By Anthony Diosdi
The Canadian diaspora in the United States comprises approximately 3.1 million individuals who were either born in Canada or reported Canadian ancestry. Many of these individuals have Canadian registered retirement accounts or (“RRSPs”). An RRSP is a retirement savings and investing vehicle for employees and self-employed individuals in Canada. Under Canadian tax law, money that is placed into an RRSP grows tax-free until it is withdrawn from the account. An RRSP is similar to a U.S. 401(k) plan.
There are a number of retirement plans available to Canadian residents to save for retirement. These plans provide tax deferral benefits and are intended to promote savings for retirements. Some common Canadian retirement plans are RRSPs, registered retirement income funds (“RRIFs”), tax-free savings accounts (“TFSAs”), registered education savings plans (“RDSPs”), and registered disability savings plans (“RDSPs”). This article summarizes the U.S. income tax implications that apply to U.S. persons that have an interest in a Canadian retirement account. Because RRSPs are one of the most popular Canadian retirement plans, this article will focus on RRSPs.
The U.S. Reporting Requirements of a Canadian RRSP
The basic rule of the U.S. income tax system is that a U.S. citizen or resident alien is subject to tax on his or her worldwide income regardless of the country from which the income derives, the country in which payment is made or the currency in which the income is received. Under this general rule, a U.S. citizen or U.S. resident could potentially be subject to U.S. tax on any growth with a RRSP and from any distributions received from an RRSP. In addition, an RRSP can be treated as a foreign pension, a foreign grantor trust (for U.S. tax purposes) as the U.S. beneficiary has a certain level of control over the investments and distributions and is considered the plan “owner.” In other words, if a trust is a grantor trust, its income and gains will be taxed to the grantor.
A U.S. person who receives a distribution, directly or indirectly, from a foreign trust is required to report a number of matters relevant to the trust on Form 3520 and/or Form 3520-A, including the name of the trust and the aggregate distribution received during the taxable year. Failure to report a distribution received from a foreign trust could result in a 35 percent penalty on the gross amount of the unreported portion of the distribution. Although an RRSP can be classified as a grantor foreign trust for U.S. tax purposes, in Notice 2003-75, the Internal Revenue Service or (“IRS”) repealed the need for U.S. beneficiaries of most Canadian retirement plans to file Forms 3520 and 3520-A. Although the IRS repealed the annual filing requirements for most Canadian retirement plans, the IRS cautioned that U.S. beneficiaries of RRSPs may still be subject to other filing requirements. See Notice 2003-75, Section 3.
Even though U.S. beneficiaries of RRSPs are no longer required to disclose these retirement accounts on Forms 3520 and/or 3520-A, U.S. beneficiaries of RRSP retirement plans will likely need to disclose RRSP retirement plans on:
1. A Schedule B “Interest and Ordinary Dividends” of Form 1040.
2. A FinCEN 114 or (“FBAR”).
3. A Form 8938 “Statement of Specified Foreign Financial Asset.”
4. Potentially on Form 8833 “Treaty-Based Return Position Disclosure.”
The U.S. Taxation of a Canadian RRSP
As discussed above, RRSP retirement plans are treated as foreign grantor trusts for U.S. tax purposes. This typically means that a U.S. beneficiary of such a trust would be subject to U.S. taxation on income earned by the trust regardless as to whether or not it was paid to the U.S. beneficiary. The harshness of the grantor trust rules have been mitigated by the U.S.-Canada income tax treaty. A U.S. beneficiary of an RRSP retirement plan may elect to defer U.S. federal income tax on the income earned by the RRSP until there is an actual withdrawal or distribution from the retirement plan. See U.S.-Canada tax treaty, Article XVII. In order to make a tax-deferral treaty position on a tax return, the U.S. beneficiary of an RRSP must attach a “written statement” to his or her individual federal income tax return for the election year. See Rev Proc 89-45 and Rev Proc 2002-23. The “written statement” should include the plan’s account number, the amount earned from the plan during the tax year, contributions made to the plan during the year, and the balance of the plan at the end of the year.
If a U.S. beneficiary of an RRSP retirement plan does not make an election to defer U.S. taxation of the retirement plan, he or she will report the income earned by the RRSP plan annually. It generally makes sense to make an election under the U.S.-Canada tax treaty to make a tax deferral election. There are certain situations in which a U.S. beneficiary of a RRSP may not want to make an election to defer the U.S. taxation of retirement accounts. For example, if an RRSP has investments in mutual funds, the RRSP could be subject to the Passive Foreign Investment Company or (“PFIC”) tax regime.
A PFIC is a foreign corporation that satisfies either the “income test” or the “asset test.” Under the income test, a foreign corporation is a PFIC if 75% or more of its gross income is passive. See IRC Section 1297(a). Under the asset test, a foreign corporation is a PFIC if 50% or more of the average value of its assets consists of assets that would produce passive income. See IRC Section 1297(a)(2). For purposes of the income test and asset test, passive income means any income which is of a kind which would be foreign personal holding company income under Internal Revenue Code Section 954(C). There is no minimum threshold for ownership by U.S. persons under the PFIC regime. Hence, any percentage of PFIC stock owned by a U.S. person will implicate the PFIC regime with respect to that shareholder.
Many Canadians come to the U.S. holding foreign stocks that are PFICs in their RRSPs. Unknown to most Canadians coming to the United States, the tax consequence to holding foreign corporate stock that are PFICs is extremely punitive. Under the PFIC rules, the U.S. person holding stock in the PFIC pays tax when they receive a distribution from the PFIC or sell their shares of PFIC stock. The individual must also pay an interest charge attributable to the value of the tax deferral when he or she receives an unusually large distribution (called an “excess distribution”) or when he or she has gains from the disposition of the PFIC stock. If the holder of the PFIC receives a usually large distribution (called an “excess distribution”) or has gain from the disposition of the PFIC stock they are subject to special tax which will be discussed below.
An excess distribution includes the following:
1) A gain realized on the sale of PFIC stock, and
2) Any actual distribution made by the PFIC, but only to the extent the total actual distribution received by the taxpayer for the year exceeds 125 percent of the average actual distribution received by the taxpayer in the preceding three taxable years. The amount of an excess distribution is treated as if it had been realized pro rata over the holding period of the foreign share and, therefore, the tax due on an excess distribution is the sum of the deferred yearly tax amounts. This is computed by using the highest tax rate in effect in the years the income was accumulated, plus interest. Any actual distributions that fall below the 125 percent threshold are treated as dividends. This assumes they represent a distribution of earnings and profits, which are taxable in the year of receipt and are not subject to the special interest charge.
Below, please see Illustration 1. and Illustration 2. which demonstrates a typical sale of PFIC stock.
Illustration 1.
Jim is an engineer and a citizen of Canada. Jim moved to California and became a U.S. green card holder. Jim likes to invest in foreign mutual funds. On the advice of his German broker, on January 1, 2016, Jim buys 1 percent of FORmut, a mutual fund incorporated in a foreign country for $1. FORmut is a PFIC. During the 2016, 2017, and 2018 calendar years, FORmut accumulated earnings and profits. On December 31, 2018, Jim sold his interest in FORmut for $300,001. To determine the PFIC excess distribution, Jim must throw the entire $300,000 gain received over the entire period that he owned the FORmut shares – $100,000 to 2016, $100,000 to 2017, and $100,000 to 2018. For each of those years, Jim will pay tax on the throw-back gain at the highest rate in effect that year with interest.
It is easy to envision significantly more complex scenarios. Such a scenario is described in Illustration 2 which is based on an example in Staff of Joint Comm. On Tax’n, 100 Cong., 1st Sess., General Explanation of Tax Reform of 1986, at 1027-28(1987).
Illustration 2.
On January 1 of year 1, Samatha, a U.S resident and citizen of Canada, acquired 1,000 shares in FC, a foreign corporation that is a PFIC. She acquired another 1,000 shares of FC stock on January 1 of year 2. During years 1 through 5, Samatha receives the following dividend distribution from FC:
Date of Distribution Amount of Distribution
Dec. 31 of year 1 $500
Dec. 31 of year 2 $1,000
Dec. 31 of year 3 $1,000
Dec. 31 of year 4 $1,000
Apr. 1 of year 5 $1,500
Oct. 1 of year 5 $500
Under Internal Revenue Code Section 1291, none of the distributions received before year 5, are excess distributions since the amount of each distribution with respect to a share is 50 cents. However, with respect to distributions during year 5, the total distribution to each share is 37.5 cents ($1 minus 62.5 cents (1.25 times 50 cents)).
Accordingly, the total excess distribution for FC’s tax year ending December 31 of year 5 is $750 (37.5 per share times 2,000 shares). This excess distribution must be allocated ratably between the two distributions during year 5. Thus, $562.50 (75 percent of the excess distribution, i.e., $750 times $1,500/$2,000) is allocated to the April 1 distribution and $187.50 (the remaining 25 percent of the excess distribution, i.e. $750 $500/$2,000) is allocated to the October 1 distribution. These amounts are then ratably allocated to each block of stock outstanding on the relevant distribution date. For the distribution on April 1 of year 5, $281.25 of the excess distribution is allocated to the block of stock acquired on January 1 of year 1 and $281.25 is allocated to the block of stock acquired on January 1 of year 2 and $281.25 is allocated to the block of stock acquired on January 1 of year 3. The $187.50 excess distribution on October 1 of year 5 is also allocated evenly between the two blocks of stock outstanding on the date of the distribution. Finally, the excess distribution for each block of stock is in accordance with Internal Revenue Code Section 1291(a)(1).
The federal tax due in the year of disposition (or year of receipt of an excess distribution) is the sum of 1) U.S. tax computed using the highest rate of U.S. tax for the shareholder (without regard to other income or expenses the shareholder may have) on income attributed to prior years (called “the aggregate increase in taxes” in Section 1291(c)(1)), plus 2) U.S. tax on the gain attributed to the year of disposition (or year of receipt of the distribution) and to years in which the foreign corporation was not a PFIC (for which no interest is due). Items (1) and (2) together are called the “deferred tax amount” in Section 1291. Item (2), the interest charge on the deferred tax, is computed for the period starting on the due date for the prior year to which the gain on distribution or disposition is attributed and ending on the due date for the current year in which the distribution or disposition occurs.
As indicated above, not only are the PFIC taxing rules complex, these rules can generate significant tax liabilities which, in certain cases, exceed the value of the foreign stock.
Potential Planning PFIC Options
In some cases, RRSP beneficiaries can make a Qualified Electing Fund (“QEF”) election in connection with his or her PFIC shares. If a PFIC is treated as a QEF, the excess distribution regime is generally superseded by the QEF regime. Under the QEF regime, the shareholder is taxed on a pro rata portion of the PFIC’s income and gain each year. Specifically, the shareholder includes in gross income, as ordinary income, such shareholder’s pro rata share of the ordinary earnings of the PFIC for each year, and as long-term capital gain, such shareholder’s pro rata share of the net capital gain of the PFIC for each year. A shareholder may elect to defer the payment of the tax liability resulting from the QEF election until the PFIC makes a distribution to the shareholder.
If the shareholder’s stock in a PFIC is considered “marketable stock,” the shareholder may make a mark-to-market election. In general, stock is considered marketable stock for purposes of the mark-to-market regime if it is regularly traded on a national securities exchange which is registered with the Securities and Exchange Commission or the national market system established pursuant to Section 11A of the Securities and Exchange Act of 1934, or any exchange or other market which the IRS may determine.
As with a QEF election, a market-to-market election supersedes the PFIC regime. A mark-to-market election applies to the current year and all subsequent taxable years unless such stock ceases to be “marketable stock,” or the IRS consents to the revocation of such election. If the election is made, each taxable year the U.S. person must include in gross income, as ordinary income, an amount equal to the excess of the fair market value of the stock (as of the close of the tax year) over its adjusted basis, and the basis in such stock shall be increased by the amount included in gross income. If, however, the adjusted basis exceeds the fair market value of the stock, the shareholder may be entitled to deduct the inherent loss and reduce his or her basis accordingly under the circumstances.
There are a number of complexities and nuances to consider before making a QEF or mark-to-market election in connection with PFIC shares. For this reason, an international tax attorney should model the potential short and long-term implications of making these elections. It may be necessary not to make a tax deferral election discussed above in order to make a QEF or mark-to-market election in connection with PFIC shares held by an RRSP retirement plan.
Conclusion
The foregoing discussion is intended to provide the reader with a basic understanding of the basic U.S. tax consideration of RRSP retirement plans. It should be evident from this article, however, that it is a relatively complex subject, especially if an RRSP contains investments that can be classified as PFICs. As a result, it is crucial that the U.S. beneficiary of a RRSP retirement plan review his or her particular circumstances with a qualified U.S. tax attorney.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.