There appears to be a widespread misunderstanding of Internal Revenue Service (IRS) treatment of Canadian RRSPs and RRIFs for tax purposes. This article will attempt to explain the reasons why RRSP holdings may have unwittingly put many unsuspecting US taxpayers into a non-compliant situation.
US Tax Policy
In simple terms US tax policy is predicated on the basic premise that if you are a US taxpayer the IRS will tax you on your worldwide earnings in the year that they are received no matter where in the world you might live. Accrued earnings are deemed to be received unless there is a specific exemption provided by law, regulation, administrative decision, or ruling by a competent US court. US taxpayers, therefore, must pay taxes on both income and investment earnings that are received as well as accrued earnings within trusts and investment or similar accounts even though such earnings are undistributed. Pension and retirement plans, however, are exempt from this “taxes due now” policy and earnings within approved plans are not subject to US taxation until they are distributed. To qualify for tax relief such plans must be “created in the United States”. Obviously RRSPs and RRIFs don’t qualify because they were created in Canada.
RRSPs are Not the Same as US Retirement Programs
Many Canadian residents in the United States and Americans resident or working in Canada consider that RRSPs are the equivalent of the US 401(k) accounts or that Canadian Registered Pension Plans are similar to American Pension Plans. Due to this misconception many taxpayers have erroneously assumed that there is similar tax treatment for both plans and many have been lax in submitting information forms required by the IRS.
Application of US Tax Policy to RRSPs and RRIFs
For clarity, the IRS considers Canadian RRSPs and RRIFs to be foreign trusts subject to US taxes on accrued earnings within the plan even though such earnings are not distributed. This interpretation also applies to Canadian Registered Pension Plans and Deferred Profit Sharing Plans.
Under US domestic law an individual who is a US citizen or a resident of the US that is the beneficiary of a Canadian retirement plan must pay US income tax on earnings accrued within the plan. This also applies to Canadians who have stayed too long in the US and are deemed to be US residents by way of the Substantial Presence Test.
Any person that was present in the US for at least 31 days in a calendar year triggers a calculation formula of presence in the US for the previous two years. If the result of this calculation is 183 or more the IRS considers you to be a US resident subject to US taxes on your total worldwide income. We encourage you to read our article on the Substantial Presence Test for further information.
Application of Canada – US Tax Treaty to US Tax Policy Effecting RRSPs and RRIFs
Unfortunately, application of this policy by the IRS results in the dreaded double taxation scenario – a taxpayer is taxed in the US in the year earnings are accrued and taxed in Canada in the year earnings are distributed. Since the US and Canadian tax obligations occur in different years there is no tax set-off available in either country.
To alleviate this double taxation situation a taxpayer must turn to the 1980 United States – Canada Income Tax Convention (Canada US Tax Treaty) and the subsequent amending protocols. This treaty provides that a “natural person” who is a citizen or resident of either country and a beneficiary of a trust, company, organization, or other arrangement (a plan) operated exclusively to provide pension, retirement or employee benefits that is generally exempt from taxation in the country of origin may elect to defer taxes in the country of citizenship or residence under rules established by the competent authority of that country. In simple terms if earnings accrued within a plan are tax deferred in one country, a citizen or resident of the other country that is a beneficiary of such a plan may also elect to defer taxation until the earnings of such plan are distributed.
The applicable section is Article XVIII(7). This favorable tax treatment does not extend to contributions to a plan. For instance, contributions to an approved RRSP are deductible from income in Canada but not in the United States.
The operative words, however, is “may elect”. US taxpayers that have failed to specifically elect tax relief under Article XVIII(7) are required to pay US income tax on the accrued earning within the plan. The IRS considers those taxpayers that have failed to make the election and have not paid the taxes on earnings within Canadian RRSPs and RRIFs to be non-compliant.
How RRSPs and RRIFs Must be Handled to Meet IRS Requirements
In this article we will only deal with the filing requirements to be compliant with IRS requirements. We will discuss procedures to correct non-compliance in another article. For simplicity sake we will assume that a US tax payer has become the beneficiary of a Canadian RRSP during the current year. No later than April 15 of the following year, barring extensions, the taxpayer must file a US Income Tax Return (Form 1040) including Schedule B. Many taxpayers believe that they are only required to file Schedule B if they have earned over $1500 dollars in interest or dividends during the taxation year. However two other events trigger the Schedule B requirement even if you have zero interest and zero dividend income:
- If you are the beneficiary of a foreign trust
- If the aggregate balance of all your foreign financial accounts exceeded US$10,000 at any time during the year.
Canadian RRSPs and RRIFs are foreign trust accounts and must be included in your financial accounts. If you report that you have interests in foreign accounts exceeding $10,000 on Schedule B you are required to file Form TD 90-22-1 (FBAR). The low threshold for triggering the requirement to file a FBAR means that you probably will be required to file one. Form TD 90-22-1 is a stand-alone form that must be received by the IRS June 30 of the following year. It is important to ensure that the IRS actually receives the FBAR by June 30 since under the peculiar US laws governing Form TD 90-22-1 there is no penalty distinction between filing an FBAR 1 day late or not filing it at all. Of course one would hope that the IRS might exercise discretion in applying penalties in such situations but the point is – they don’t have to if they don’t want to.
Requirement to File Form 8891
You have also indicated on Schedule B that you have a beneficial or grantor interest in a foreign trust (your RRSP or RRIF) and they would ordinarily be looking for Forms 3520 and 3520A. In actual fact you have both a beneficial and a grantor interest in an RRSP. However you are specifically exempt from the requirement to file forms 3520 and 3520A starting with the 2003 taxation year. You are required to file Form 8891 instead. On form 8891 you may elect to defer tax on you Canadian RRSP under the provision of Article XVIII(7) of the Canada – US Tax Treaty but you must specifically make the election. Once made this election is irrevocable except with the consent of the Commissioner.
Form 8891 must be included with a timely filed Form 1040 including extensions to be valid. Absent a validly filed 8891 you will be responsible for paying US income tax on accrued earnings within your RRSP or RRIF. A late-filed 1040 or an amended 1040 is not timely filed and therefore any included 8891 will not be valid. You must file Form 8891 even if you are not required to file form TD 90-22-1 (FBAR).
Summary
To sum up, the following is the correct procedure to account for your RRSPs and RRIFs
- File Form 1040 by April 15 of the following year or by approved extension date
- Include Schedule B
- Include Form 8891
- File Form TD 90-22-1 if required and ensure the IRS receives it by June 30 of the following year.
AG TAX LLP Can Help
If you have any other tax-related queries, and/or need assistance with tax planning/filing please contact AG Tax. Our tax professionals are highly-experienced with U.S. and Canadian tax laws and can provide you the right guidance to handle your tax situation.
Aylett Grant Tax LLP is a full service accounting firm with a dedicated team of experts, who are highly-qualified and experienced in handling situations related to U.S., Canada and other international tax laws.
We can assist with:
- Canadian Personal and corporate tax returns
- Cross Border Taxation and Business Planning
- Personal and Corporate Taxation
- Disclosure of Foreign Assets and other information filings
- Retirement planning
- Estate Planning, Inheritance tax advice
To obtain a quote or to arrange for a consultation to discuss your tax related queries, please contact us at:
- 416-238-5920 (Greater Toronto Area, ON)
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Disclaimer: The information in this publication is accurate as of the time of its publication. AG Tax assumes no responsibility for changes to tax legislation subsequent to the publication of this document. The information provided is for general information purposes only and should not be acted upon without seeking professional advice. If you would like to engage our services, please contact our staff and obtain authorization to send our firm confidential information. A client relationship is not created by the transmission of information. A client relationship is only formed with our firm when a scope and engagement letter signed by the firm and the potential client detailing the terms of engagement is present.
