The challenge of two-fold tax compliance

Both Canada and the United States levy income tax on their residents. The US also taxes its citizens and ‘green card’ permanent residents (collectively “US persons”) wherever they are in the world.

Though our two systems are generally coordinated to avoid double-taxation, the US treatment of Canadian registered plans varies. The US taxes some income that is tax-sheltered in Canada, and has reporting rules that can make it more costly and complicated for US persons to hold such plans.

Retirement savings – RRSP, RRIF

Contributions

A Canadian Registered Retirement Savings Plan (RRSP) is like a US 401(K), the main US workplace retirement plan. The number refers to the relevant section of the US tax code. Despite the similarity, US domestic rules don’t allow a deduction for RRSP contributions, though the later withdrawal of those amounts are not taxable.

However, a deduction may be possible through an exception in the Canada-US Treaty (the “Treaty”) for qualifying retirement plans (QRPs). This is directed at plans that are primarily employer-sponsored, so not all RRSPs qualify as QRPs, though group RRSPs likely do. The deduction is limited to the current year’s maximum 401(K) limit, which is $US23,000 for 2024, and may be higher for those over age 50.

Note that 401(K) room is a per-year allotment, unlike Canadian RRSP rules that allow unused room to be carried forward to future years. Bear this in mind when considering a large single year RRSP catch-up contribution. It may be necessary to spread that contribution over multiple years to assure deductibility in both countries.

Growth

Income in an RRSP or Registered Retirement Income Fund (RRIF) is taxable in the year earned under US domestic law. Fortunately the Treaty has an exception that allows a deferral of that taxation until withdrawal. Prior to 2014, the RRSP/RRIF holder had to file Form 8891 to obtain the deferral, but it is now automatic.

Withdrawals

As noted above, undeducted RRSP contributions may be withdrawn tax-free for US purposes. Otherwise, both Canada and the US tax RRSP and RRIF withdrawals in the year taken. When filing the US tax return, a foreign tax credit can be claimed for the Canadian tax paid. Be aware that the Canadian pension income splitting rules (allowing a portion of certain RRIF payments to be allocated and taxed to a recipient’s spouse) have no effect on US reporting, where each person reports the income he or she actually received.

Non-retirement savings – TFSA

The Canadian tax-free savings account (TFSA) was legislated in 2008. Contributions are not tax-deductible, growth is tax-sheltered, and withdrawals are not taxable.

There is no special status for TFSAs under US domestic law, nor is there any relief under the Treaty, which was amended by the Fifth Protocol in 2007, just prior to the TFSA’s introduction. While the US makes no reference to TFSAs, the tax community consensus is that they are likely to be treated as foreign trusts, requiring an annual report of transactions and ownership information, using Forms 3520 and 3520-A respectively.

Details will also have to be reported at the same time as the US person’s income tax return using Form 8938 “Statement of Specified Foreign Financial Assets”, and for banking secrecy disclosure to the US Treasury on FinCEN Form 114, known as the “Report of Foreign Bank and Financial Accounts (FBAR)”.

Education savings – RESP

The Canadian Registered Education Savings Plan (RESP) provides tax assistance for education savings. Most commonly, parents or grandparents are the plan subscribers, saving for a child’s education. Contributions are made from after-tax money, with potential assistance from government sources. Income is tax-deferred when in the plan, and generally taxed to the student when withdrawn for education purposes.

A Canadian RESP is not tax-exempt under US domestic rules, and instead is likely to be treated as a foreign trust. Until recently, this required the annual filing of Forms 3520 and 3520-A as outlined above under TFSAs; but in March 2020, the US announced an exception for non-US plans for “medical, disability, or educational benefits”. There is however no relief from Form 8938 and FBAR filing, and the tax treatment remains unchanged.

That being so, a U.S person subscriber will be taxed on income generated in the plan. In addition, government grant money is likely to be treated as income for that subscriber in the year it is paid into the plan. Double-taxation can arise later when a student-beneficiary is taxed in Canada on education assistance payments.

If the student-beneficiary is a US person, RESP distributions will be taxed each year paid, unless proof is shown that the amounts are not taxable (for example, if they are partly or fully return of capital). Historically, a US person beneficiary would have to file Form 3520 in the year of any distributions. A US tax professional can advise whether the March 2020 exception relieves this requirement.

Disability needs – RDSPs

The Canadian Registered Disability Savings Plan (RDSP) provides tax assistance for those with a qualifying disability. Parents or other close family members may open a plan for a minor-age child beneficiary with a disability. The child may become the holder at age of majority if he or she is contractually competent.

Contributions are made from after-tax money, with significant assistance from government sources. Income is
tax-deferred when in the plan, and taxed to the beneficiary when withdrawn later in life.

Like RESPs, US tax concerns arise with RDSPs if the beneficiary (or a holder on behalf of the beneficiary) is a US person. These include the treatment as a foreign trust (along with the relief from Form 3520 and 3520-A filing), continuing Form 8938 and FBAR filing obligations, and similar concerns about double-taxation. Once again, a US tax professional can advise on these matters.

Summary

This article provides an overview to help financial advisors alert their US person clients resident in Canada when they may need to seek advice from a qualified US tax professional. The key points are:

• • While there are constraints, RRSPs and RRIFs can provide effective tax sheltering of retirement savings.
  • TFSAs are not tax-exempt, and they carry stringent information reporting requirements.
  • RESPs and RDSPs are not tax-exempt, on top of which government grant money is taxable when paid into them. They are also subject to stringent information reporting, but some relief was announced in 2020.