November 15, 2016 - Haoshen Zhong

PFIC Wrapper Miniseries #1: Canadian RESP

This week’s topic is the first of a series of posts that will talk about how various “wrappers” affect the US taxation of PFICs. The particular topic came by way of email:

I established a Canadian RESP for my child. I will move to the US this year and become a US resident. What can I do with the PFICs inside?

This post will talk about how the US sees the RESP and why there are issues other than PFIC rules that should be of concern. For this post, I am skipping the question about what to do with the PFICs inside and focus on the RESP itself: Are there any US tax issues that might make the RESP itself undesirable?

PFIC defined

A passive foreign investment company (PFIC) is a foreign corporation that meets either 1 of the following 2 tests (IRC §1297(a)):

  1. Income test: At least 75% of the corporation’s gross income is passive income.
  2. Asset test: At least 50% of the corporation’s assets are passive assets.

Income from PFICs (whether gain or distribution) is subject to special punitive rules to discourage US persons from making passive investments abroad. Our correspondent is quite right to be concerned about the PFICs inside the RESP. But there is a RESP wrapper around the PFICs. Let us address the wrapper first.

Introduction to RESP

RESP stands for Registered Education Savings Plan. In Canada, is a way to defer tax on savings intended for post-secondary education. This is how it works:

  1. A promoter offers a plan to the public.
  2. A subscriber (the person who wants to set up the plan) contributes cash to the plan to be held by the promoter. These are subscriber contributions.
  3. The promoter helps the subscriber apply for government grants to be contributed to the plan.
  4. The plan makes investments that accumulated income.

The RESP is probably a foreign trust

US tax law has a specific definition of trust:

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. Reg. §301.7701-4(a)

In the case of the RESP, a settlor (the subscriber) transfers title to property (cash) to a trustee (the promoter) for the purpose of conserving it for the beneficiaries (the intended future students, typically the subscriber’s child).

The RESP custodian is charged with preserving the assets (and possibly making a reasonable return through prudent investments). This is a classic trust relationship, and in fact RESPs are usually organized under Canadian trust law. It is almost certain that they are trusts under US tax law as well.

To be a US trust, US courts must be able to exercise primary administrative supervision over the trust, and US persons must control all substantial decisions of the trust. Reg. §301.7701-7(a). Because the RESP is established in Canada and has a Canadian trustee, both of these conditions are false, so it is not a US trust.

The RESP is most likely a foreign trust.

The RESP is probably a grantor trust

A grantor trust is a term of art not defined anywhere in the Code or the regulations. It just means that the trust’s income is taxed to someone other than the trust itself, as if that someone else owned the trust assets directly. Usually, the someone else is the grantor.

The grantor includes anyone who creates a trust or makes a gratuitous transfer to the trust. Reg. §1.671-2(e)(1). For a RESP, this subscriber is the grantor of the RESP to the extent that he funded the RESP. If the RESP contains grants, the Canadian government is probably also a grantor.

The subscriber is taxed as the owner of the portion of the trust attributed to his transfers, because he has the power to revoke the trust. IRC §676(a). The portion of the trust attributed to the grant is more complicated, but I suspect the subscriber is also taxed as the owner, because he can terminate the RESP and vest all income in himself–the Canadian government cannot terminate the RESP or receive income from the RESP. IRC §678(a).

No special tax provisions

If you examine the definition of a trust closely, you see how wide the trust rules reach. For example, in a pension, the employer (settlor) transfers funds to a custodian (the trustee) to invest for retirement (preserve) for the employee (the beneficiary).

US tax law does generally treat pensions as trusts. But the Internal Revenue Code contains special provisions that distinguish between “employees’ trusts”, “compensatory trusts”, and normal trusts. See e.g. IRC §§401, 402, 672(f)(2)(B). These rules can–though not always–prevent the pension from being taxed like a normal trust. For US and Canada, the treaty also provides significant benefits for RRSP beneficiaries.

Similarly, the Code provides benefits for a Health Savings Account, which prevents a HSA from being treated like a normal trust. IRC §223(d).

No such special provision exists for RESPs, either in the Internal Revenue Code or in the US-Canada income tax treaty.

Tax implications

Because the subscriber is the owner of the entire RESP for US tax purposes, and the RESP is a trust, the subscriber is taxed as if he owned the trust assets directly. IRC 671.

If there are PFICs in the RESP, he has to report income from the PFICs and file Form 8621 as if he owned the PFICs directly. Reg. §1.1291-1T(b)(8)(iii)(D).

In addition, he has to file Form 3520 annually to report his ownership of the trust, and he has to ensure the trust files Form 3520-A (or file a substitute Form 3520-A himself) to report information about the trust. IRC §6048(b). If he creates a RESP, makes a transfer to the RESP, or receives a distribution from the RESP, he has to file Form 3520 as well. IRC §6048(a), (c). The penalty for not meeting these requirements is, at a minimum, $10,000 per year.

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