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Since the Tax-Free Savings Account (TFSA) was introduced in 2009, it has been used by Canadians to earn investment income on a tax-free basis. Many U.S. citizens, however, have shied away from this account for several reasons. But should TFSAs really be avoided by all U.S. citizens? While there are some roadblocks to owning and deriving income from this account, they can potentially be overcome by some U.S. taxpayers.
A primer on the TFSA
Contributions of after-tax funds can be made to a TFSA up to an annual prescribed amount ($6,500 for 2023). Any unused amount can be carried forward to the future. As of 2023, anyone who was 18 years of age or older in 2009 (the year of the TFSAs inception) can contribute up to $88,000 if they never contributed before.
The benefit of the account is that funds can be invested in a myriad of investments such as stocks, bonds, mutual funds, ETF’s and GIC’s. The income earned in these accounts (i.e., interest, dividends, or capital gains) is not taxed for Canadian purposes. This makes the account a powerful savings vehicle for Canadians.
Potential problems for U.S. citizen TFSA account holders
The following are the primary barriers thought to render the TFSA ineffective for U.S. taxpayers:
- The requirement to annually file IRS Forms 3520 and 3520-A pertaining to foreign (non-U.S.) trusts to report transactions with and ownership by a U.S. citizen
- Potential for taxation of TFSA income due to U.S. income inclusion
- Producing TFSA income figures without tax slips
IRS Forms 3520 and 3520-A
The IRS requires U.S. taxpayers file these informational forms annually, coinciding with their U.S. tax returns, if they have transactions with (e.g., make contributions to or withdrawals from) and/or own a foreign trust. The TFSA has long been considered by many a foreign trust, necessitating the need for these filings. Failure to file these forms when required (or filing them after their due dates) can attract harsh penalties of USD $10,000 or more. These several-page-long forms providing an accounting of the trust’s holdings and activity are somewhat complex and the associated preparation fees alone can offset any tax benefits that might accrue to the U.S. account holder.
However, in recent years, there have been a growing number of U.S. taxpayers, on the advice of certain cross-border tax practitioners, taking the position that a TFSA, as is normally set up, is not considered a trust for the purposes of this reporting requirement. In short, the TFSA does not meet the criteria for a trust because it is simply an investment account held at a financial institution that doesn’t “… take title to… [the account’s assets]… for the purpose of protecting or conservating it for the beneficiaries…”[1]
While abating this burdensome compliance obligation under this position can provide substantial relief to U.S. account holders, it must be stressed that no authoritative source has ruled, one way or another, on this reporting requirement vis-à-vis TFSA’s. That being said, the IRS has granted abatement of the aforementioned late-filing penalties for certain U.S. TFSA holders on the merits of this argument. At any rate, a tax advisor should be consulted before adopting this position.
Potential for U.S. tax on TFSA income
For U.S. tax purposes, U.S. citizens are generally taxed on all of their income, even if derived outside of the U.S. Since the U.S. Internal Revenue Code (IRC) does not respect the tax shelter of the Canadian TFSA, all income earned inside the account is taxable, even if not withdrawn. This asymmetry has been considered a major weakness of the account for U.S. citizens as it can trigger taxation in the U.S. thereby negating the tax advantage intended with the TFSA. However, this issue can be mitigated, if not eliminated, through the foreign tax credit system.
When Canadian-sourced income (such as employment income, capital gains on the sale of shares to a Canadian resident and dividends paid by a Canadian corporation) is included on a U.S. tax return, a foreign tax credit (FTC) is allowed based on the Canadian tax paid and used to offset U.S. tax payable on this income. In fact, since Canadian tax rates are higher than U.S. federal tax rates across virtually all tax brackets[2],[3], most U.S. citizens generate enough FTC’s to eliminate their tax liability on Canadian income.
To see how this applies to TFSA income, it is necessary to understand how FTC’s are computed. The IRC requires income to be categorized by type. Most taxpayers have income of only two types for the purpose of the FTC system: general and passive. General income is earned from employment or business activities whereas passive income includes investment income, such as interest, dividends and capital gains (including such income earned inside a TFSA). The foreign (Canadian) tax paid must be proportionally bifurcated among these two type of income and applied against the U.S. tax accordingly. There is no “mixing and matching,” so a U.S. taxpayer with TFSA income but no other passive income cannot use his or her Canadian tax paid on employment (general) income to offset the tax payable attributed to TFSA income.
Mitigating U.S. tax on TFSA income may prove to be difficult for U.S. taxpayers without taxable-in-Canada Canadian investment income[4] (earned outside a registered account). To the extent FTC’s allocated to passive income fall short, there will be residual U.S. tax paid which will deny the tax benefits of the TFSA. This limitation especially applies to younger Americans who have not yet exhausted their contribution room in their registered accounts (e.g., TFSA and Registered Retirement Savings Plan).
However, other U.S. taxpayers with significant Canadian investment income should find their U.S. tax on TFSA income eliminated due to the generated passive FTC’s. While there is no Canadian tax paid on TFSA income, since Canadian tax rates are relatively higher, a surplus of FTC’s should still be produced. FTC’s in excess of the U.S. tax liability for a particular year can be carried forward to future tax periods.
Producing TFSA income figures without tax slips
Because TFSA income isn’t reported on traditional tax slips, figuring the correct amount of income to report can be difficult. Year-end brokerage statements might neatly summarize annual interest and dividend amounts but determining the correct capital gains figures can be complicated. For each transaction, the following items must be tracked for proper reporting on the U.S. tax return: date of sale, original purchase date[5], sale proceeds and tax basis. Investment brokerages generally do not provide tax bases summaries as they aren’t relevant for transactions that are tax-exempt for Canadian purposes. Without the convenience of tax slips or appropriate income summaries, account holders can be left scrambling to provide their accountants the proper information.
This reporting challenge is not insurmountable. Prospective TFSA holders can investigate at the outset whether their broker or financial advisor of choice can provide income reports so that the relevant figures can easily be extracted for the U.S. tax return. Additionally, a leaner portfolio of only a few holdings will simplify the process. While a bookkeeper can be commissioned to accurately track investment income, this additional cost is obviously undesirable.
How to proceed
A U.S. citizen wanting to invest through a TFSA should consult with their tax advisor to ensure the tax benefits will outweigh the costs (both tax and accounting). Investment income, both inside and outside a TFSA, should be managed to ensure there is no residual U.S. tax liability. Zeifmans has a dedicated tax group with extensive expertise in helping U.S. citizens living in Canada manage these kinds of issues. For any questions on this article or other cross-border tax matters, please contact Stanley Abraham at sa@zeifmans.ca or 647-256-7551.
Notes
- § 301.7701-4(a)
- The 2022 Canadian and U.S. marginal tax rates on income (other than the types of income mentioned in the next note) taxed in the highest bracket are 53.53% and 37%, respectively.
- Dividends received from a Canadian corporation (considered “eligible” for Canadian tax purposes and “qualified” for U.S. tax purposes) are taxed at a highest tax rate of 39.34% and 20%, respectively. Long-term capital gains (on shares held for more than one year) are taxed at a highest tax rate of 26.76% and 20%, respectively. The highest tax rate on short-term capital gains (on shares held for one year or less) is actually higher in the U.S. (37%) than in Canada (26.76%). Therefore, all else being equal, short-term capital gains should be minimized; this is consistent with the directive to simplify the TFSA portfolio mentioned later in the article.
- U.S. dividends are not considered foreign (passive) income. As such, the tax thereon cannot be offset by FTC’s. Therefore, U.S. dividend-paying securities should not be held inside a TFSA.
- Transaction dates are important for two reasons. Firstly, the sale proceeds and tax bases must be converted to U.S. dollars using the foreign exchange spot rate from the sale and original purchase dates, respectively. Secondly, the timespan of each holding must be ascertained to determine whether the lower long-term capital gains tax rate (mentioned in a previous note) is applicable.
