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.
Eliza is a US Citizen and an aspiring actress in Los Angeles. Through fate and destiny, she meets and falls in love with Gordie, a Canadian citizen who plays hockey for an iconic Canadian NHL team. Gordie and Eliza decide to get married in a fairy tale wedding in Prince Edward Island, during the summer of course, and Eliza moves to Toronto to live with her husband. As fate would have it, the couple’s marriage tanks, much like the team Gordie plays for. Eliza decides to return to Los Angeles and Gordie, with his massive NHL contract, has to pay Eliza alimony. A lot of alimony. Enough alimony that Eliza can turn down a starring role on a Fox TV series.
Since Gordie is a Canadian tax resident, he will be able to deduct the alimony payments to Eliza on his Canadian tax return. But with the right cross border tax planning, Eliza can exclude her alimony from US 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 Gordie agrees not to deduct the alimony payments for US tax purposes. Since Gordie 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 very simplified example – the rules to make this legitimate are more complex – the fact remains that in Eliza’s case, a US resident can receive alimony tax free for US tax purposes. In Gordie’s case, he also gets to reap the tax benefits from this strategy, unless, in the final year of his contract, the fan’s get their wish and he is traded to a US NHL team at the trade deadline in return for some quality prospects.