Kevyn Nightingale and David Turchen, MNP LLP
A US citizen or resident living in Canada is subject to US tax on worldwide income. There are circumstances, such as holding a green card, that can cause a person to be considered a US resident, even while living in Canada.
There are estimated to be one million Americans living in Canada. Some have contributed to tax-free savings accounts (“TFSAs”). Secondly, an ordinary Canadian (US non-resident alien) may contribute to a TFSA and subsequently move to the United States while holding the TFSA. The number of such people is unknown.
The question is then how the United States treats income earned inside a TFSA for such individuals.
At this point, there is no meaningful guidance on proper reporting to the Internal Revenue Service (“IRS”). While many publications have stated that a TFSA is not eligible for treaty protection, we are not aware of one which has set out the arguments for or against such treatment. This article attempts to address that void.
The Nature of a TFSA
A TFSA is a savings vehicle for Canadians. Contributions are not tax-deductible, earnings inside the plan are not taxable, and withdrawals are not taxable. In these ways, the TFSA is very similar to the US Roth individual retirement arrangement (“IRA”) plan.
Contributions are limited to a fixed dollar number ($5,500 for 2013) that applies for each year that an individual has been a resident of Canada and age 18 or older. Contribution room is cumulative and is reduced by the amount of withdrawals.
One may not contribute to a TFSA while being a non-resident of Canada without being penalized.
A TFSA may be a trust, but it need not be.
Because of the restrictions on the types of investments a TFSA must hold, income will be, almost invariably, interest, dividends, royalties, and capital gains in respect of investments in public companies.
US Domestic Law
A TFSA that is a financial account holds no special status under US law. Income earned in the TFSA is ordinarily taxable.
A TFSA that is a trust will be regarded as a “grantor trust”, because the individual who contributed the funds has the right to withdraw the funds. The grantor is treated as the owner of the funds, and the income earned by the trust is treated as his or hers.
The bottom line is that TFSA income is taxable under US domestic law.
Treaty
The Canada-US Income Tax Convention contains a provision that allows deferral of income earned inside an RRSP for US tax purposes and for income earned inside a US IRA for Canadian purposes. The question is whether this paragraph of the treaty also applies to a TFSA.
Currently Circulating Views
The IRS has not pronounced on this question, and the issue has not yet been litigated.
Given the small size of a TFSA (the maximum aggregate contribution to date for any one person is $25,500), it is not likely that any individual will have enough money at stake to justify the cost of a private letter ruling, let alone a court case. Similarly, because of the small size and today’s low-return investing environment, the issue is not likely to be pressing for the US Treasury. So we are not likely to see a government opinion on this matter in the short term.
Most of the larger accounting firms are taking the conservative position that a TFSA is not treaty-protected.
The “Big Four” clientele of Americans in Canada consists primarily of employees of large multinationals. These employees are generally tax-equalized and consequently are generally indifferent towards foreign (non-US) tax savings.
These firms have little to gain by taking anything other than a conservative position. If they told clients TFSAs were treaty-protected and they were subsequently found to be wrong, the number of return amendments would create a large expense for them or their clients (the individuals’ employers). Given the widespread publicity, the media impact could be problematic. Weighing the upside against the downside, the choice is pretty easy.
Relying on the Big Four accounting firms, most financial institutions have parroted this position, so it is the dominant one in the media. In many cases, other writers have simply taken this position as a given.
However, we believe this is a case of “where you stand often depends on where you sit”. To this date, we have not seen an academic defense of this position.
For individuals paying their own taxes, especially those living in high-tax Canada, tax minimization is indeed a meaningful goal, and a TFSA can help in that endeavor.
Analysis
We expect none of the above is new to most readers. But as for a direct analysis of the question? We have seen none.
The treaty reads:
A natural person who is a citizen or resident of [the United States] and a beneficiary of a trust . . . or other arrangement that is a resident of [Canada], generally exempt from income taxation in [Canada] and operated exclusively to provide pension or employee benefits may elect to defer taxation in the [United States], subject to rules established by the competent authority of [the United States], with respect to any income accrued in the plan but not distributed by the plan, until such time as and to the extent that a distribution is made from the plan or any plan substituted therefor.
As noted above, the owner of a TFSA is a beneficiary of a trust or other arrangement. The TFSA is a resident of Canada. It is generally exempt from income taxation in Canada. The TFSA meets all these treaty requirements.
The sole remaining question is whether a TFSA is operated “exclusively to provide pension . . . benefits”. We would argue that it is, in essentially the same way that a registered retirement savings plan (“RRSP”) is.
“Exclusively” is a bit of a loose term:
- RRSP funds can be used for home purchase and education purposes; and
- IRA funds can be directly used for charitable and medical purposes.
Yet, RRSPs and IRAs clearly qualify.
A TFSA is specifically designed to assist with savings. The investments permitted are the same as for an RRSP. Retirement is one of the listed objectives—generally a major objective.
And of course, early withdrawals are permitted, albeit with tax consequences.
Some say that the absence of a withdrawal penalty for a TFSA should impact its status under the treaty, because this diminishes the likelihood of retaining funds to retirement. However, there is no early withdrawal penalty for a Canadian RRSP. A disabled taxpayer, or one affected by certain hurricanes, can withdraw IRA funds without the early withdrawal tax. The same applies to someone willing to withdraw funds in substantially equal periodic payments.
Furthermore, in an empirical study of RRSP and IRA withdrawals, the presence or absence of a penalty for early withdrawal had little or no impact on the withdrawal behavior of contributors:
Despite differences in penalties for early withdrawals, we find that Canadian taxpayers are no more likely to withdraw savings from their RRSPs than US taxpayers from their individual retirement accounts.
So the absence of penalty should have no impact on the TFSA’s status.
Comparison with a Roth IRA
As described above, in most meaningful ways, a TFSA is similar to a Roth IRA. After an initial period of balking, the Canada Revenue Agency conceded that a Roth IRA qualified for deferral under the treaty. This acceptance was prior to the Fifth Protocol, so the Roth IRA-specific amendments to the treaty did not impact this acceptance.
For a Canadian holder of a Roth IRA, earnings inside the plan are exempt from tax and withdrawals are also tax-free, provided the individual makes no contribution to the plan after 2008 while resident in Canada.
Finally, from a foreign relations point of view, it would be in the United States’ interest to reciprocate Canada’s acceptance of the Roth IRA.
Conclusion
A TFSA should be treaty-protected in the same way as a Roth IRA.