Security is around $20,000. She also has $500,000 in an RRSP.

The mother has financial assets of $1.2 million: $400,000 is invested in Canadian government bonds, $150,000 in cash and $650,000 in blue-chip Canadian equities, preferred shares and income trusts. This generates about $60,000 in taxable income a year after dividend gross-up, plus 2% in accrued capital gains. The mother also has pension, annuity and OAS benefits amounting to about $40,000 annually, which brings her total annual income to $100,000.

The pair purchase travel medical insurance to cover them while in the U.S. But neither has any life or extended medical, critical illness or long-term care insurance.

They spend all the mother’s annual income and expect to spend the daughter’s CPP and OAS benefits of $20,000, which she is starting to receive, as well. Their goal is to increase their after-tax income by as much as possible, without running too much risk. The mother’s estate is to be divided equally between her two daughters.

The Recommendations:
Income-splitting is the key to this situation, in Moran’s view. He recommends the mother make a low-interest investment loan of about $600,000 to the daughter-client.

The loan, which would have no term but bear a 0.5% interest rate with the interest payable in January of the following year, would come from transferring the $400,000 fixed-income portion of the mother’s portfolio, plus $200,000 of the highest-yielding equities, preferreds and income trusts, to the daughter. The mother would have to pay any capital gains taxes that would be triggered by the “sale” of these securities. So, investments should be chosen with this in mind. A formal promissory note should be signed and witnessed.

The result: an approximate equalizing of the mother’s and daughter’s annual taxable income at about $60,000 each.

This would mean that the mother’s OAS payments would not be clawed back, as her income would be less than the $64,178 level at which clawbacks begin. The mother would also save about $10,000 in income taxes, while the daughter would pay $5,000 more. That means a net annual saving of $5,000 in income taxes and $6,028 in OAS.

Moran points out that this is feasible because the mother and daughter are not spouses. Investment loans at rates less than the Canada Revenue Agency’s prescribed rate are not permitted for spouses. The prescribed rate moves in line with three-month T-bills and was recently 4%.

Ritchie points out that the daughter, a U.S. citizen, is considered a U.S. resident for income, gift and estate taxes purposes and, therefore, should be filing a U.S. income tax return on her worldwide income. In addition, the daughter is required to make additional filings to the U.S. Internal Revenue Service, including disclosure of her financial interests in Canadian bank and investment accounts and her RRSP.

In most cases, the taxes the daughter will pay in Canada on her worldwide income should be sufficient to offset any exposure to U.S. income taxes through the use of foreign tax credits, which are applied to her U.S. tax return.

Nevertheless, because of the daughter’s U.S. citizenship, Ritchie says, care is needed in picking the investments to be transferred to the daughter in the loan — a concept he supports — and the kind of income they generate. Canadian income trusts and mutual funds that are classified as trusts are considered foreign trusts by the IRS and, he cautions, if the daughter has any of these, there are three additional and “rather onerous” forms that have to be filed with her U.S. tax return.

@page_break@Failure to file these forms can result in significant penalties, says Ritchie, whose practice focuses on U.S./Canada planning and investment management. He is an “enrolled agent” with the IRS, which allows him to discuss clients’ affairs with the IRS.

Ritchie also notes that the treatment of capital gains and the taxation of dividends is different in the two countries, and his research indicates that the biggest determinant of investment performance is the initial and underlying cost of the investments and taxes. He prefers to put clients into low-cost investments such as exchange-traded funds and low-cost institutional mutual funds, such as those offered through Santa Monica, Calif.-based Dimensional Fund Advisors. The latter are generally more tax- and cost-efficient than Canadian mutual funds. Management expense ratios for DFA funds are as low as 0.45% for fixed-income and 0.42%-0.65% for domestic, international and small-cap funds.

Another issue is the amount of time the mother spends in the U.S. Under U.S. income tax rules, a Canadian who spends at least 183 days in the U.S. a year, calculated over three consecutive years, is deemed to be a U.S. tax resident. However, Ritchie notes, if the mother files IRS Form 8840 — the closer connection exception statement — by June 15 each year, she can demonstrate to the IRS that she has a “closer connection” to Canada for income tax purposes.

A further concern is that the daughter is the sole owner of both the Alberta and the Palm Springs homes in which the two live. To ensure that the mother can continue to live in both residences should anything happen to the daughter, the daughter should have medical and financial powers of attorney in both Alberta and California to deal with any incapacity or financial control issues that might come about while in either jurisdiction. Given the mother’s age, the daughter also should choose individuals as backups who are trusted and could easily step into the daughter’s shoes in the event of her incapacity. The mother also needs powers of attorney in each jurisdiction.

Moran recommends that the mother revise her will so that her estate is left to her daughters in testamentary trusts, which are taxed as separate entities.

Ritchie says that to comply with U.S. rules, all testamentary trust income should be distributed annually and not accumulated in the trust to avoid heavy taxation in the U.S. Furthermore, additional U.S. tax filings will be needed, given that the daughters would be beneficiaries of Canadian trusts.

If the daughters are trustees or have the power of appointment over their trusts, these trusts could be subject to U.S. inheritance taxes upon their deaths. The current minimum for U.S. inheritance taxes is $2 million, which the daughter-client is close to, but the threshold is scheduled to increase to $3.5 million in 2009, so they should be fine.

Assuming the daughter is not concerned about leaving an estate, she doesn’t need to buy LTC insurance, Moran says; she should have sufficient assets to cover the costs of health care if needed. Ritchie agrees, particularly as the daughter qualifies for U.S. medicare now that she’s 65. He notes that if she wanted this insurance, she’d need to find a policy that covered her in both countries or take out separate policies for each jurisdiction.

Moran suggests that the mother’s financial assets be invested in line with her daughters’ investment objectives rather than her own to provide a two-pronged benefit — besides providing as much income as possible without running too much risk, these funds will provide income for her daughters after her death. (He has no specific suggestions on the asset mix or types of securities, as he doesn’t manage money.)

Ritchie would discuss with the daughter-client whether she would spend more time in the U.S. after her mother’s death. If so, she could look at strategies to sever her Canadian income tax ties and move to the U.S., as the level of U.S. net taxes during her retirement is probably lower than in Canada. She would still be entitled to OAS and CPP, and her OAS would not be subject to clawbacks or Canadian withholding taxes. She could also look at withdrawing her RRSP from Canada; with proper structuring of her U.S. investment portfolio, he says, any Canadian withholding taxes imposed on her RRSP could be recovered.

Ritchie believes that half of the mother’s and daughter-client’s income should be generated in U.S. dollars, in case the C$ falls significantly, thereby raising the amount of Canadian income needed to cover U.S. expenses. With the C$ recently around par with the US$, this is an ideal time to do this, he says. This can help hedge future U.S. lifestyle costs should the C$ drop in value vs the US$.

The portfolio that Ritchie recommends would retain the 50% fixed-income/50% equity asset mix, but the equity portion would be 50% Canadian, 30% U.S. and 20% international. The portfolio could also include 5%-10% in alternative investments, such as real estate.

Moran would charge $3,000-$5,000 to develop a financial plan. He charges by the hour, so the exact amount depends on the complexity of the situation and the amount of discussion involved.

Ritchie’s fee to develop a comprehensive cross-border financial plan is 1% of net worth (including real estate), which would work out to about $16,500 for the mother and daughter together. There would be a fee of a slightly less than 1% to manage the financial assets and make ongoing adjustments to the financial plan. Ritchie does tax preparation, for which he charges separately. IE