Introduction And Purpose
— John Richardson – lawyer for "U.S. persons" abroad (@ExpatriationLaw) December 7, 2022
As the article referenced in the above tweet makes clear, a very small percentage of Canadians can expect their retirements to be funded by pensions. The message is that individuals have an obligation to themselves and to their families to engage in responsible financial and retirement planning. The tax laws in every country have provisions in their tax codes to facilitate this planning. Almost all of these planning vehicles are based on “before tax” advantaged vehicles (RRSP or Conventional IRA) or “after tax” vehicles (TFSA or ROTH IRA) which allow for tax free growth.
I am frequently asked by Canadian residents who are US citizens whether they should open a TFSA (“Tax Free Savings Account”) in Canada. The purpose of this post is to discuss this very issue. As usual there is no “one size fits all answer” that is correct for everybody. In order to analyze this question I am joined by Oliver Wagner of “1040 Abroad” who has provided his thoughts, experience, commentary and some sample tax US tax returns which illustrate the various principles.
About The TFSA
The TFSA was introduced in Canada effective January 1, 2009. In simple terms a TFSA allows one to deposit “after tax” income (subject to limitations) into an account that is designated as a TFSA. TFSAs can hold individual shares, cash, mutual funds and ETFs. Significantly the income earned inside the TFSA is NOT taxable to tax residents of Canada. The contributions are NOT tied to income (although they are maximum contributions). They are wildly popular in Canada and are conceptually similar to the US ROTH IRA (which is wildly popular in the US). My understanding is that the TFSA and ROTH IRA are similar to the UK ISA. A comprehensive description of the TFSA may be found on the Canada Revenue Agency site here.
The last amendments to the Canada US Tax Treaty were prior to January 1, 2009. Interestingly the Treaty does provide for special treatment for ROTH IRAs held by US citizens living in Canada. The treaty does NOT specifically allow for similar treatment for Canadian TFSAs held by Canadian residents. Whether the treaty can be read broadly enough to conclude that TFSAs should be given preferential tax treatment by the IRS is the subject of some debate.
This post makes the following five assumptions:
1. The US does NOT recognize the TFSA as an investment product that is subject to preferential tax treatment.
2. Therefore the TFSA is treated like any normal investment account and the income earned inside the TFSA is reportable/taxable in the United States even though it is not taxable in Canada.
3. Income earned inside the TFSA retains its character when it appears on a US tax return. In other words, the income is identified as interest, dividends or capital gains inside the TFSA and therefore is reported as interest, dividends or capital gains on the US return.
4. Because the income earned inside the TFSA is reportable in the US, Canadian residents should NOT include Canadian mutual funds or ETFs in their TFSAs in order to avoid the PFIC regime.
5. TFSAs do NOT meet the requirements of qualifying as “trusts” under the 7701(a) Treasury regulations. Therefore, 3520 and 3520A reporting is not relevant. (The fact that a TFSA may be called a “trust” under the Income Tax Act of Canada does NOT mean that it meets the requirements to be treated as a “trust” under the Internal Revenue Code.)
In the context of these five assumptions, the question becomes:
Does it make sense for US citizens who are resident in Canada to own and contribute to TFSAs?
The answer depends. Olivier and I have been discussing this question and we will each offer our opinions after analyzing the question by considering hypothetical US tax returns (thanks Olivier for preparing the returns!). Interestingly, the issue for any particular individual seems to depend on one or more of the following circumstances:
– Does the person make use of the Sec. 911 FEIE (“Foreign Earned Income Exclusion”) or does the individual use the Sec. 911 FTC (“Foreign Tax Credits”)?
– Does the individual have investment income outside the TFSA that is taxable in Canada and therefore creates Canadian tax which can be used for Foreign Tax Credits?
– What is the character of the income earned inside the TFSA? Is it interest, dividends or capital gains? Remember that the US has different tax rules for different kinds of income.
Four Different Tax Returns With Four Different Circumstances
The following four examples assume between $12,000 USD and $20,000 USD of income earned inside a Canadian TFSA. This is certainly higher than the income earned inside most TFSAs. Remember also that US taxpayers have a standard deduction of approximately $12,550.00 to shelter income from taxation.
First, Returns That Elect To Use The Foreign Earned Income Exclusion (Form 2555)
The “Foreign Earned Income Exclusion” means that the salary income is excluded from US taxation. For some of Olivier’s commentary on the “Foreign Earned Income Exclusion” read here.
A. Example – In this example the taxpayer has $100,000.00 USD of income that is excluded under the “Foreign Earned Income Exclusion”. He also has $12,000 USD of ORDINARY income earned inside his TFSA.
Conclusion: There is NO US tax owing.
See the sample tax return which is titled Exhibit A. Conceptually this is a very simple result. Because the $100,000 salary income is excluded, the taxpayer has $12,000 USD of ordinary income which is slightly less than the standard deduction. In this case there is no cost to being a US citizen.
See Tax Return Exhibit A.
B. Example – In this example the taxpayer has $100,000.00 USD of income that is excluded under the “Foreign Earned Income Exclusion”. He also has $20,000 USD of ORDINARY income earned inside his TFSA. In this case there will be some income taxable on the US return because the standard deduction is only $12,550.00 USD. The use of the FEIE and the standard deduction means that only income in excess of the standard deduction ($20,000.00 USD – $12,550.00 = $7450.00) would be subject to US tax.
The total tax and penalty (remember all US citizens live live in the penalty box) = $1820.
Conclusion: Yes, there is tax owing. But, the rate of tax is $1820.00/$20,000 = a tax rate if 9.1%. In other words, the cost of US citizenship is 9.1% of the income earned in the TFSA. This is NOT (in comparison to Canadian taxes) a high rate. A US citizen under this scenario gets 90.9% of the benefit of the TFSA (of course the pure Canadian gets 100%).
See Tax Return Exhibit B
D. Example – In this example the taxpayer has $100,000.00 USD of income that is excluded under the “Foreign Earned Income Exclusion”. He also has $20,000 USD of “Qualified DIVIDEND” income earned inside his TFSA. In this case there will be some income taxable on the US return because the standard deduction is only $12,550.00 USD. The use of the FEIE and the standard deduction means that only income in excess of the standard deduction ($20,000.00 USD – $12,550.00 = $7450.00) would be subject to US tax. But, it’s important to understand that different forms of US income are taxed in different ways.
Canadian dividends and capital gains are – on US tax returns – taxed differently from ordinary income. Dividends and capital gains may be subject to preferential U.S. tax rates (0% to 20%). Do NOT make the mistake of thinking that they will be taxed at the same rate as they are in Canada. In this context, the tax paid on the TFSA will be the reduced US rate from 0% to 20% which still makes the TFSA attractive (at the same time it’s exempt in Canada).
Conclusion: The only difference between this example and Example B above is that the $20,000.00 earned in the TFSA is taxed as “qualified dividends” instead of ordinary income. In this case note that the tax and penalty totals $1138.00 instead of the $1820.00 that was paid if the $20,000.00 TFSA income was treated as ordinary income. Note that the cost of US citizenship is only 5.7%. (Does this give you any ideas for planning?)
This example has been designed to demonstrate that (1) different kinds of US income are taxed differently and (2) how those differences might mitigate the impact of US taxation of the TFSA.
See Tax Return Exhibit D.
Second, A Return That Elects To Use The Foreign Tax Credit (Form 1116)
In order to use a FTC to avoid US tax on the income earned in the TFSA one must find Canadian tax paid on other sources of passive income. Therefore, this example assumes that in addition to the TFSA the taxpayer has another source of passive income that is taxable in Canada and where tax is paid to Canada on the income.
C. Example – in this case the taxpayer uses the FTC to offset tax that might be paid on the TFSA income. This example assumes $100,000.00 USD of employment income, $20,000.00 of TFSA income and additional Canadian investment income on which Canadian tax is paid (all the tax paid goes into the passive bucket.) The point is that there may be sufficient Canadian tax paid on the non-TFSA investment income that it can be used as a credit against US tax owing on all of the Canadian investment income.
I turn to Olivier’s explanation of the tax return used in this example:
Explanation for exhibit C:
Here we see how we can still use the foreign tax credit for taxes paid on other passive income.
We have 20,000 USD of TFSA income.
We also have 10,000 USD of capital gains and 5,000 USD of foreign taxes paid. The Canadian tax rate is not 50%, rather the capital gain is distorted due to foreign currency exchange fluctuations.
For instance, assuming a purchase price of 110,000 Canadian dollars when the exchange rate was 1.1 would have us have a basis of 100,000 US dollars.
At the time of sale, the asset is worth 150,700 Canadian dollars with an exchange rate of 1.37, leaving us with a sale price of 110,000 US dollars. And the 6,850 Canadian dollars of income tax would translate into 5,000 US dollars.
It is a slightly unusual, yet realistic example, to illustrate that the excess foreign tax credit can offset the liability on other income (TFSA income in this case) as long as they are in the same foreign tax credit basket (the passive category in this case).
Conclusion: Under this fact pattern there is no US tax owing.
See Tax Return Exhibit C
Bringing it together …
Avoiding US taxation on the TFSA is sometimes dependent on the use of the FEIE. But, this does come with some disadvantages. Using the FEIE exclusion means one is not reporting income and is therefore: (1) not eligible for the additional child tax credit of $1400 per child per year (2) not eligible to invest in IRAs (3) most importantly those who use the FEIE instead of the FTCs deprive themselves of FTC “carry forwards”.
Use Of Foreign Tax Credits
C. FTCs: Assuming other forms of non-US passive income that is taxable in the US and Canada there may be sufficient FTCs in the current year or that can be carried forward to offset any US tax owing
See Tax Return Exhibit C
To TFSA Or Not To TFSA, That Is The Question …
Consideration 1 – The Cost Of Using The FEIE (“Foreign Earned Income Exclusion”)
Note that the first three examples which suggest a TFSA should be owned by a US citizen in Canada are reliant on the use of the FEIE (“Foreign Earned Income Exclusion”). Reasons to NOT use the Foreign Earned Income Exclusion include:
– you will NOT be able to access the $1400.00 non-refundable child tax credit
– you will NOT be able to invest in a US IRA
– you will NOT be able to accumulate excess tax credit carry-forwards in the regular income category
Consideration 2 – US “Qualified Dividend” And “Capital Gain Income” Are Taxed Differently From Ordinary Income
As “Exhibit D” demonstrates, Canadian dividends and capital gains may be subject to preferential tax rates (0% to 20%) in the US. Don’t make the mistake of thinking that they will be taxed at the same rate as they are in Canada. In this context, the tax paid on the TFSA will be the reduced US rate from 0% to 20% which still makes the TFSA attractive (at the same time it’s exempt in Canada).
Oliver Wagner’s Conclusion:
The fear around US citizens having a TFSA is overblown and US citizens in Canada can have a TFSA and still not pay tax to the US.
A downside of having a TFSA is that it might limit your tax filing options. Namely, you might be forced to use the Foreign Earned Income Exclusion, and would miss on the benefits of the foreign tax credit.
The standard deduction would offset TFSA income in most situations.
While a TFSA can make sense and lead to a lower tax rate, albeit paid to the US instead of Canada, there are clear instances in which it is not desirable, particularly if it causes the taxpayer to forgo the refundable additional child tax credit of 1,400 US dollars per child per year.
John Richardson’s Conclusion:
People who almost certainly should open a TFSA are:
– people (including married couples) with little or no income
– people (including married couples) with no need for the child tax credit AND are willing to forgo the benefit of FTCA carry forwards
– people with sufficient passive income from non TFSA sources to create enough FTCs to offset tax paid on the TFSA income
– people who are not concerned with US taxation of TFSA income because they simply regard it as a lower overall rate of tax on the passive income. (All TFSA qualified dividend and capital gain income taxed by the United States will attract a tax rate of 0% to 20% depending on the circumstances)
People who may NOT want to have a TFSA are likely those who:
– people who value the child tax credit (the more children the more likely they are to value it)
– recognize the value and importance of FTC carry forwards (passive income carry forwards can even be used to offset the capital gains tax on the sale of a home)
Conclusion: US citizens living in Canada (particularly younger people with lower incomes) should presume that investing in a TFSA is a good idea and should avoid it ONLY if there is a clear reason to do so! The more simple the situation, the more likely the TFSA will make sense.
Oliver and I hope that this post brings “some” clarity to this “confusing” situation!
All the best!