Fixing Problems with Canadian RRSPs Held by US Taxpayers

Due to a misunderstanding of the way the Internal Revenue Service treats Canadian RRSPs and RRIFs, many U.S. taxpayers residing in Canada hold a beneficial interest in a Canadian RRSP or RRIF and have failed to file the required annual information returns. They have wrongly assumed that since the Canadian income taxes they paid offset U.S. income taxes that would otherwise be owed, they were not required to file U.S. 1040 Income Tax Returns. In other cases U.S. resident taxpayers wrongly assumed that any Canadian retirement plans that they owned would be treated in the same fashion as U.S. retirement plans.

Canadian RRSPs and RRIFs Taxed as Foreign Trusts

In fact, the IRS treats Canadian RRSPs and RRIFs as foreign trusts subject to U.S. taxes on accrued earnings within the trust in the year earned. Since the IRS taxes United States citizens and U.S. residents on worldwide income even if they live in another country, U.S. taxpayers must include the earnings on their Canadian retirement plans as gross income on their U.S. income tax returns. The IRS deems that the taxpayer has received such accrued earnings even though these earnings are undistributed. Pension and retirement plans must be “created in the United States” to qualify for tax deferment. Canadian RRSPs and RRIFs don’t qualify because they are not created in the U.S..

Failure to File Forms TD 90-22-1 and 8891

As a result of these misunderstandings many U.S. taxpayers that are resident in both countries who hold beneficial interests in Canadian RRSPs or RRIFs are not in compliance with U.S. tax requirements. U.S. resident taxpayers have almost certainly filed annual 1040s but may not have filed Schedule E because they didn’t realize that they held a foreign trust. Canadian resident U.S. taxpayers may not have filed U.S. 1040s because they had no U.S. income tax payable. In both cases U.S. taxpayers unwittingly have failed to file Schedule Es. As a consequence they may not have filed Form TD 90-22-1 (FBAR) and they have not filed Form 8891 for their Canadian RRSPs and RRIFs.

The Case of Form TD 90-22-1 (Report of Foreign Bank and Financial Accounts)

In the case of Form 90-22-1 the U.S. resident taxpayers outlined above do not qualify for special treatment under OVDI even though they may have filed 1040’s. They are technically in the identical situation as their Canadian resident brethren – both have failed to report income and both have failed to pay tax on that unreported income. Neither, therefore, qualifies for special treatment for filing delinquent FBARS. One way of dealing with a failure to file Form TD 90-22-1 is to file the delinquent forms with a covering letter explaining why you unwittingly failed to file, cross your fingers, and hope the IRS doesn’t impose penalties. If they do at least such penalties will not be deemed to be “willful” and not subject to the greater amount of 50% of the value of the account or $100,000 penalty. Since Form TD 90-22-1 is a stand-alone form you do not need to include amended 1040s although you will have to address that particular problem some time soon.

The Peculiar Case of Form 8891 (US Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans)

As we have explained above a failure to file Form TD 90-22-1 can be rectified but the IRS may impose a penalty. If you have failed to file Form 8891, however, there is no filing procedure to enable a taxpayer to file an amended or a delinquent 8891. Under the procedure 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 must be included with a timely filed (including extensions) 1040 income tax return to be valid.

Since an amended income tax return is not timely filed, and Form 8891 cannot be filed as a stand-alone document, and Notice 2003-75 specifically states that the IRS will not accept an invalid 8891, there is no filing procedure available rectify the problem. To further confuse bewildered taxpayers there is no apparent penalty that the IRS can impose if you have failed to file Form 8891. Notice 2003-75 specifically exempts Form 8891 from penalties under Section 6677 of the Internal Revenue Code vaguely stating, “A beneficiary or an annuitant of an RRSP or an RRIF may, however, be subject to other penalties”.

Nobody seems to know what an “other penalties” penalty might be let alone how a court might interpret it. So we have the strange case of a taxpayer being required to report the existence of a Canadian RRSP foreign trust account and the earnings and transactions within that trust account on Form 8891. But if the taxpayer has failed to file Form 8891 or discovers that a mistake has been made that needs to be amended there is no way to do it – and there seemingly is no penalty that can be applied.

The Importance of Form 8891 (Obsolete)

The IRS requires U.S. taxpayers to report income earned within Canadian RRSPs and RRIFs that they hold and pay taxes on these earnings. Since the U.S. would ordinarily tax such earnings in the year that they accrue and Canada would ordinarily tax these same earnings in the year that they are distributed, there would be no offsetting tax credits available in either instance. Canadian RRSPs, therefore, would be subject to double taxation. Article XVIII (7) of the Canada – U.S. Tax Treaty addresses the problem by basically agreeing that each country will defer taxes on the other’s qualified retirement plans until the funds are distributed. However, the IRS requires that U.S. taxpayers specifically claim relief under Article XVIII (7) of the Canada – U.S. Tax Treaty or pay the taxes that would otherwise be due. The only vehicle to make an election for such relief is a checkbox at line 6 (c) of Form 8891. Once an election is made under Article XVIII (7) it can only be revoked with the consent of the Commissioner. In short, a tax payer must pay U.S. income taxes on Canadian RRSPs and RRIFs until he or she includes a Form 8891 with a properly checked line 6(c) with a timely filed 1040 including Schedule E.

Since there is no apparent procedure to fix the problem of failing to file Form 8891 one solution might be to file a completed Form 8891 with your current timely filed tax return and amend previously filed 1040 income tax returns declaring the income within your RRSPs and RRIFs, and pay any delinquent taxes and penalties due. Since you cannot file delinquent 8891s you might include a separate spreadsheet accounting for yearly earnings and transactions detailing how the revised taxable income was calculated. It never hurts a taxpayer to include an explanation letter, which in effect, is a taxpayer’s plea for mercy. If the Value within the Canadian RRSPs is fairly modest this might be the most economical way to become compliant at least going forward. It might be argued that absent filing delinquent Form 8891s you can never be fully compliant but that might be as much of a problem to the IRS as to you.

A final word of warning – if your RRSP holdings predate 2003 and you were a U.S. taxpayer at that time you were required to file Forms 3520 as a beneficiary of a foreign trust and 3520A as the grantor of a foreign trust. The IRS can penalize you as much as $10,000 per year for each year for each form that you have failed to file and the Statute of Limitations doesn’t start until the delinquent forms are filed. The IRS has the right to examine you tax returns as far back as you have held these RRSPs if they get around to it in the next three year after you file – or forever if you don’t.

Private Letter Ruling to Avoid Taxes and Penalties and become Compliant

There is a method under U.S. tax procedures to avoid taxes and penalties on earnings within your Canadian RRSPs and RRIFs – obtain a Private Letter Ruling. A Private Letter Ruling is like you own personal law that applies only to you and is binding on both you and the IRS. In this case the ruling that you seek is essentially a personal ruling by the IRS that you will be allowed to file all amended and delinquent forms and the IRS will treat these filings as if they were done correctly and were filed on time. In this case you will be allowed to file missing 8891s and the IRS will accept your exemption claim under the Canada – U.S. Tax Treaty as far back as you have held your RRSPs (under Article XVIII from 1996 and former Article XXIX (5) prior to that time).

An application for a Private Letter Ruling is a complicated and exacting process that requires legal, accounting, and taxation expertise. The professional services required to complete an application could involve substantial fees and an applicant should prepare a cost benefit analysis before making any decision. If you have substantial RRSPs that you have held for a length of time you need to weigh the cost of paying the taxes required and all applicable penalties including FBARs and 3520s against the cost of obtaining a Private Letter Ruling.

It is very important that your application exactly detail what relief you seek, the amendments you wish to file, and the delinquent forms you intend to submit. Do not assume that it will cover any document that is not specifically listed in your application. The good news is that if you have elected to obtain a Private Letter Ruling there is an excellent chance that you will receive a favorable ruling. The fact that previous applicants in a similar situation have received favorable rulings gives a reliable indication that the IRS is disposed to granting relief in matters involving failure to file Form 8891 with respect to Canadian RRSPs and RRIFs.

For clarity the following outline explains why this application qualifies under IRS rules for issuing Private Letter Rulings.

Section 301-9100.3 of the Regulations on Procedures and Administration permits a taxpayer to apply for an extension of time to make an election required by the IRS in a tax matter. Since the relief sought is essentially an extension of time to file form 8891 (if an 8891 had been filed originally there would not be a tax problem) the application meets a legal requirement.
The tax matter under consideration is not listed on the “Areas in which rulings will not be issued” in the current Revenue Procedure (2011-1)
The relief sought involves an election. The election sought is to apply Article XVIII (7) of the Canada – US Tax Treaty to defer taxes on earnings inside a Canadian RRSP until the funds are distributed
The conditions that must be met to qualify for relief are set out as follows:
- I. The applicant acted reasonably and in good faith. Any one of the following could be viewed as constituting reasonable and good faith status.
  - The applicant requested permission to late file Form 8891 before the IRS discovered the error: or
  - The applicant’s failure to request relief was beyond his or her control: or
  - The applicant was unaware of US tax requirements governing RRSPs even after exercising reasonable diligence (taking into account the applicant’s experience and the complexity of the issues): or
  - The applicant relied on the advice of a tax professional who failed to make the election or advise the applicant to make the election: or
  - The applicant relied upon written advice from the IRS.
- II. The applicant will not be deemed to have acted reasonably and in good faith if any one of the following conditions apply:
  - The applicant is attempting to change a position on a tax return for which the IRS has already imposed or could impose an accuracy related penalty: or
  - The applicant was informed in all material respects of the required election but chose not to file the election: or
  - The applicants is attempting to use hindsight in which specific facts have changed since the original election date that now make the election more advantageous.
- III. Granting the relief sought will not harm the government.
  - The argument that granting the relief sought will cause the government to loose tax revenue is defeated by the argument that the government was not entitled to tax the investment earnings of a Canadian RRSP under the terms of the Canada – US Tax Treaty, therefore, the government cannot be hurt by not receiving tax revenue it is not entitled to.
  - The government’s interests are not prejudiced because the amount of tax to be collected on Canadian RRSPs over an aggregate number of years is not be less than the tax that would have been collected had the election been made on time.
  - The government’s interest would be prejudiced by the general three year limitation to collect penalties unless the applicant waives his or her rights under the tax Statute of Limitations.

The IRS attempts to issue Private Letter Rulings within 120 days of receiving the application. It should be mentioned, however, that U.S. Treasury Department Inspector General has issued a report that criticized the IRS Office of Chief Counsel for missing this target 77% of the time. For greater certainty, an applicant can request a closing agreement to be included with a letter agreement. Requests that include closing agreements are certain to take longer, probably cost more, and since the IRS is unalterably bound by a Private Letter Ruling it would appear to add little to what, in this case, is a routine time extension.

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.

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