Article XVIII of the Canada U.S. Tax Treaty Continued – The question of the TFSA

It's 2022 and time to revisit the issue the US taxation of the #TFSA: "Canada U.S. Tax Treaty: Why the 5th protocol of the Canada US Tax Treaty Clarifies that the TFSA is a pension within the meaning of the Canada U.S. Tax Treaty" https://t.co/1qVKlrz0Po via @expatriationlaw

— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) March 10, 2022

In a previous post I discussed how a U.S. citizen moving to Canada with an existing ROTH will be treated under the Canada U.S. Tax treaty.

The purpose of this post is two-fold:

First, to argue that the the TFSA should be treated as a “pension” within the meaning of Article XVIII of the Canada U.S. Tax Treaty; and

Second, to argue that the 5th protocol (which clarifies that the ROTH IRA) is a pension within the meaning of the Canada U.S. Tax Treaty means that the Canadian TFSA has the same status.

This will be developed in three parts:

Part A – How the Canada U.S. Tax Treaty affects U.S. Taxation of the Canadian TFSA

Part B- Wait just a minute! I heard that the “Savings Clause” means that the treaty would not apply to U.S. citizens?

Part C – The TFSA and Information Returns: To file Form 3520 and 3520A or to not, that is the question

Part A – How the Canada U.S. Tax Treaty affects U.S. Taxation of the Canadian TFSA

The relevant section of the Tax Treaty are as follows:

Article XVIII – (After the September 21, 2007 – 5th Protocol)
Pensions and Annuities

(JR Note: Paragraphs 1 and 3 address the issue of whether distributions from the pension are taxable. They do NOT address whether income earned in the pension is taxable.)
1. Pensions and annuities arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State, but the amount of any such pension that would be excluded from taxable income in the first-mentioned State if the recipient were a resident thereof shall be exempt from taxation in that other State.
3. For the purposes of this Convention:

(JR note: it is reasonable to conclude that (1) both U.S. Roths and Canadian TFSAs meet the requirement of paragraph (a) below and (2) should therefore be treated as pensions without the confirmation in paragraph (b) that ROTH IRAs are deemed to be pensions. On this point see this well written article by Kevyn Nightingale.)

(a) The term “pensions” includes any payment under a superannuation, pension or other retirement arrangement, Armed Forces retirement pay, war veterans pensions and allowances and amounts paid under a sickness, accident or disability plan, but does not include payments under an income-averaging annuity contract or, except for the purposes of Article XIX (Government Service), any benefit referred to in paragraph 5; and

(b) The term “pensions” also includes a Roth IRA, within the meaning of section 408A of the Internal Revenue Code, or a plan or arrangement created pursuant to legislation enacted by a Contracting State after September 21, 2007 that the competent authorities have agreed is similar thereto. Notwithstanding the provisions of the preceding sentence, from such time that contributions have been made to the Roth IRA or similar plan or arrangement, by or for the benefit of a resident of the other Contracting State (other than rollover contributions from a Roth IRA or similar plan or arrangement described in the previous sentence that is a pension within the meaning of this subparagraph), to the extent of accretions from such time, such Roth IRA or similar plan or arrangement shall cease to be considered a pension for purposes of the provisions of this Article.

(JR Note: Paragraph 7 addresses the issue of whether income earned by the pension is taxable. It does not address the question of whether distributions from the pension are taxable.)

7. A natural person who is a citizen or resident of a Contracting State and a beneficiary of a trust, company, organization or other arrangement that is a resident of the other Contracting State, generally exempt from income taxation in that other State and operated exclusively to provide pension or employee benefits may elect to defer taxation in the first-mentioned State, subject to rules established by the competent authority of that State, 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 a reminder:

1. Paragraph 3 (a) defines the meaning of a “pension” in a way that suggests that both the ROTH IRA and TFSA qualify as “pensions” under the treaty. But paragraph 3(b) makes it clear that a ROTH is a pension withing the meaning of Article XVIII. (Even without the addition of paragraph 3(b) of Article XVIII, it is reasonable to infer that both the ROTH and the TFSA qualify as “pensions” within the meaning of Article XVIII.)

2. Paragraph 1 of Article XVIII makes it clear that the distributions from a ROTH will be taxable in Canada only to the extent that they are taxed in the United States (which is not at all)

3. Paragraph 7 of Article XVIII clarifies that an election can be made to defer the income earned inside the ROTH.

Is the TFSA a Pension under the Canada U.S. Tax Treaty?

The U.S. ROTH and the Canadian TFSA are the same kind of financial planning vehicle. In both cases, in their respective countries:

– they are created with “after tax” money
– the income earned in them is “tax free”
– distributions taken from them are not subject to taxation in Canada

In other words, they share the same characteristics.

Therefore, it is reasonable to conclude that:

Since the ROTH IRA is a pension within the meaning of the Canada U.S. Tax Treaty then the Canadian TFSA is a pension within the meaning of the Canada U.S. Tax Treaty.

The consequence of this is that, pursuant to the Canada U.S. Tax Treaty:

1. For a resident of Canada who owns a TFSA: the income earned inside the TFSA would NOT be subject to U.S. income taxation

2. A Canadian or U.S. citizen could move to the United States and make a election to continue deferral of the income inside the existing TFSA (Paragraph 7 of Article XVIII).

But, taking this position pursuant to the Canada U.S. Tax Treaty means that …

Internal Revenue Code Section 6114 requires that the “treaty based position” must be reported on Form 8833.

Part B- Wait just a minute! I heard that the “Savings Clause” means that the treaty would not apply to U.S. citizens?

In general the “savings clause” is a problem. There are exceptions to the “savings clause”. In this case the “savings clause” specifically does NOT apply to the relevant sections of the Canada U.S. Tax Treaty which incorporate the 5th protocol.

Article XXIX

Miscellaneous Rules

1. The provisions of this Convention shall not restrict in any manner any exclusion, exemption, deduction, credit or other allowances now or hereafter accorded by the laws of a Contracting State in the determination of the tax imposed by that State.
2.

(a) Except to the extent provided in paragraph 3, this Convention shall not affect the taxation by a Contracting State of its residents (as determined under Article IV (Residence)) and, in the case of the United States, its citizens and companies electing to be treated as domestic corporations.
(b) Notwithstanding the other provisions of this Convention, a former citizen or former long-term resident of the United States, may, for the period of ten years following the loss of such status, be taxed in accordance with the laws of the United States with respect to income from sources within the United States (including income deemed under the domestic law of the United States to arise from such sources).

3. The provisions of paragraph 2 shall not affect the obligations undertaken by a Contracting State:

(a) under paragraphs 3 and 4 of Article IX (Related Persons), paragraphs 6 and 7 of Article XIII (Gains), paragraphs 1, 3, 4, 5, 6(b), 7, 8, 10 and 13 of Article XVIII (Pensions and Annuities), paragraph 5 of Article XXIX (Miscellaneous Rules), paragraphs 1, 5, and 6 of Article XXIX B (Taxes Imposed by Reason of Death), paragraphs 2, 3, 4, and 7 of Article XXIX B (Taxes Imposed by Reason of Death) as applied to estates of persons other than former citizens referred to in paragraph 2 of this Article, paragraphs 3 and 5 of Article XXX (Entry into Force), and Articles XIX (Government Service), XXI (Exempt Organizations), XXIV (Elimination of Double Taxation), XXV (Non-Discrimination) and XXVI (Mutual Agreement Procedure);

Part C – The TFSA and Information Returns: To file Form 3520 and 3520A or to not, that is the question

It is important to remember that the TFSA has no status under the Internal Revenue Code of the United States. Under the Internal Revenue Code only “U.S. entities qualify for tax deferral”. The question then becomes:

Does the TFSA constitute a “Foreign Trust” (under the Internal Revenue Code) for the purposes of Form 3520 and Form 3520A

In order to be a “foreign trust”, the TFSA would have to be a “trust” within the meaning of the Internal Revenue Code. Although a TFSA “could” be a “trust” under the Internal Revenue Code, in most cases it is NOT one.

Meaning of “trust” under the Internal Revenue Code …

The meaning of “trust” under the Internal Revenue Code in considered in the following regulation:

https://www.law.cornell.edu/cfr/text/26/301.7701-4

The definition includes:

§ 301.7701-4 Trusts.

(a)Ordinary trusts. In general, the term “trust” as used in the Internal Revenue Code refers to an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts. Usually the beneficiaries of such a trust do no more than accept the benefits thereof and are not the voluntary planners or creators of the trust arrangement. However, the beneficiaries of such a trust may be the persons who create it and it will be recognized as a trust under the Internal Revenue Code if it was created for the purpose of protecting or conserving the trust property for beneficiaries who stand in the same relation to the trust as they would if the trust had been created by others for them. Generally speaking, an arrangement will be treated as a trust under the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.

A TFSA is simply a “financial account” with preferential tax treatment under Canadian law. There are few cases where the bank accepts the TFSA contribution for the purpose of protecting or conserving the TFSA contribution.
Therefore, it is hard to characterize a TFSA as “trust” (and therefore it cannot be a “foreign trust”.)

A more detailed and rigorous analysis of the the characterization of a TFSA under U.S. law has been done by Max Reed here and here where he suggests:

In short, our view has always been that the TFSA is not a trust under US tax law and so no Form 3520 or Form 3520-A is required. That view has recently been supported by the resolution of three separate cases. Our position remains that no 3520 or 3520-A is required to be filed to tell the IRS about the TFSA.

In conclusion …

Q. Should those Canadian residents who are “U.S. persons” avoid the TFSA.
A. They should NOT avoid the TFSA. Every Canadian should have a TFSA.

Obviously (particularly because this post contradicts most of the information written about the TFSA), I emphasize that this is NOT legal advice. Discuss this issue with your adviser. The 5th protocol by emphasizing that the ROTH IRS is a “pension” within the meaning of the Canada U.S. tax treaty has strengthened the argument that the Canadian TFSA is also a “pension”.

As a result, as goes the treatment of the U.S. ROTH, so goes the treatment of the Canadian TFSA!

John Richardson Follow me on Twitter @Expatriationlaw