Written by Max Reed If you’re a U.S. citizen living in Canada, you might be frantic about the IRS tax crackdown and hefty fines if you haven’t been tax compliant....
Canada has a raft of registered plans. They all have different US tax consequences.
Consider the following example. Julia is a US citizen living in Canada. She has an RRSP to save for retirement. She uses her Tax Free Savings Account to invest in some individual stocks. She has an RESP and an RDSP for her disabled son, Julio. When doing her annual US tax return, Julia can’t figure out what to do with all of these different accounts.
There are two pieces to the puzzle: reporting the income and reporting the existence of the account. The RRSP is the easiest, because for tax purposes, retirement savings plans function the same way in the US as in Canada. The tax on income that builds up inside the plan is deferred until the money is taken out. Under a recent IRS ruling, if Julia is filing US taxes through the amnesty program (the streamlined program) then she will need to file Form 8891 each year in order to defer the tax and report the account. If Julia is all caught up on her US taxes, however, she no longer needs to file that form every year.
Julia’s other plans create more complications. For US tax purposes, income that builds up inside TFSA, RESP, and RDSP accounts is taxable. Let’s say that in one year, Julia earned $1000 in dividends in her TFSA. In Canada, she would not have to pay tax on this $1000. But in the US, this income is not protected and she has to pay tax on it. The same would be true if the $1000 was earned in an RESP or RDSP. If Julia were married to someone who is not an American, she could put the RESP or RDSP in her spouse’s name. However, depending on its value, transferring an existing plan might constitute a gift under the US tax rules so Julia should consult a tax advisor first.
Figuring out how to report these plans is a bit tricky. The IRS hasn’t clarified its position. In Canada, many of these plans are organized as trusts, and therefore the conventional wisdom is that they are also trusts under US law. This means a US citizen in Canada has to file the complicated 3520 and/or 3520A forms every year. However, a detailed technical analysis suggests that TFSA, RDSP, or RESP plans are not trusts under US law, thus sparing US citizens in Canada the pain of filing the 3520 and/or 3520-A annually.
So how should Julia report her various plans on her annual US tax return? Julia can attach a letter to her annual US tax return which describes the plans, states that the income earned has been reported on US Form 1040, recognizes that the IRS hasn’t been clear on how they want these plans reported, and asks the IRS how to report these plans in the future. If audited, Julia would simply tell the IRS she didn’t know how to report the accounts and has written a letter telling them the plans exist. Such an approach may protect her from any IRS penalties, as she has made an effort in good faith to report accounts for which the IRS has not provided an official form.
In Canada, registered plans shelter income. With the exception of the RRSP, under US tax law they do not — but they don’t necessarily need to be avoided just because of the hassle of reporting them.