In a previous article we explained the procedures that US taxpayers who have a beneficial interest in a Canadian RRSP or RRIF must follow to be compliant with IRS tax requirements.
Unfortunately many Canadians who are US taxpayers by way of residency and many US citizens and residents of the United States that have a beneficial interest in a Canadian RRSP or RRIF have wrongly assumed that since they had no US income tax payable by way of offset under the Canada – US Tax Treaty that they were not required to file US 1040 Income Tax Returns.
In fact, the IRS requires that US taxpayers report their worldwide earnings on Form 1040 even if no tax is owed. Since penalties are based on the amount of taxes owed no penalties are applied if no taxes are actually owed – but the requirement to report income still stands.
Due to the fact that many taxpayers did not file US Income Tax Returns they also failed to file Schedule Bs and may not have filed any required Form TD 90-22-1 (Report of Foreign Bank and Financial Accounts). If these individuals failed to file FBARs they probably didn’t file Form 8891 (US Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans). Since these taxpayers did not file 1040s they are not eligible for preferred treatment for filing delinquent FBARs under the 2011 Offshore Voluntary Disclosure Initiative.
Taxpayers that have failed to file required FBARs and 8891s for Canadian RRSPs and RRIFs should consult a cross border tax specialist without delay.
Obligation to File Required FBARs for Foreign Accounts and Form 8891 for Canadian RRSPs and RRIFs
A US taxpayer that has an interest in a foreign financial or trust account must disclose the fact on Schedule E to Form 1040. Additionally, if a US taxpayer has interest in or control over certain foreign financial accounts and foreign trust accounts including Canadian RRSPs and RRIFs that have an aggregate value of $10,000 or more at any time during a tax year, he or she must file Form TD 90-22-1 (FBAR). Regardless of the value of a foreign trust account Forms 3520 and 3520A must be filed to report both the existence of a foreign trust account and any transactions within the account. In the case of Canadian RRSPs and RRIFs Form 8891 is substituted for Forms 3520 and 3520A for the 2003 and subsequent taxation years. Any taxpayer, for whatever reason, that has failed to file the required Schedule E and Forms 8891 and TD 90-22-1 (if applicable) for Canadian RRSPs and RRIFs is not in compliance with US tax requirements.
Obligation to be Compliant with US Tax Requirements
Unfortunately, the first inclination of many non-compliant taxpayers is to do nothing and hope that the IRS does not discover them in the ever-widening Criminal Investigation Division net. These taxpayers believe that they simply can’t afford the costs involved in becoming compliant or mistakenly assume that the savings are worth the risks involved.
The fact is that the costs of becoming compliant, and there is no argument that they can be substantial, pale in comparison to the life-altering costs that can be imposed if a non-compliant taxpayer is discovered by the IRS.
Assuming that a taxpayer suddenly realizes that he or she should have filed FBARs and takes sincere steps to become compliant the best thing to do is to file the delinquent FBARs with a covering letter explaining the reason why you were unaware of your filing requirement or the reasons why you failed to file required FBARs. It wouldn’t hurt to vow that now you are aware of your filing obligations it will never happen again. The IRS can do one of two things – they can send you a letter saying OK but don’t let it happen again or they can impose a penalty for each delinquent year. But at least it will be an unwillful penalty limited to a maximum of $10,000 per year and the IRS can not go back more than six years to apply the penalty. It is unlikely that the IRS would impose the maximum penalty on a taxpayer stepping forward in this situation. If you can convince the IRS that there were extenuating circumstances causing your failure to file (for instance faulty advice from a tax specialist or an IRS agent) no penalty will be imposed.
On the other hand, if you fail to act to become compliant after you become aware of your filing obligations at some point the failure to file becomes willful. If the IRS discovers your failure to file FBARs and concludes that such failure was willful they could decide that it was appropriate to impose willful penalties. The maximum willful penalty that can be imposed is the greater of 50% of the total value of unreported financial accounts or $100,000 for each year up to six years. If the failure involved other criminal activity the IRS could go back even longer. Additionally, the IRS could recommend criminal prosecution to the Department of Justice. The maximum criminal penalty is a $500,000 fine and up to 10 years in jail.
Failure to File Form 8891 (US Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans)
Under US law United States citizens and US residents are taxed on their worldwide income in the year that it is earned no matter where they live. Earnings accrued within financial and trust accounts are deemed by the IRS to be earned in the year that they accrued even though they are not distributed. Qualified US pension plans are specifically exempt from being taxed in the year that earnings accrued within such plans. Taxes on qualified plans are deferred until the earnings are distributed. However, the IRS considers Canadian RRSPs and RRIFs be foreign trusts subject to taxes on earnings within the plans under Section 70 of the Internal Revenue Code. Canadian RRSPs and similar employee benefit plans cannot qualify as approved pension plans under US law for various reasons but the single best reason is that qualified US retirement benefit plans must be created in the US.
Since the US taxes earnings within Canadian RRSPs and RRIFs in the current taxation year and Canada defers taxes until the year of distribution a double taxation situation is created with no corresponding offsets. The United States – Canada Income Tax Protocol (Canada – US tax Treaty in Canada) addresses this double taxation situation under Article XVIII (7) in a simple and direct manner. Simple and Direct provided that a taxpayer is fully knowledgeable of IRS regulations and is filed in the taxation year that the RRSP or RRIF was first opened or first year it was subject to US taxes (in the case of A Canadian becoming a resident of the US). If you file Form 8891 (US Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans) in a timely manner with your US Income Tax Return Form 1040 including Schedule E and specifically make an election under Article XVIII (7) the IRS will defer Taxes on your Canadian retirement plans until the proceeds are distributed. Unfortunately, few ordinary taxpayers are experts in US tax laws and, in fact, proper treatment of Canadian RRSPs has slipped through the fingers, so to speak, of some US tax preparers. As a consequence many US taxpayers holding Canadian RRSPs and RRIFs find themselves not only in the position of failing to file Forms 8891 and TD 90-22-1 but also in the position of failing to declare income earned within their Canadian retirement plans and failing to pay the required taxes.
What is the Process To Become Compliant with the Requirement to File Form 8891
This is one of the strangest and most peculiar regulatory environments surrounding any US tax or information reporting requirement. The fact is, if you have failed to file Form 8891 there is no way that you can file an amended or file a delinquent Form 8891. As a consequence you will be responsible for taxes on accrued earning within your Canadian RRSPs and RRIFs until you file a valid Form 8891 and make an election Under Article XVIII(7) of the Canada-US Tax Treaty. Form 8891 to be valid must be included with a timely filed (including extensions) 1040 and Schedule E – it cannot be filed as a stand-alone document. Since an amended 1040 is not timely filed it is not possible to file Form 8891 with amended 1040s (although you will have to file amended 1040s to report revised earned income and amended taxes owing). But it gets worse – Canada is going to tax you again on these same earnings when your RRSPs and RRIFs are distributed.
Technical Provision to Late-File Form 8891
If you have not filed Form 8891 and made a declaration under Article XVIII (7) for the 2010 tax year you can still file what is basically a stand-alone 8891 due to another peculiarity in the rules affecting Form 8891 provided that you do it by October 15, 2011. Treasury Regulations Section 301.9100-2 grants a 6-month extension to taxpayers that wish “to make a regulatory or statutory declaration”. A regulatory regulation is one where the due date for action is set by a “regulation, a revenue ruling, a revenue procedure, notice or announcement”. In the case of an election concerning your Canadian RRSPs the due date for such election is set by Revenue Procedure 2002-23 and is therefore a “regulatory election” for the purposes of Section 301.9100-2.
In addition to the technical requirement set out above, under Treasury Regulation 301.9100-2 a six-month extension is only permitted if the due date for the election is tied to the due date of a tax return (or the due date of a tax return plus extensions). Revenue Procedures 2002-23 and 2002-15 require Form 8891 to be submitted with a timely filed with extensions income tax return for the current year thus meeting the second technical requirement of 301.9100-2. Since an automatic filing extension is applied to US taxpayers living outside the US, if you are living in Canada you have until December 15, 2011 to file a Form 8891 for taxation year 2010. You will need to include Form 1040X and a revised Schedule B with Form 8891. If all goes well the IRS will send you a letter saying, “thanks everything looks ok”. But then this is the IRS and it is beyond our ability to guarantee that this is the treatment you will receive.
Penalty for Failing to File Form 8891
This might be the only good news in the IRS treatment of Canadian RRSPs saga. There doesn’t appear to be a bank-busting penalty that the IRS can apply if you have failed to file the required yearly Form 8891 (although the potential for double taxation might qualify as a penalty). A quick explanation lies in the new reporting regime for Canadian RRSPs set out in Notice 2003-75, 2003-50 IRB 1204 authorizing a new reporting form (Form 8891) under the authority of Section 6001 of the Internal Revenue Code. Form 8891 replaced Forms 3520 and 3520A that were authorized under Section 6048. Section 6677 sets out the penalties that can be applied for failing to file forms required by the IRS under section 6048. Notice 2003-75 specifically states that penalties under Section 6677 do not apply but vaguely states “A beneficiary or an annuitant of an RRSP or an RRIF may, however, be subject to other penalties” without specifying what such other penalties might be. Since there are no penalties set out in the instructions for submitting Form 8891it appears that the IRS uncharacteristically cancelled one penalty regime and failed to specify another. It might be that the worst penalty that can be applied for failing to file Form 8891 is the $135 flat minimum under Section 6651(a).
Penalty for Failing to File Forms 3520 and 3520A
If your Canadian RRSP holdings predate the new reporting regime established effective the 2003 taxation year you were required to file Form 3520 as a beneficiary of a foreign trust and Form 3520A as the grantor of a foreign trust. If you failed to file these two forms you are subject to penalties set out in Section 6677 – up to $10,000 per year. The three-year Statute of Limitations clock does not start to tick until Forms 3520 and 3520A are filed. Taxpayers that were required to file these two forms in taxation years 2002 and earlier should be aware of the fact that the IRS can examine all years for which the taxpayer failed to file Forms 3520 and 3520A. If these taxpayers failed to file FBARS there could be no limit on how far back the IRS can go. The best thing that a taxpayer can do at this point is file amended and delinquent reports with an explanatory letter and hope for the best.
How to Become Compliant with Reporting and Tax Requirements for Canadian RRSPs and RRIFs
There are only two ways to become compliant with the reporting and tax requirements for Canadian RRSPs and RRIFs:
- File Form 8891 and make an election under Article XVIII (7) of the Canada-US Tax Treaty going forward, and:
- File amended and delinquent reports as required and pay US taxes on accrued earnings within the RRSPs or RRIFs, or:
- Request a Private Letter Ruling from the IRS to file delinquent 8891s in which case no additional income taxes would be payable.
A Private Letter Ruling is a one-off legal ruling that concerns the application of a tax law specifically to you and only you. In this case you will be requesting that the IRS give you permission to make an election under Article XVIII (7) of the Canada-US Tax treaty even though the deadline for doing so has passed. We recommend that you read our article on Private Letter Rulings for further information.
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)
- 604-538-8735 (Greater Vancouver Area, BC)
- 780-702-2732 (Greater Edmonton Area, AB)
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.
