I have titled this essay as my “ultimate” write-up on RRSPs. I use the word “ultimate” in its true meaning: the last one. There will be no more coming from me on this topic (unless I change my mind), because the IRS has (finally) solved (more or less) the problems (or some of them) in a (somewhat) complete way (until further notice, of course).1
RRSPs are Canadian retirement accounts. Until late 2014, they were semi-toxic for U.S. tax purposes when owned by U.S. taxpayers who were unaware of the paperwork requirements south of the border. These problems bedevilled countless Canadians living in the United States, as well as U.S. citizens and green card holders living in Canada.
By administrative fiat in late 2014, the U.S. government blew away the problems it had created–problems that cost countless people money and caused high levels of stress.
This is the current state of affairs for U.S. taxpayers and their RRSPs:
The IRS has not eliminated the stress and agony of waking up to the fact that your RRSP triggers some U.S. tax paperwork, but they have eliminated enough of it so that we can declare victory and go home.
With that overview, let’s look at why all of this is true.
Problems with RRSPs happen because they natively behave like pensions in Canada but do not natively behave like pensions in the United States. “Behave like pensions” means that you put money into an RRSP–a contribution. Investment gains (interest, dividends, and capital gain) are not taxed as the RRSP receives them. Instead, everything stays inside the RRSP. You pay income tax only when you take money out of the RRSP–a distribution.
Canadian law ensures that an RRSP achieves that tax result for Canadian income tax purposes. In the United States, however, an RRSP cannot achieve the same result because the legal structure of an RRSP does not satisfy the definition of a “qualified plan”–the technical description of an account that behaves in the way I described. The critical reason is simple:in order for a retirement plan to be a “qualified plan” all of the money in the plan must sit in a special trust organized under U.S. law. RRSPs, of course, are organized under Canadian law.
In order to make an RRSP behave (in the United States) as a qualified plan, external intervention is required. That external intervention comes in the form of special rules in the income tax treaty between the United States and Canada. In it, the two countries agree to a simple idea: “If you treat something like a pension, we will, too”.
Making that simple idea work was a task that fell to IRS attorneys. As you might guess, they found a number of places where existing tax law conflicted with the simple idea, or where the the simple idea became fiendishly difficult to implement. The IRS issued a series of rulings and announcements in an attempt to fix the problems they saw, and this rush of effort culminated with the creation of Form 8891. All of this happened in the 2002–2003 time period. And then it stopped.
American citizens and residents are taxed on their worldwide income. This means that a U.S. citizen or green card holder living in Canada would be taxed as a resident of Canada and a resident of the United States simultaneously. The RRSP would work perfectly well for Canadian tax purposes, but (under U.S. tax law) astonishingly poorly on the U.S. income tax returns.
Similarly, Canadians living south of the border would become U.S. resident taxpayers, and suddenly the U.S. government would be looking at their RRSPs through Internal Revenue Code-colored goggles.
For both sets of people, the problems were economic, of course–what was not taxable in Canada was taxable in the United States, making retirement savings terribly difficult for the people affected.
But the bigger problem was–and continues to be–simple lack of awareness of the rules. Most ordinary people simply did not know of the arcane U.S. tax rules and the obscure tax forms that were required for their RRSPs. When they found out, they were horrified, because the U.S. tax system threatened penalties that could completely wipe out their retirement savings–simply for failing to file a form or two.
With that background, let’s look at the four problems that RRSP owners had–problems entirely created by a broken set of tax laws clumsily administered. We will then look at how the IRS fixed the broken stuff bestowed on taxpayer by Congress, our intrepid diplomats who negotiated the income tax treaty, and by the IRS itself.
You have an RRSP with money in it. It grows in value from interest, dividends, and capital gains. The increase in value would not be taxed in Canada, of course. But due to the peculiarities of U.S. income tax law, that increase in value–the interest, dividends, and capital gains earned inside the RRSP–would be taxable income in the United States.
Almost no one, of course, is aware of this. So any U.S. taxpayer with an RRSP would have unreported income, and you know how happy the IRS is when they find out you haven’t reported all of the income you should have reported.
Everyone knows that The Bogeyman uses foreign trusts. Communists used foreign trusts to spread Godless communism and lure the flower of American youth into the den of iniquity (1960s). Drug lords used foreign trusts to hide the money from forcing Americans to buy cocaine against their will (1970s and 1980s). The commies came back (Nicaragua and the Contras), and you know they were using foreign trusts, too. Then of course we have the current Bogeyman–terrorists. I’m pretty sure “How to use a foreign trust” is in the Al Qaeda HR Manual, in Chapter 2 or Chapter 3 somewhere. Probably. I think. Maybe.
If you are reading this essay thirty years from now, look around and see who the Bogeyman is for your time, and ask yourself whether your favorite politicians are waving a Bogeyman at you to generate a Culture of Fear (warning: Thievery Corporation on YouTube) for purposes that don’t necessarily make your life better and in fact they probably make your life markedly worse.
But I digress.
The IRS is allergic to foreign trusts. And if you look at an RRSP, then look at the definition of a foreign trust in the Internal Revenue Code and Treasury Regulations, you will conclude that an RRSP is a foreign trust. Yep. Commies, Pablo Escobar, bloated plutocrats cruising the Mediterranean on their yachts, and that retired Canadian schoolteacher in Saskatchewan with an RRSP are all using foreign trusts for tax evasion and worse.
The upshot? If you have an RRSP, you have an obligation to file Form 3520 and Form 3520-A, or risk amputation-level penalties if you are late or forget to file them.
RRSPs are accounts at a financial institution outside the United States. They were (and still are) classically required to be reported to the United States government on Form FinCen 114 (the current incarnation of the unlamented Form TD F 90–22.1), and starting in 2011 they were part of the things to be reported on Form 8938.
Penalties here, as you might guess, could in size from a decent but not extravagant used car to total bankruptcy. Because why not? You’re a retired schoolteacher living in Saskatchewan. You should have known better.
The final problem was that the official way to fix the problem was, itself, broken.
The approved method for fixing these problems (according to the IRS) was to apply for a Private Letter Ruling. Our office processed many of these things, all successfully. This “solution”, however, was no real solution. Successfully getting a Private Letter Ruling from the IRS Commissioner to fix your problems sounds like you are home free, right? Well, no. You would still be left with penalty risks for not reporting your RRSPs on the FBAR form–Form TD F 90–22.1.
The approved method for fixing RRSP problems was also expensive. The filing fee, once reasonable (a few hundred dollars) is currently $6,900. Because why not? That’s not counting the legal fees to do the work in putting together the application.
Spoiler alert: the old way of fixing problems is still there, as broken as ever, and is offered up for you to use if you want it. You would be a fool to use the old “apply for a Private Letter Ruling” system. Don’t do it.
The bad old days for RRSPs were a mess. Things are mostly better now.
The IRS fixed the RRSP problems itself. No Congress, no treaty, just soul-searching, decisions, and prose. And, I will bet, endless meetings and internal memoranda.
A set of procedures attempts to give taxpayers the ability to file obscure tax forms late without suffering financial calamity through oversized penalties. These procedures offer a way for taxpayers to file FinCen Form 114 and Form 8938 late without incurring penalties and without risking heart attacks from fear and stress. That solves “Broken Stuff 3”.
These procedures are not formally adopted in the way that tax lawyers like to see; they are found in a bunch of web pages on irs.gov. Periodically the pages are updated with new stuff and the rules change. This is your new “shoot from the hip” Uncle Sam. I hope you like him.
In late 2014 the IRS published Revenue Procedure 2014–55. It gives solutions to the unreported income problem (“Broken Stuff 1”) and the “your RRSP is a foreign trust” problem (“Broken Stuff 2”).
A Revenue Procedure is a formally-adopted administrative position, carrying a good deal more weight than web pages with stuff on them. You should expect the policy announced in Revenue Procedure 2014–55 to be around for a long time, and to evolve slowly–after deliberation.
Collectively, these two actions by the IRS made their existing “fix it” system irrelevant (“Broken Stuff 4”). Good news. The system of applying for a Private Letter Ruling was expensive, slow, and did not completely solve the problems anyway.
From the IRS side, too, it is good news. These Private Letter Ruling applications burned up thousands of hours of IRS attorney time on zero risk, zero revenue paper-pushing. Perfectly good government attorney brains were wasted on trivia. No more.
The IRS mostly succeeded. As you read through here you will find me questioning some points, but for 98% of U.S. taxpayers with RRSPs, risks are eliminated and the correct cleanup strategy will be obvious. I leave 2% as undefined because every system has randomness built into it. You, indeed, might be special.
We are close enough. Let’s declare victory and go home.
Let’s start with the unreported income problem. An RRSP is an entity that matches the U.S. tax definition of a “foreign trust” and specifically it matches the definition of the type of trust that passes all of its income through to its owner every year–a foreign grantor trust. Unless the RRSP owner wields the mighty axe of the income tax treaty to defeat this problem, there is income missing from the owner’s U.S. income tax return.
And of course normal people did not know about the treaty, or indeed about this unreported income problem. By the time they woke up to the problem, it was years late and the deadline for claiming the treaty benefits to protect their RRSP had long passed. They could not go back and fix the problem.
The IRS neatly fixed this problem in October, 2014 by publishing Revenue Procedure 2014–55. The solution was found by creating a moment of fiction. The IRS declared that anyone who is an “eligible individual” will be treated as if he or she made the necessary treaty election at the earliest necessary date:
An eligible individual who did not previously make an election under Article XVIII (7) of the Convention to defer current U.S. income taxation on the undistributed income of a Canadian retirement plan will be treated as having made the election in the first year in which the individual would have been entitled to elect the benefits under Article XVIII (7) with respect to the plan.2
By pretending that you made the election under the treaty, we then can pretend that you did not have any unreported income from your RRSP. Problem solved.
Only “eligible individuals” are allowed to use the simple, easy, and logical “let’s pretend” of Revenue Procedure 2014–55.3 Who are these favored souls, who, like the 144,000 in the Book of Revelations Chapters 7 and 14, will gain entrance to heaven?
An “eligible individual” is a beneficiary of a Canadian retirement plan who:
A) Is or at any time was a U.S. citizen or resident (within the meaning of section 7701 (b) (1) (A)) while a beneficiary of the plan;
B) Has satisfied any requirement for filing a U.S. Federal income tax return for each taxable year during which the individual was a U.S. citizen or resident;
C) Has not reported as gross income on a U.S. Federal income tax return the earnings that accrued in, but were not distributed by, the plan during any taxable year in which the individual was a U.S. citizen or resident; and
D) Has reported any and all distributions received from the plan as if the individual had made an election under Article XVIII (7) of the Convention for all years during which the individual was a U.S. citizen or resident.4
The first arm of the definition5 is a problem. It states, in the present tense, that in order to use the special rules of Rev. Proc. 2014–55, you must be a beneficiary of an RRSP right now. If your RRSP is closed, you are not now a beneficiary. It seems to me that the plain language in Rev. Proc. 2014–55, Section 4.01 says:
If we knock out the second element, I don’t think you can use Rev. Proc. 2014–55 to solve your RRSP paperwork problems. Conclusion: if you are trying to clean up the past after you have closed out your RRSP, you are out of luck.
You can only be an eligible individual if, among other things, you filed U.S. tax returns for time periods that you had a legal requirement to file.6
The language is curious (the phrase “any requirement to file” is a clanger to my ear), but not fatal. The intention was probably to express the following thought (my words, not the government’s):
You are an eligible individual if the IRS can find a tax return in the system for every year that you were a U.S. citizen or resident (for tax purposes).
The trigger for the filing requirement, in other words, was personal status (citizenship or residence) rather than some other trigger, such as receipt of U.S. source taxable income.
That is unnecessarily restrictive. It cuts off from relief a large number of people who probably need help the most. I’m talking about people who never filed a U.S. tax return. I have met these people in Canada, and I have talked to many on the phone or by email. You were born in Detroit and when you were 8 days old your parents took you back home to Canada, where you have lived a normal life for the last 50 years. I know people like that.
I am not sure why the IRS excluded these people from relief using the rules in Rev. Proc. 2014–55. Let’s be charitable and say this was inadvertent, and can be clarified by the government (if we are lucky) or by a bit of reasoning.
Here is my interpretation. I think that this particular requirement does not say when you were to have satisfied the filing requirements. The requirement is that you did something (filed a tax return); when you did it is not a specified requirement. I would take the position that someone who wakes up and files a bunch of remedial tax returns would be able to say “Yes, I satisfied my filing requirements” (albeit years late). As long as the “fix-it” methodology for your RRSPs includes the fact that your tax returns on file, you can do this late.
This is just my interpretation. You can’t take that to the bank.
The other two requirements limit the easy solution to people who “acted as if”. On their US. tax returns, they did not report the income accruing inside their RRSPs as taxable income on their U.S. income tax returns.7 There are a few people (not many) who were alerted to the “RRSP is a foreign trust” problem and sincerely tried to do the right thing. They reported the internal investment returns on their U.S. income tax returns begrudgingly.
In return for following the law correctly, they get shut out of the Rev. Proc. 2014–55 “let’s pretend” solution for RRSPs. There are probably so few of these that the U.S. government can write them off as collateral damage in the War on American Taxpayers Abroad. From a broader perspective, however, damaging people who sincerely follow the law to their detriment is terrific antimarketing for the U.S. tax system, which after all is built on the foundation of taxpayers voluntarily8 telling the truth.
For people who received RRSP distributions, they, too, must have behaved consistently with the income tax treaty in reporting the distribution and paying income tax. If they received distributions from their RRSPs, they reported those distributions on their U.S. income tax returns the way the income tax treaty says they should have.9
Pensions and annuities arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State, but the amount of any such pension that would be excluded from taxable income in the first-mentioned State if the recipient were a resident thereof shall be exempt from taxation in that other State.10
If we substitute “Canada” and “United States” in the correct places, and if we throw a few other simplicity bombs on the paragraph, the rule reads:
Pensions and annuities arising in Canada and paid to a resident of the United States may be taxed in the United States, but the amount of any such pension that would be excluded from taxable income in Canada if the recipient were a resident of Canada shall be exempt from taxation in the United States.
The recipient’s home country gets to tax the pension.
However, RRSP distributions to a U.S. taxpayer are taxable by both Canada and the United States under their respective local tax laws.The treaty anticipates this, and limits Canada’s tax bite to 15%.
(a) Pensions may also be taxed in the Contracting State in which they arise and according to the laws of that State; but if a resident of the other Contracting State is the beneficial owner of a periodic pension payment, the tax so charged shall not exceed 15 per cent of the gross amount of such payment[.]11
Again, let’s wave the magic wand of simplicity and rewrite this:
Pensions may also be taxed in Canada and according to the laws of Canada; but if a resident of the United States is the beneficial owner of a periodic pension payment, the tax so charged [by Canada] shall not exceed 15 per cent of the gross amount of such payment[.]
Canada can tax RRSP distributions paid to a U.S. resident, but at a maximum rate of 15%.
Back to Rev. Proc. 2014–55. Your RRSP can qualify for the easy “let’s pretend” solution if you (a U.S. taxpayer) paid tax on your RRSP in Canada at a maximum rate of 15%, and you also paid U.S. income tax on the RRSP distribution.
If this did not happen, you cannot be an “eligible individual” and therefore the easy rule of Revenue Procedure 2014–55 will not apply.
It’s a mess. An individual taxpayer will need to figure out if he/she is an eligible individual and hope that the definition applies. Here are the things that I think are knockout punches, disqualifying you:
There is another disqualification knock-out punch. If you previously made a treaty election you cannot use the Rev. Proc. 2014–55 method. That is no particular problem because you already have the protection from tax that you are seeking.
There is a comment section on this page. Please use it and prove me wrong. I am no longer in the business of fixing RRSP problems, so this is just my attempt to do a complete brain dump to Save the Planet, and I want to be sure that what I say is right. There is no better way to be right than to test your ideas in public against skeptical brains.
If you are an eligible individual and you never filed an election to make your RRSP earnings protected by the treaty,16 the government has solved the problem of unreported income. Remember that without the income tax treaty you are treated as if you earned all of the income generated inside your RRSP and you are supposed to report it on your Federal income tax return.
You are treated as if you made a treaty election that protects the accrued but undistributed income inside the RRSP from U.S. income taxation.17 This is effective for all tax years starting with January 1, 1996.18 As a result, for all years from 1996 forward, you will not be required to report RRSP internal investment income on your U.S. income tax return.
This applies to you whether you are an “eligible individual” (as defined in Revenue Procedure 2014–55) or not.This is because the result I am about to describe is derived from the operations of Form 8891, not from the way Revenue Procedure 2014–55 is written.
If you claimed treaty benefits in the past (you filed Form 8891 for your RRSP), you are protected.Go look at Form 8891, Line 6a through Line 6c.Note that Line 6c says “If you have not previously made the election described on line 6a above, you can make an irrevocable election for this year and subsequent years by checking this box”.
This means that if you ever filed Form 8891, you must have made the election. And having made the election by checking the box on Line 6c, you made an irrevocable election for that year and all subsequent years.
If you somehow fit within the scope of Rev. Proc. 2014–55 as an eligible individual, you can pretend that you made the treaty election. If not, however, what do you do? Here are your choices.
I think we have adequately disposed of Broken Stuff 1. Unreported income from accrued and undistributed income in your RRSP is not something to worry about.
Your RRSP is a foreign trust. U.S. taxpayers are required to file Form 3520 to report transactions with foreign trusts–contributions and distributions. The penalties are horrific.
A trustee of a foreign trust is required to file Form 3520-A. Again, the penalties are horrific (5% of the balance of the trust, every year.)
For everyone–eligible individual or not–the requirements for filing Form 3520 are waived. There is no requirement to file this form to report contributions to or distributions from an RRSP.20
The RRSP custodian is not required to file Form 3520-A. Ever.21That was easy.
The problem of what to do if you missed prior years’ form filing continues. The path to getting this cleaned up lies in the Streamlined Procedures. There is a set of rules for American taxpayers living outside the United States, a different set of rules for taxpayers living in the United States, a process for filing late FBARS (FinCen Form 114), and a process for filing late informational forms such as Form 8938.
These procedures are magnificent at first glance but you soon will become confused. Never mind. Read the rules carefully. Your biggest risk is the “dog ate my homework” certification you have to give the IRS as part of any “fix-it” you do through these processes. Essentially you are saying “Dear IRS, here are the bullets. Please don’t shoot me.” If they don’t like your reason for missing the deadlines for filing these forms, you can be sent to audit and penalties can be imposed.
Get some advice from someone and plow forward with your life. Decide if you need to file these forms, and if you do, this is probably the least-bad way to do it.
I wish the IRS wouldn’t put a little turd of gratuitous, unnecessary risk and stress on every little rosebud they plant in the garden of taxation. But that’s wishful thinking. If things were different, they just wouldn’t be the same.
There is one other option for fixing the problem of late-filed FBARs and Form 8938–the Offshore Voluntary Disclosure Program. Oh, FFS. No. Just no.
If you’re a normal person with RRSPs and the normal kit of normal person tax stuff, stay away from the Offshore Voluntary Disclosure Program. This is something to consider only if the stakes (money or freedom) are high. That’s probably not you, and there is no way an RRSP alone will raise the stakes high enough to put you at risk of IRS-induced bankruptcy or loss of liberty. (Disclaimer: not legal advice, etc. etc.)
My theory is that you should never use the Private Letter Ruling process to fix an RRSP problem. It is too expensive, and it solves the smallest tax problem of all of them–the unreported income problem raised by the failure to file a Form 8891 long, long ago.
I think we can say that the IRS has successfully solved the problem of being overloaded by Private Letter Ruling applications for RRSPs. The alternatives discussed here are adequate to the task of solving most (if not all) RRSP-driven U.S. tax problems.
Here are the new filing rules for Form 8891 for everyone–eligible individual or not.24
The first thing to know is that Form 8891 is obsolete and will not be in use at all for the 2015 tax year forward. It is gone after December 31, 2014 for everyone and every purpose.25
The Instructions to the 2014 Form 8938 specifically tell you not to use Form 8891 in 2014. (Thanks to Richard in the comments below for this.)
Federal tax complexities for RRSPs are largely banished, but State income tax may remain a problem for RRSP owners. States sometimes cheerfully choose to ignore Federal law. /cough/ California /cough/ is a notorious and flagrant offender. “Federal income tax treaties? F— off”26 is the Standard Operating Procedure in Sacramento, and this philosophy specifically applies to California taxation of RRSPs (warning: PDF).
That’s it for me and RRSPs. Thanks for reading. Please comment and tell me if I’m wrong, if I wrote something that is as understandable as a bag of doorknobs, or if a particular topic needs to be added or amplified. I will get this as good as I can, so it will remain in place and I can focus on other stuff.