U.S. Tax Treatment of Tax-Free Saving Accounts

“Income earned in a TFSA is taxable on a current year basis in the U.S..”

The Tax Free Savings Account (TFSA) was introduced in Canada to allow qualified individuals (essentially Canadian residents over the age of 18 who have a valid Social Insurance Number) to be able to earn income, tax-free, on cumulative contributions of up to $5,000 per year. Unused TFSA contribution room can be carried forward to future years and withdrawn contributions can be added to future contribution room.

The goal of a TFSA is to encourage Canadians to save on a tax-free basis. The initial amount contributed as well as income earned in the plan is tax free, even when it is withdrawn. However, this is not the case for U.S. taxpayers (U.S. citizens and green card holders) resident in Canada.

A TFSA has no special status under the Internal Revenue Code and there are no relieving provisions contained in the Canada-United States Tax Convention (1980). As such, U.S. taxpayers are taxable on any income earned in a TFSA on a current year basis. This taxable status eliminates the TFSA benefits for most Canadian resident U.S. taxpayers. In some cases, U.S. taxpayers with other investment income may have sufficient Canadian taxes that they will be able to shelter the potential U.S. tax on TFSA income with foreign tax credits.

TFSAs are generally offered as deposits, annuity contracts or trust type arrangements. All of these products create U.S. reporting requirements, in addition to U.S. taxable income.

A TFSA is a foreign financial account for purposes of reporting the account on a U.S. taxpayer’s form TD F 90-22.1, “Report of Foreign Bank and Financial Accounts” (“FBAR”) since the contributor has a direct financial interest in the plan. The FBAR is due June 30th, following the end of the taxation year. There is no ability to extend the due date of this form. Failure to disclose the account can result in significant penalties.

The IRS may consider TFSAs to be foreign trusts. If a U.S. taxpayer is an owner of a non-resident trust, Form 3520-A, “Annual Information Return of Foreign Trust With a U.S. Owner”, is required to be filed 2 ½ months after the trust’s year end. TFSAs originated in 2009 so, by now, the 2009 and 2010 Form 3520-A are past their respective March 15, 2010 and 2011 deadlines.

An automatic extension can be obtained by filing Form 7004, “Application for Automatic Extension of Time To File Certain Business Income Tax, Information and Other Returns”, by the original due date. The filing of this form extends the filing date from March 15th to October 15th. These deadlines have also passed for the 2009 and 2010 years.

If a TFSA is considered to be a foreign trust and Form 3520-A is not timely filed, the IRS can assess a penalty equal to the greater of $10,000 (US) or 5% of the gross value of the TFSA at the close of that tax year (the December 31st fair market value). This yields a minimum penalty of $10,000 US per year, double the maximum annual contribution amount.

In addition, Form 3520, “Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts” may be required to report contributions and withdrawals from the TFSA. Form 3520 is due at the same time as a taxpayer’s personal tax return, including extensions. Failure to file this form may result in a penalty equal to 35% of the amount of the contribution or of the withdrawal.

To date, there has been no official IRS position on whether these forms are required. There are provisions that allow the IRS to abate the above-noted penalties where there was reasonable cause for the late filing. While it would seem that there is reasonable cause with respect to TFSAs, one can never be sure.

U.S. taxpayers resident in Canada should consider withdrawing their TFSA funds. The withdrawal will not be taxable in Canada or the U.S. and will reinstate TFSA contribution room for future years. If the IRS relieves the taxation of TFSAs in the future, the renewed contribution room can be used efficiently.

TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.

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