Foreign Nationals & Expats
Houston Tax Attorney
Canadian Investments and U.S. Tax Compliance
For Canadians foreign nationals residing in the U.S. and U.S. expatriates living in Canada, taxation of Canadian investments in the U.S. can be complicated. It can even be difficult to find a tax advisor who can properly report these investments. Failure to file one or more of these forms can lead to severe penalties. This article provides a summary of the more commonly found Canadian investments.
Canadian investments may be similar to their US equivalents, but their income and distributions are taxed differently in the U.S. Canadian investments include:
- RRSPs (Registered Retirement Savings Plans);
- RRIFs (Registered Retirement Income Funds);
- TFSAs (Tax Free Savings Accounts);
- RESPs (Registered Education Savings Plans; and
- Canadian Mutual Funds
RRSPs and RRIFs
RRSPs are similar to traditional IRAs, where contributions are deductible from income, and earnings are tax-deferred until distribution. Distributions are taxed as ordinary income. By the end of year when the owner reaches the age of 71, RRSPs have to be full withdrawn (fully taxable) or converted to RRIFs with a required yearly minimum distribution.
However, up until the 5th Protocol of the US-Canadian tax treaty (effective starting 2009), the US did not allow deduction of RRSP contributions from taxable income. Therefore, the RRSPs would have a cost basis for non-deductible contributions made prior to 2009. Assuming the taxpayers are tax compliant for all prior contributory years, upon distribution, only the portion not attribute to after-tax contributions would be taxable. For US persons not tax-compliant or for persons who were non-residents when contributions were made, all distributions would be fully taxable as ordinary income.
Since RRSPs are not qualified retirement plans by IRC (Internal Revenue Code) definition, the 10% penalty for early distribution will not apply.
TFSAs and RESPs
TFSAs (similar to ROTH IRAs) and RESPs (similar to 529 plans), where contributions are not deductible and earnings are not taxable in Canada, are treated as foreign grantor trusts for US tax purposes. Yearly earnings from a foreign grantor trust flow through to the US grantor/owner and are subject to US income tax even if no distributions are made in the year. The distributions are not taxable to the beneficiaries.
The US owner must file Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner, to report the trust income statement and balance sheet. In addition, the US owner/trustee must provide, by the due date, the owner statement for each US owner and the beneficiary statement for each US beneficiary receiving a distribution from the trust during the tax year. The Form 3520-A is due by the 15th day of the 3rd month after the end of the trust’s tax year, and is eligible for an automatic 5-1/2 months extension of time to file provided Form 7004 is filed in time.
The US owner, and/or US beneficiary must each file Form 3520, Annual Return to Report Transactions with Foreign Trust and Receipt of Certain Foreign Gifts, as part of the US tax return. Failure to file Forms 3520-A and 3520 can result in a penalty of US$10,000.
Canadian Mutual Funds
Canadian Mutual Funds are treated as PFICs (Passive Foreign Investment Company). Starting 2013, new regulations issued by IRS and Treasury Department require all US persons that directly or indirectly own shares in a PFIC at any time during the year to file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. The annual filing requirement does not apply if the year-end value of all PFICs owned by the individual does not exceed $25,000, and, there were no income/distributions from, or dispositions of, a Canadian mutual fund during the year.
Canadian mutual funds held in RRSPs and RRIFs are not subject to this requirement because earnings from these plans are tax-deferred until distribution. On the contrary, a separate Form 8621 is required for each Canadian mutual fund held in TFSAs and RESPs.
Canadian mutual funds are generally treated as Section 1291 funds unless elections are made on Form 8621 for either QEF (Qualified Electing Fund, Section 1295) or Mark to Market (Section 1296). Income from Section 1291 funds are separated into three categories and each taxed differently:
- Non-excess distributions (reported as ordinary dividends);
- Excess distributions allocated to the current year (reported as ordinary income); and
- Excess distributions allocated to prior years (treated as ordinary income subject to deferred taxes and interest charges).
Dispositions of Section 1291 funds are treated as excess distributions
- RRSPs and RRIFs: Distributions are taxed as ordinary income, similar to traditional IRAs with or without basis;
- TFSAs and RESPs: Information returns on Forms 3520-A and 3520 must be filed annually. Income is taxed to the US owner yearly regardless of distributions;
- Canadian mutual funds are treated as PFICs. A Form 8621 must be filed for each Canadian mutual fund. Calculations for properly reporting Section 1291 funds can be quite tedious and involved.
If you have not been reporting your Canadian foreign income or assets, or filing your FBAR (finCEN Form 114), it is possible to become compliant with U.S. tax law without the risk of severe penalties through programs such as OVDP and streamlined filing compliance procedures. It is important to find a tax advisor who understands these investments and how to properly report them.