As cross border tax advisors, we routinely meet with American citizens who have lived in Canada for many years without understanding their tax obligations in the US. A similarly complex situation may arise for Canadian citizens who have moved to the US for work or retirement. Even those who are compliant with the income tax filings are sometimes surprised at the reporting that is required to maintain full compliance with US income tax laws.
This blog post focuses on the rules around US citizens or tax residents who have Canadian Registered Retirement Savings Accounts (RRSPs). As we know, RRSPs are a government sanctioned savings program in which contributions are deducted from taxable income, and any investment growth is deferred from taxation until the owner of the account makes withdrawals. This is a fantastic program for Canadian residents, as it provides significant tax savings in the short term, while allowing pre-tax retirement accounts to grow for use in a later year when income (and thus marginal tax rates) are expected to be lower.
However, there is a complication for US citizens resident in Canada, who are subject to both Canadian and US tax rules. Many assume that because the growth in an RRSP account is sheltered from tax in Canada, it need not be reported and taxed in a US tax return either. Unfortunately, this is not necessarily the case. In fact, the default treatment of RRSP accounts under US tax law is no different than a non-registered investment account – interest, dividends or gains on invested funds are reportable in the Form 1040 tax return, with no deduction for contributions in a given year.
However, there is relief available under Article XVIII(7) of the Canada-US Tax Treaty. Since 2002, US income tax residents have been able to make an election to defer US tax on the growth within an RRSP. The election is made by filing Form 8891 with a timely filed income tax return. Of course, the IRS will not permit a deduction for RRSP contributions; even so, Canada’s generally higher income tax rates usually mean that no US income tax is payable on the difference in taxable income, after foreign tax credits are applied. And, it is important to recall that RRSP accounts must be disclosed on FBAR returns annually.
This Treaty election is certainly helpful, but what should be done for those just hearing about their US tax obligations? The difficulty is that Form 8891 must be filed with a Form 1040 income tax return, so coming into compliance after the fact will not necessarily be effective. However, a trio of recent Private Letter Rulings (PLRs) from the IRS does provide some comfort regarding the IRS’ view on this issue.
As background, PLRs are written memoranda released by the IRS in response to specific enquiries by taxpayers regarding their tax situations (all personal information is redacted prior to public release on the IRS website). While these rulings are completely fact-specific, and cannot be used as legal precedents in any future cases, the IRS reasoning and interpretation of the rules can be instructive.
On September 12, 2013, three PLRs were released in which the IRS granted an extension to taxpayers in order to file appropriate Form 8891 Treaty Elections without penalty or interest accruing. In each case, the taxpayer was seeking discretionary relief from the IRS to permit late filings of Form 8891 in respect of their RRSP accounts in Canada. In each case, the extension was granted.
While each case was ostensibly decided on its own facts, a few common elements from all three cases are worth noting. First, in each case the taxpayer was otherwise tax compliant. This may be a relevant factor in terms of how the IRS would view late-filed Form 8891 – if the tax returns were timely filed at first instance, amended returns attaching the Treaty election form may be less likely to attract attention.
More significantly, however, in each case the IRS made a point of noting that the taxpayers promptly took action upon learning about the need to file Form 8891. The taxpayers did not wait until the IRS sent letters or notices of deficiency regarding the RRSP income.
The regulation that permits the IRS to grant extensions (i.e. Treasury Regulation § 301.9100-3(a)) requires that the taxpayer must satisfy the Commissioner that she acted reasonably and in good faith, and that the grant of relief will not prejudice the interests of the US government.
This factor should serve as fair warning to anyone in this position who is still trying to decide how to deal with their US tax compliance issues. While it may be the simplest and cheapest option, leaving your head in the sand is unlikely to earn any sympathy from the IRS if and when your delinquency does come to their attention. Instead, acknowledging an honest mistake and taking action to come into compliance will help to build a set of facts that will permit the IRS to grant some leniency toward your situation.
The information contained herein is for informational purposes only, and is not legal advice or a substitute for legal counsel. It is not intended to be attorney advertising or solicitation. If you have a legal question, please consult with a licensed attorney.