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April 20, 2005 - Phil Hodgen

Canadians in the U.S. and their RRSPs

If you’re a Canadian living in the U.S. and you have a Registered Retirement Savings Plan, your tax world is a little bit complicated. Heads up.

COMPARISON: Canadian “RRSP” and U.S. “IRA”

The RRSP and its U.S. equivalent–the Individual Retirement Account or “IRA” work in much the same way: you make a contribution to the account. You get a tax deduction for the contribution to the account.

Money stays in the account and earns investment returns, and you don’t pay income tax on the investment returns until you pull money out of the account. At that point the entire withdrawal is taxable income to you.

WHILE YOU LIVED IN CANADA

Whilst living in Canada, your RRSP was pretty easy to understand. You contribute to your RRSP. Investment returns are not subject to Canadian income tax. You only get taxed when the money comes out of the RRSP and into your wallet.

NOW YOU LIVE IN THE U.S.

Now you’re living in the U.S. Your investments inside the RRSP are earning investment returns.

Guess what? The U.S. wants to tax you (for Federal income tax) on those investment returns being earned inside the RRSP, even though you haven’t withdrawn anything from the RRSP.

PREVENTING THE U.S. FEDERAL PROBLEM

You can (and should) make an election under the Canada/U.S. income tax treaty, Article XVIII(7). This will tell the U.S. Federal tax authorities that your investment earnings inside the RRSP aren’t taxable income in the U.S. until you actually withdraw the funds from the RRSP.

Do this by attaching Form 8891 to your U.S. Federal income tax return every year.

BUT THERE’S STILL A STATE TAX PROBLEM

If you (the Canadian expatriate) live in a State that has income tax (and most do), you have a secondary problem: the Canada/U.S. Income Tax Treaty does not apply to State income taxes (or Provincial income taxes either, for that matter).

This means that for State income tax purposes, you are probably considered to be receiving taxable income on your RRSP investment returns every year, even though all of the money stays neatly locked up inside the RRSP.

In California, for instance, the law is quite clear: the investment returns on your RRSP are considered taxable income if you are a California resident, and you must pay California income tax on it. Here is a link to a Franchise Tax Board publication explaining this. (See page 2, warning–PDF).

WHY?

Here’s the logic. It’s tax logic, not real world logic.

First, the Income Tax Treaty logic. An income tax treaty is an agreement between two sovereign governments, in this case, Canada and the United States. It is an agreement at the Federal level for both governments. By operation of the U.S. Constitution this agreement is not binding on the States’ ability to tax their residents. Thus, even though you might be exempt from U.S. Federal tax under the Income Tax Treaty, you can be taxed by the State in which you live.

Second, the “normal” tax law logic. In the U.S. tax regime, everything is taxable unless the government says it isn’t. So investment returns on your RRSP (or your IRA) will be taxable unless the government says so. In the case of IRAs, the government has said so–if you set up an account under the specific IRA rules, no tax is payable on investment returns.

A RRSP is not an IRA, therefore the exception for IRAs doesn’t apply, and the RRSP income is taxable.

Wrap your head around that and you get an idea of what it’s like to be a tax lawyer. Rule, exception to the rule. Exception to the exception placing you back in the rule. Etc.

Nonresidents with US Activities