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February 16, 2016 - Phil Hodgen

Canadian TFSAs and the Certification Test

Hi, it’s Phil again and we’re talking about Expatriation again. Every other Tuesday, it’s what we do. If you want to stop getting this email, just find the Unsubscribe link at the bottom of this email and you will stop receiving the emails.

This Week’s Question

This week’s email touches on the certification test and a question that a lot of Canadians have. It comes from reader D.K., who is an EA in Canada. After saying some nice things about the blog and the newsletter (blush) says:

I read the article about UK ISAs with interest. Canada has a similar vehicle called TFSAs (Tax Free Savings Accounts). Analyzing your logic from this article, I guess you would argue that TFSAs are “accounts” and do not require 3520 and 3520-A filings. Any thoughts you have on this matter would be most appreciated.

Short answer: you have a two out of three chance that TFSAs are probably just regular old accounts, not trusts. However (here is the uncertainty), there is a type of TFSA called an “arrangement in trust”. For that one, all bets are off, though I have an opinion about what the better outcome should be. 🙂

The Problem: Satisfying the Certification Test

The problem is the TFSA’s impact on the “certification test” for Canadian-resident Americans who wish to expatriate. The certification test requires the expatriating American to certify that the five previous years’ US tax returns are completely accurate. For an American citizen living in Canada, that pesky TFSA poses a bit of a problem for answering the certification test question with the desired “Yes”. (See Form 8854, Part IV, Section A, Line 6.)

TFSA’s Income

The fact that a TFSA’s income is tax-free in Canada means nothing to the IRS: the income is fully taxable in the United States. An American taxpayer with a TFSA must, without question, report the income earned on the TFSA’s assets.

TFSA as Foreign Trust

Additionally, there is a question about whether the TFSA is a “foreign trust” in the ever-vigilant eyes of the US tax system. If TFSAs are “foreign trusts” from the perspective of the US tax system, then a US taxpayer in Canada must file Form 3520 and Form 3520-A annually to report the TFSA.

When that US taxpayer renounces US citizenship, the failure to file Form 3520 and Form 3520-A will mean that he/she fails the certification test and will be treated as a covered expatriate.

TFSAs Explained

Tax-Free Savings Accounts are not retirement accounts. They can be used for any savings purpose. There is a limit to how much can be contributed to a TFSA every year. The contribution is not tax-deductible. Income is tax-free (the clue is in the TFSA’s name!), and distributions are not taxed.

More information about TFSAs is on the Canada Revenue Agency website if you are dying to read an overview of what these things are and how they work.

Critically, there are three types of TFSAs:

  • A deposit;
  • An annuity contract; and
  • An arrangement in trust.

Two Out of Three? No “Foreign Trust” Problem

Look at your TFSA. If it falls into one of the first two categories (a deposit or an annuity contract), you definitely do not have a “do I have a foreign trust?” dilemma. Your job is to ensure that you properly reported the TFSA’s income on your US income tax return for the five years before your expatriation. This allows you to pass the certification test – at least as to the TFSA.

The biggest problem here will be a PFIC problem. A TFSA need not just hold cash deposits. It can be used to invest in stocks, bonds, mutual funds, and other assets. If your TFSA invests in mutual funds, then you will be filing Form 8621 and reporting the income from those mutual funds there.

“An Arrangement In Trust” – What Does That Mean?

If we are trying to decide whether a TFSA is a “trust” in the eyes of the Internal Revenue Code, those first two TFSA types are easy to dismiss. Neither a deposit nor an annuity will be a trust.

But that third one is a problem. The word “trust” is in its name. Surely a TFSA that is an “arrangement in trust” will be a foreign trust for US tax purposes, right?

Not necessarily.

What’s a Trust?

The Treasury Regulations define “trust” for US tax purposes, at T. Reg. § 301.7701-4(a):

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.

I have highlighted the key phrase:

“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”.

When I read the typical account documentation for a TFSA that is an “arrangement in trust” I see something that is a trust in name only. Essentially the person setting up the TFSA holds all of the powers, and the trustee is more akin to a custodian than a true fiduciary.

Take a look, for instance at the account documentation for Oaken Financial. (Warning: PDF). I know nothing about these people, and found this document via Mr. Google.

A casual review of this document tells me it doesn’t behave exactly like a trust as defined in the Treasury Regulations. The purpose of the arrangement is to provide a tax-free savings vehicle for the Account Holder. (Page 3, Section 2.) The Account Holder has all of the powers for investment decisions. (Page 4, Section 5.)

Please understand. I am not analyzing this particular TFSA document, and I am not telling you what it is or is not for US tax purposes. I’m just point out that it does not behave much like a trust, even though it is drafted to look like one.

There is an analogous trust-like structure in Mexico, and we should now take a look at it to see if we can glean some information about how to deal with a TFSA.

Lessons Learned: Fideicomiso Structures

Let’s look at how the IRS treated Mexican fideicomiso structures.

People who are not Mexican citizens may not directly own real estate too close to the coast or the border. When a foreigner wishes to buy real estate, title is taken by a Mexican bank, for the benefit of the foreign buyer. When you look at the document, you would be forgiven for thinking that this is a trust arrangement. There is a party that looks like a trustee (the Mexican bank), a party that looks like the settlor (the foreign individual who provides the cash to buy the real estate), and a beneficiary (usually the same foreign individual who provided the cash to buy the property).

It is only when you start to read the documents carefully that you realize that the Mexican bank has no responsibility whatsoever to protect the asset. All management responsibility and risk is allocated to the foreign individual who wanted to buy the Mexican real estate.

For decades, it was the IRS position that a fideicomiso was a foreign trust. Specifically, it was a foreign grantor trust for a number of reasons under the grantor trust rules.

Eventually, the IRS issued a private letter ruling saying that a fideicomiso is not a trust. See PLR 201245003 (PDF). It’s really just a nominee or agent arrangement. You can thank Amy Jetel for this one.

From Fideicomisos to TFSAs

What this tells me is that you should be able to successfully argue that a TFSA “arrangement in trust” may not be a trust for purposes of the US tax system. And that is the position that I take. Canadian trust companies wanted to share in the bounty when TFSAs were introduced in 2008. The only way they can take money for TFSAs is by acting as a trustee. Banks take money from people for TFSAs by opening up accounts. And insurance companies take money from people to invest in TFSAs by issuing annuity contracts.

Horses for courses.

TFSAs that are “arrangements in trust” are not, in my opinion, trusts as defined in T. Reg. § 301.7701-4. They are merely financial accounts.

So What Do You Do?

But that’s my opinion. Does the IRS agree? I don’t know. There is nothing published that I can find where the IRS takes a position one way or another.

Most people don’t want to play Dirty Harry Tax Planning (“Do you feel lucky, punk? Well, do you?”). This is especially true when you want to renounce your U.S. citizenship. It is more important to make a clean break than it is to make some sort of philosophical statement.

Here is the decision tree, as near as I can tell:

    • The conservative approach would be to make sure you report the income, and file late Form 3520 and Form 3520-A forms for the five years prior to your expatriation year. Do it directly with the IRS or through the Streamlined Procedure, as you choose. Here you are paying extra money to someone to prepare Form 3520 and Form 3520-A for five years. The extra money is your insurance policy: if TFSAs are foreign trusts, you are covered, and if they are not, you spent a few thousand dollars but you’re safe.
    • The less conservative (but still correct, I think) approach would be to make sure you report all of the income from the TFSA for the previous five years, and be done with it. Expatriate, check the “yes” box for the certification test question, and move on.
  • Look at your TFSA plan documents. If it is a deposit account or an annuity, your job is done. The TFSA is not a foreign trust. Make sure you have reported your income correctly for the previous five years. Make sure you did the magic Form 8621 if your TFSA held mutual funds.
  • If your TFSA is an “arrangement in trust” you must report all of the income, just as you do for the other types of TFSAs. But you also need to make a decision on the “foreign trust” question.

Disclaimer

This week I waded into the unknown, so it is doubly important that you go pay money to someone and get concrete advice. I might be wildly wrong. And besides, even if I turn out to be right at the end of a long fight with the IRS, you still had to pay (in money and stress) for that fight. So get some good advice, will you?

I am happy to talk about this at length. I do not hold my TFSA opinions with strong conviction. I might be wrong and I want to learn. Email me and let’s talk. Wee beasties like TFSAs put on the camouflage of trusts, but I think the IRS shouldn’t treat them as such.

That’s it for now. See you in a couple of weeks.

Phil.

Americans Living Abroad Expatriation Tax and Trusts