If you are a Canadian who lives in the United States and you have an RRSP, there are three problems that arise because of the quirks of U.S. tax law. This chapter deals the first problem you face: how investment earnings inside the RRSP are taxed. For the unprepared Canadian living in the United States, the difference can be costly, in tax and (if you screw things up) penalties.

USA: tax RRSP investment earnings now

U.S. income tax laws start from a simple idea: if you are a U.S. citizen or resident, the United States will tax everything you earn, no matter where you earn it, in the year that you receive it. That general concept applies unless there is a specific exception to the rule.

Pension plans are an exception to the “all worldwide income is taxable now” idea. If you have the right kind of pension plan, then the investment earnings inside the plan (interest, dividends, capital gains) are tax-free when earned. Income tax is paid only when money is distributed from the pension plan to the person entitled to the money.

These pension plans are called “qualified plans” because they qualify for tax-free treatment by satisfying a mind-boggling array of tax and labor law rules.

An RRSP is not—and cannot be—a “qualified plan” as that concept is defined in U.S. tax law.[ref]In order to be a qualified plan, an RRSP must be an “employees‘ trust” as defined in Section 401(a) of the Internal Revenue Code. One key requirement of Section 401(a) is that the plan must be “created or organized in the United States.” An RRSP is “created or organized” in Canada. Therefore it cannot be an “employees’ trust” in the United States, and will not qualify for U.S. income tax exemption on its investment earnings. Rev. Proc. 2002-23, Section 2.01 says:

“Under the domestic law of the United States, an individual who is a citizen or resident of the United States and a beneficiary of a Canadian retirement plan will be subject to current United States income taxation on income accrued in the plan even though the income is not currently distributed to the beneficiary, unless the plan is an employees’ trust within the meaning of section 402(b) of the Internal Revenue Code and the individual is not a highly compensated employee subject to the rule of section 402(b)(4)(A).”

This result is reached because, as noted above, a Canadian retirement plan can never be an “employees’ trust” because it is not “organized or created in the United States.”[/ref] Thus, an RRSP’s income will never be tax-exempt in the U.S. under the pension plan rules.

As a result, we have to figure out what U.S. tax law says to do with the RRSP’s investment income. And the short answer is that the RRSP is treated as a foreign trust for U.S. income tax purposes, and is furthermore treated as a foreign grantor trust.

The technical reasons for this are the topic for a riveting cocktail party conversation sometime. But the end result of such a characterization is that you are taxable on the income earned inside the RRSP, every year as it is earned. Any investment earnings in the RRSP (interest, dividends, capital gains) will be taxable income for its owner, in the year that the income is earned.

Example

You established an RRSP while living in Canada. You relocated permanently to the USA starting on January 1, 2009. During calendar year 2009 your RRSP investments earned C$150 of interest.

The USA will treat the C$150 as taxable interest income in 2009. You would convert this to U.S. dollars and report the interest income on your U.S. tax return (specifically on Form 1040, Schedule B).

Canada: tax RRSP income later

The Canadian treatment of your RRSP investment earnings is simple: you do not pay income tax on the investment earnings inside an RRSP. You only pay income tax when you receive a distribution from your RRSP.

Example

You established an RRSP while living in Canada. You relocated permanently to the USA starting on January 1, 2009. During calendar year 2009 your RRSP investments earned C$150 of interest.

Canadian tax law says that the C$150 of interest earned in 2009 will be tax-free in Canada.

Tax me now + tax me later

This leads to a mismatch: the U.S. says “tax it now” and Canada says “tax it later.”

That mismatch can cause double taxation.

Example

You established an RRSP while living in Canada. You relocated permanently to the USA starting on January 1, 2009. During calendar year 2009 your RRSP investments earned C$150 of interest.

The USA will treat the C$150 as taxable interest income in 2009. You would convert this to U.S. dollars and report the interest income on your U.S. tax return (specifically on Form 1040, Schedule B).

Canadian tax law says that the C$150 of interest earned in 2009 will be tax-free in Canada.

On January 1, 2011, you leave the United States permanently and return to Canada to live. You take a distribution from your RRSP in 2011 and pay Canadian income tax on that distribution.

You have now paid income tax twice on the C$150 of the investment earnings inside the RRSP from 2009: once in 2009 to the USA, and then again in 2011 to Canada when the money was distributed to you.

The solution to double taxation

You can solve the mismatch problem—and eliminate the U.S. Federal income tax—by invoking a specific clause of the income tax treaty between the United States and Canada.

Here is why the income tax treaty fixes the problem.

Remember that pension plans are an exception to the “tax everything you earn in the year that you earn it” rule? And remember that a Canadian RRSP cannot be a U.S. pension plan?

The income tax treaty has a provision that says “If something is a pension plan in one country, the other country will not tax income earned inside the plan until it is distributed.” The Treaty is actually a good deal wordier:

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.

In other words, if you choose to use the treaty, U.S. income tax treatment of RRSP investment earnings will be just like the Canadian treatment of those earnings—tax-free until distributed to you.

Mismatch problem remains for State income tax

The income tax treaty does not limit the ability of U.S. States or Cities to impose income tax. As you will see in Chapter xx (where I describe California’s treatment of RRSPs), this means that although you can use the income tax treaty to protect your RRSP investment earnings against U.S. Federal income tax, you cannot necessarily use it to protect against State income tax.