Recently, Canada and the U.S. reached an agreement providing that Canada will assist with the collection and reporting of information to the U.S. Internal Revenue Service (IRS) on U.S. persons living here in Canada in order to comply with the U.S. Foreign Account Tax Compliance Act (FATCA). See our February U.S. Tax Flash for details on the agreement. News on these types of developments tends to renew interest by Americans living in Canada to catch up with their U.S. personal tax filings if they haven’t been filing in the past. These filings bring with them a host of complications, including those related to certain investments such as Registered Education Savings Plans (RESPs) and Tax Free Savings Accounts (TFSAs).
Many Canadian residents invest in RESPs and TFSAs to enjoy tax-deferred or tax-free growth within these accounts. While these plans may be useful for Canadian persons from a Canadian tax perspective, they can result in complications for Canadian residents who are also U.S. citizens. Indeed, the complications may be such that it is best that these investments be avoided altogether, as these plans can be costly to report for U.S. tax purposes and do not provide the tax benefits under U.S. tax rules that they do under Canadian tax rules.
An RESP account allows money deposited for a child’s post-secondary education to grow on a tax-deferred basis for Canadian tax purposes, with the income ultimately taxed in the child’s hands upon withdrawal. In addition, the Canadian government provides grants that match contributions to this plan, subject to certain limitations. A TFSA is a savings plan that allows after-tax funds to be contributed to a savings/investment account in the name of the contributor, with all resulting investment income treated as tax free for Canadian tax purposes. Both RESPs and TFSAs are very common investment savings vehicles for many Canadians and for the most part, they are not viewed as complex investments by Canadian tax standards.
The trouble with these investments for U.S. persons is two-fold. First, the RESP and TFSA accounts do not receive the tax-deferred or tax-free treatment for U.S. purposes that they do in Canada. They have no special treatment under U.S. domestic tax law or under the Canada-U.S. Income Tax Convention (the Treaty) and thus, the income generated by these accounts is taxable to the subscribers of the RESP, usually the parents, or in the case of a TFSA, the income is taxable to the contributor. U.S. persons must report this income on their U.S. tax return, despite the fact that they are not required to do so for Canadian tax purposes. In the case of RESPs, this can result in the RESP income being taxed twice – once in the hands of the parents on their U.S. tax return, and again in Canada in the hands of the child when the funds are withdrawn from the RESP several years later.
The second difficult issue to manage is that the IRS considers RESPs to be foreign trusts, requiring IRS Forms 3520 and 3520A to be filed on an annual basis. The IRS may consider TFSAs to be foreign trusts as well. These foreign trust returns can be complicated to prepare and thus, the compliance required for these investments can become very costly.
To further illustrate the downside of a TFSA held by a U.S. person, suppose the taxpayer invests $10,000 in a TFSA for 2013. If the $10,000 investment earns 3% and assuming a marginal Canadian income tax of 50%, the taxpayer will save $150 of Canadian tax – $300 of investment return x the 50% tax rate. However, if the taxpayer is subject to the top U.S. marginal tax rate of 39.6%, he or she will need to pay U.S. tax of $119, assuming the benefit of a foreign tax credit does not exist, largely offsetting the favourable Canadian tax treatment. Compounding the problem is the potential requirement to complete the U.S. foreign trust returns as described above. The fee for the completion of these tax forms varies, but for illustration purposes, assuming a fee of $1,000 per TFSA account, it is evident that the Canadian tax savings associated with the use of a TFSA would be completely eroded and actually result in an overall cost to the taxpayer after factoring in tax compliance fees.
It should also be noted that the recent announcement regarding the FATCA agreement provides relief by not including TFSAs and RESPs, among other accounts, as part of the information reporting requirement under FATCA. However, this relief only applies to the information required to be disclosed by Canadian financial institutions to the IRS under FATCA and does not grant any relief from the U.S. personal income tax issues outlined above that apply to the individual account holder.
A practical solution to one of these issues is to transfer the RESP into the hands of a non-U.S. person. As an example, the account could be transferred to a non-U.S. spouse, parent or grandparent so that a U.S. person is no longer associated with the account. This will provide relief on a go-forward basis, but the U.S. tax implications described above would still apply to the period in which the U.S. person was listed on the RESP account. Although the U.S. filing requirements can be cumbersome and costly, significant penalties can be imposed for failure to file the foreign trust forms.
Contact your Collins Barrow advisor for more information on your U.S. filing obligations and any other U.S. tax matters.
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