Do’s and Don’ts: Cross-border Investment Considerations

Understanding your client’s tax status is critical in the process of assisting with the choice of proper investment vehicles. For the vast majority of Canadian wealth advisors, their clients are Canadian residents for tax purposes.

Canadian Tax Status

Who is a Canadian resident for tax purposes, and what does it mean? Generally speaking, your client is a Canadian resident for tax purposes if:

• They have significant residential ties to Canada i.e. their home is in Canada,
• Their spouse lives in Canada,
• and/or their dependents live in Canada.

That means that they are subject to income tax in Canada on their worldwide income. It can also include various potential reporting obligations.¹

U.S. Tax Status

While your client is likely a Canadian resident for tax purposes, it’s important to consider if they are also a U.S. Person for income tax purposes. Your client may be a U.S. Person for tax purposes if:

• They are a U.S. citizen e.g. born in the U.S. and there’s been no subsequent renouncement,  
• They are a U.S. green card holder, or
• They’ve met the “substantial presence” test. i.e. they’ve simply spent too much time in the U.S.²

Why is it a big deal if your client is a U.S. Person living in Canada?

The U.S. is one of only two countries that imposes income tax on expats. This creates unique considerations for U.S. Persons who live, work and invest in Canada. They are required to report their Canadian-source income to the IRS, and potentially pay taxes on that income. It is important to know that there are various exceptions, threshold considerations, and reporting obligations can vary depending on the nature of the income itself. E.g. IRS’s foreign earned income exclusion for 2022 is $112,000³, but several criteria must be met in order to qualify. The foreign tax credit (FTC) system can potentially mitigate double taxation, however.

If your client is a U.S. Person they have lifelong tax and filing obligations in the U.S. If they live and invest in Canada, they’ll likely be subject to various reporting obligations such as the Statement of Specified Foreign Financial Assets (Form 8938) per the Foreign Account Tax Compliance Act (FATCA) and FinCEN Form 114 per Report of Foreign Bank and Financial Accounts (FBAR). If they aren’t up to speed on their filings south of the border, there may be amnesty programs available to help. There are various eligibility criteria to consider.⁴

How should your client who is a U.S. Person invest?

Generally speaking, a U.S. Person that resides in Canada will have to deal with tax complexities throughout their life, and within their estate. They should be working with a qualified cross-border tax specialist. Intricacies are in abundance when it comes to the interaction of the U.S. and Canadian tax laws. These complexities typically amplify the potential for pitfalls. E.g. A U.S. business owner living in Canada can face an abundance of complexities. There are heaps of traps and planning options; a next to impossible scenario to navigate without a specialist.

For the purposes of this article, we will stick to non-business owner individuals, and some of the more common types of investment accounts.

Registered Retirement Savings Plans (RRSPs) for U.S. Persons in Canada? RRSPs qualify as a “do”.  

Why? A U.S. Person living in Canada should strongly consider RRSP contributions if they do in fact generate RRSP contribution room. While the RRSP is subject to FBAR and FATCA reporting, significant relief is provided by the Canada-United States Tax Convention⁵ (“the Treaty”) from a tax standpoint.

What is the key benefit of Treaty coverage? Normally, when a U.S. Person makes contributions to what is considered a “foreign grantor trust”, they are subject to tax on the income earned in the trust. However a RRSP is treated as a pension plan under the Treaty. Then, an automatic tax deferral is granted in the U.S. on income or capital gains earned in these plans.

Any other benefits? In the case of a RRSP, your client is also exempt from extra filing requirements under the foreign trust rules. i.e. Forms 3520 and 3520-A. A RRSP as a savings vehicle is also preferred as it avoids the complex Passive Foreign Investment Company (PFIC) filing requirements in the U.S. per Form 8621⁶. Did you know that PFIC forms are not required for mutual funds held within a RRSP?  See chart and discussion below for more details.

What happens when your client starts a RRSP/RRIF withdrawal? Upon withdrawal from a RRSP/RRIF, the entire amount is taxable in Canada, but in the U.S. the original contributions are non-taxable. This calculation can be complex, but ultimately double taxation is typically eliminated via the foreign tax credit. Due to all these factors, RRSPs are a preferred retirement savings vehicle for U.S. Persons living in Canada. The benefits as noted also apply in the case of RPPs, group RRSPs, PRPPs and equivalent pension accounts such as LIRAs/LIFs.  

A word of caution: In the case of spousal RRSP contributions, U.S. gift tax rules may result in double taxation. That will depend on the level of the contribution and whether the spouse is a U.S. citizen as well.

Non-Registered Investments for U.S. Persons in Canada? “Do” …. but keep it simple. 

If your U.S. client (that resides in Canada) wants to invest in mutual funds or exchange-traded funds (ETFs) in a non-registered environment, there are several considerations. Especially as it relates to U.S. reporting requirements. Canadian mutual funds trusts, corporate class mutual funds and ETFs are considered PFICs. Without diving into the specifics of the underlying definition⁷, we will focus on the key considerations when investing in a PFIC. If your U.S. client invests in a Canadian mutual fund or ETF, they own a PFIC. There are other PFIC culprits, such as private company shares that hold mainly passive investments, but we’ll focus on the former for the purposes of our discussion.

Why is a PFIC a big deal from your client’s standpoint? If your client invests in a PFIC, they will be required to submit Form 8621 with their U.S. tax return. This form is highly complex and must be submitted for each individual PFIC held. Even if this task is delegated to a qualified cross-border tax specialist, the reconciliation process can take several hours to complete.

How to keep it simple? Choose a minimal number of Canadian mutual funds or ETFs within the non-registered account. If variety is an objective, that can be achieved with the investments held in the RRSP. In a perfect world, just one or two funds (that fit the client’s investment profile) in a non-registered account is preferred to minimize accounting fees etc.

The Canadian tax treatment is no different than if your client was not a U.S. Person, aside from the fact that they can claim the FTC on the U.S. taxes paid/payable.

How is your client’s non-registered account taxed in the U.S.? There’s a key caveat here. There are three alternatives for how portfolio investments that are considered PFICs may be taxed in the U.S. including:

1. Excess distribution regime – This methodology is not ideal. Especially if the extent of the total of actual distributions during the year exceeds 125% of the average actual distributions received in the three preceding years. The “excess” distribution is allocated on a pro rata basis over the entire holding period of the PFIC. Amounts allocated to prior tax years are taxed at the highest U.S. federal rate. Additionally, there is an interest charge given the fact that the taxes are effectively paid late. Why take a chance with this approach?
2. Mark-to-Market regime – This approach requires the U.S. Person to recognize a gain/loss on the PFIC each year as if the PFIC was sold at fair market value at year-end. A gain is taxed as ordinary income and does not receive preferential capital gains treatment. The risk here is double taxation as the Canadian capital gain may not be realized at the same time.
3. Qualified Electing Fund (QEF) regime – This regime requires that the investor include a pro rata share of the PFIC’s earnings and profits for the year in their U.S. income. The income is classified as either ordinary income or capital gains depending on the nature of underlying PFIC income. The U.S. Person makes the QEF election in the first year that the investment is made. This approach is typically the better of the three options noted. In this case, the PFIC must produce annual information statements in order for the QEF election to be possible.

What if my client doesn’t invest in a PFIC? There may be instances where this occurs. For example, if you are a U.S. licensed advisor and your client purchases a U.S. ETF in their non-registered account, that wouldn’t be considered a PFIC. Form 8621 would not be required, although they may be subject to Canada’s foreign reporting requirements (T1135⁸) on the foreign fund, depending on the value in aggregate with other U.S. holdings.

Contingent on the client’s appetite for risk, holding direct interest in securities/stocks within their non-registered account may be a viable alternative as well. Perhaps you are a Canadian licensed broker with a means to facilitate this option, while minimizing requirement for PFIC reporting. REITs and segregated funds are widely considered a grey area when it comes to whether or not they meet the definition of a PFIC.

Tax Free Savings Account (TFSA) for U.S. Persons in Canada? “Don’t” … for the most part

While income earned in a TFSA is tax-free for Canadian tax purposes, for a U.S. Person it is fully taxable in the U.S. Unlike the RRSP, it is not covered by the Treaty. It does not receive the same favourable treatment. Depending on what your client invests in, another 8621 Form may be required.

Are foreign reporting requirements relaxed to any extent? Revenue Procedure 2020-17 issued March 2, 2020, provided guidance and relief for U.S. Persons with tax-favoured Canadian foreign trusts. It includes  specifically Registered Education Savings Plans (RESPs) and Registered Disability Savings Plans (RDSPs)⁹. This was welcome news as Form 3520, Annual Return to Report Transactions with Foreign Trusts, and Form 3520-A, Annual Information Return of Foreign Trusts with a U.S. Owner, were previously required for RESPs and RDPSs. They are also costly and time consuming.  

Why is the 2020-17 Revenue Procedure relevant for TFSAs?  There has been a healthy debate as to whether or not a TFSA would qualify as a tax-favoured trust for the purposes of the exemption, as the IRS doesn’t explicitly mention the TFSA within the Revenue Procedure. Several reputable cross-border tax firms have taken the position that the TFSA meets the criteria, and as such wouldn’t require additional filings. We encourage your client to consult with their own qualified professional¹⁰.

When should your client consider a TFSA? While your U.S. client will still be subject to U.S. taxation, and potentially FBAR, FATCA, and PFIC reporting in the case of a TFSA, they may opt for this route given a particular set of circumstances. For example, if the Canadian taxes payable on their non-registered investments is in excess of the respective foreign tax credit applied on those investments, they may be able to offset some of the U.S tax attributable to the TFSA. This may be due to the higher rates of income tax in Canada and resulting availability of unused FTCs. In a case, where your U.S. client does not invest in a non-registered account, a TFSA will likely not add value. Many U.S. Persons opt to avoid TFSAs given the added reporting and underlying risk associated with the vehicle.

What about RDSPs and RESPs? “Don’t” … unless you can avoid common pitfalls

Just like a TFSA, RDSPs and RESPs are taxable for U.S. Persons, and subject to U.S. filing and reporting obligations – aside from forms 3520 and 3520-A as noted above. If a U.S. Persons is a subscriber, they are subject to U.S. tax on earned income within the RESP, government grants (and bonds) received within the RESP, and income earned on those grants and bonds. Your U.S. client is not off the hook until the amounts are fully distributed to the RESP beneficiary. Even if a non-U.S. Person contributes to a RESP with a U.S. subscriber, those amounts, plus the proportionate grants and bonds, would be taxable to the U.S. subscriber. There are additional tax considerations at death as well.  

When can RESPs be more appealing for U.S. clients? Ideally one of the parents of a child is not a U.S. Person, in which case the cross-border tax headaches may be avoided. If the subscriber is a non-U.S. Person and there is no U.S. contributor, the RESP will generally qualify as a foreign non-grantor trust which can yield a better tax result¹¹.

Consider the tax status of the beneficiary given the fact that one or both of their parents may be a U.S. Person. In the case where the RESP beneficiary is a U.S. Person, the U.S. tax impact can be undesirable given the harsh “look-back” provisions. Once withdrawals begin, the U.S. beneficiary may be taxed punitively on the distribution that represents income that has accumulated in the plan but not paid out in the year it was earned. There is also a resulting interest charge on the income that is considered accumulated income. Foreign tax credits can help to an extent given that a portion of the withdrawals will also be taxable in Canada. A U.S. beneficiary may also be subject to annual filing requirements given the status of the RESP as a foreign non-grantor trust. Gift taxes may also apply in certain circumstances.

Did you know? If the U.S. Person simply contributes to a RESP, the RESP may still be considered a foreign grantor trust. This would result in the same tax treatment as if they were a U.S. subscriber.

Overall, the best way to avoid these potential traps, is to have a non-U.S. parent be the contributor and subscriber of the RESP, if possible. It may still be worthwhile if it’s not possible given the available grants and bonds. In that case, the RESP won’t be tax-sheltered in the U.S. and the complexity factor would ramp up considerably. The U.S. beneficiary trap may be something that is unavoidable, however.

What if your client is a non-U.S. subscriber, but the successor spouse is a U.S. Person? If your non-U.S. client set up the RESP i.e the non-U.S spouse is the contributor/subscriber, they may be able to minimize U.S. reporting from the parents’ perspective during the non-U.S. spouse’s lifetime. If the subscriber spouse passes away, and the U.S. spouse is named as the successor subscriber, the plan may be reclassified as a foreign grantor trust thereafter and subject to U.S. tax. This may be the only reasonable course of action if there is no other appropriate successor subscriber in the family. If a non-U.S. grandparent, or aunt or uncle etc., could otherwise be named as successor subscriber that may yield a better tax result. However, considerations pertaining to the parameters of the plan and the level of trust placed upon the potential successor subscriber should be reviewed.

Are there any other unique considerations for RDSPs?

Many of the same considerations apply as with RESPs, as a U.S. holder in the case of an RDSP would also typically imply a foreign grantor trust for U.S. tax purposes. i.e. the U.S. holder would be subject to U.S. tax on contributions, grants and bonds, not to mention multiple filing obligations. As with the RESP, it may be better to structure a RDSP with the holder being a non-U.S. Person, if possible. Consider whether the beneficiary is a U.S. Person as that could create additional filings and income tax exposure.

Sampling of U.S. information forms for U.S. Taxpayer:

Conclusion

Clearly there are a lot more “don’ts” than “do’s”, but it’s important to consider each cross-border scenario on a case by case basis. Sometimes U.S. Persons want to simply renounce their citizenship to do away with their complexities, in which case there are a plethora of non-tax and tax related considerations. Perhaps they have a U.S. pension that they want to move to Canada beforehand, but their current level of income in Canada doesn’t allow for a tax-neutral transfer to their RRSP.

The interaction of the Canadian and U.S tax laws can often be complex and intricate, even if your client isn’t a U.S. Person. 

Your non-U.S. client may unknowingly create U.S. tax exposure because they purchased a condo in Palm Springs, or U.S. securities in their RRSP.  The IRS casts a wide net that advisors must be wary of.

If your client is a U.S. Person living in Canada, there are many things you can do to help make things easier for them, but they should undoubtedly consider hiring a cross-border tax specialist as part of their advisory team.