Canadian Tax-Free Savings Accounts (“TFSAs”) can be an excellent way to accumulate savings which will generally never be subject to Canadian income tax while they grow in value whether through investment income or gains. TFSAs have been around since 2009 and began with annual contribution limits of C$5,000. Beginning in 2015, the contribution limit increased to C$10,000. While they offer significant benefits to Canadian residents, US persons with interests in TFSAs should be aware of the US tax treatment of these accounts.
TFSAs are not afforded tax-free treatment under US domestic tax law because they are not available in the US. Moreover, unlike Registered Retirement Savings Plan, the Canada – US Income Tax Convention does not specifically address TFSAs and give them the same tax-free status they enjoy in Canada. The result? A US person who earns income in a TFSA will be subject to US tax on that income even though the income will generally not be subject to Canadian income tax.
More concerning then the US tax treatment of TFSAs is the potential information disclosures that could result where TFSAs are treated as non-US trusts for US tax purposes. US persons treated as owners of non-US trusts must annually file IRS Form 3520, Annual Return to Report Transactions With Foreign Trusts and IRS Form 3520-A, Annual Information Return of Foreign Trust with a US Owner. These forms are far from straight forward to complete and the professional costs to have them prepared can often well exceed the annual income earned in the TFSA. Failure to timely file these disclosures can result in penalties of US$10,000 or more per occurrence.
The question then is whether Canadian TFSAs are non-US trusts for US tax purposes. There is no consensus on this subject among US tax practitioners in Canada partly because of the IRS’ reluctance to issue guidance concluding whether TFSA trust arrangements meet the definition of trusts for US tax purposes. Furthermore, many cross-border tax advisors have concluded that TFSAs are trusts for US tax purposes simply because they are more often than not trust arrangements under Canadian law. Regardless of the TFSA status as a trust arrangement under Canadian law, US tax law determines whether these arrangements are trusts under the Internal Revenue Code and US Treasury Regulations thereunder.
Based on recent Revenue Rulings issued by the Internal Revenue Service discussing the US tax treatment of non-US trust arrangements formed in various jurisdictions, we have concluded that TFSAs are not trusts for US tax purposes. While this offers relief from filing non-US trust disclosures, there may be other applicable information disclosures required if a US person owns a TFSA with funds invested in non-US mutual funds.