While most people know that alimony is normally taxable income to the recipient and tax-deductible by the payer, in the case of cross-border taxes, alimony can be received tax-free while the payer still gets a tax deduction.
Let’s look at an example where this would apply.
Sarah is a U.S. Citizen who has been transferred to Toronto for a job opportunity. While living in Canada, she meets and falls in love with John, a Canadian citizen. After a few years of dating, Sarah and John decide to get married and live together in Toronto. Five years into their marriage, due to irreconcilable differences, they decide to divorce. Sarah chooses to return to the U.S. to live close to her family. As part of the divorce settlement, John must pay Sarah alimony.
Since John is a Canadian tax resident, he will be able to deduct the alimony payments to Sarah on his Canadian tax return. But with the right cross border tax planning, Sarah can exclude her alimony from U.S. tax. How? By including specific language required by the IRS in the divorce agreement.
In our couple’s case, they would include language along the lines that John agrees not to deduct the alimony payments for U.S. tax purposes. Since John is a Canadian tax resident only, he is still able to deduct the alimony on his Canadian taxes and is not affected by the agreement.
While this is a very simplified example – the rules to make this legitimate are more complex – the fact remains that in Sarah’s case, a U.S. resident can receive alimony tax-free for U.S. tax purposes. In John’s case, he also gets to reap the tax benefits from this strategy, unless he decides to take up a job in the U.S. and become a U.S. tax resident.