Canadian RRSPs: U.S. tax considerations.

Taxpayers in the U.S. can use an individual retirement account (IRA) as a tax-advantaged investment vehicle to accumulate funds for retirement. Canadian taxpayers have a similar option available called a registered retirement savings plan (RRSP). Tax preparers need to be aware of the consequences for an individual with RRSPs who becomes subject to U.S. income taxation and the relief available under the United States/Canada Income Tax Treaty (Treaty).

RRSPs vs. IRAs

RRSPs and IRAs share many characteristics. Contributions to an RRSP are deductible in determining Canadian taxable income. The earnings of an RRSP are deferred from Canadian income tax until actual distributions are made from the plan. RRSP withdrawals must begin before the end of the year in which the participant turns 69 years old.

Unlike IRAs, however, RRSPs generally do not allow nondeductible contributions. Distributions before retirement are allowed without penalty. Eighteen percent of earned income, up to a maximum of $13,500, can be contributed to an RRSP each year. Because of the significant tax benefits offered by RRSPs, they are quite popular with Canadian taxpayers.

U.S. Tax Consequences

For U.S. income tax purposes, current-year earnings of an RRSP are not eligible for tax-deferred treatment, since an RRSP is not a qualified retirement plan under the Internal Revenue Code. For this reason, a U.S. taxpayer who is a participant in an RRSP is subject to U.S. income tax on the RRSP's undistributed annual earnings. The RRSP is treated no differently for U.S. income tax purposes than a regular savings account.

Besides the obvious problem of Canadian tax-deferred earnings being taxed in the U.S., this situation also creates a mismatch between the year in which the income is reported and the year in which the tax is paid for purposes of claiming a foreign tax credit.

Election Available

A recent amendment to the Treaty added Article XVIII(7), providing for an election to defer taxation on income accrued in, but not distributed from, a pension or retirement plan. The new election is to be made "under rules established by the competent authority" of the U.S. or Canada. As this item goes to press, the IRS has not issued guidance on this election.

Prior to the Treaty's amendment, Article XXIX(5) explicitly provided for an election to defer U.S. income taxes on an RRSP's annual earnings. Article XXIX(5) has been deleted from the Treaty in connection with this recent amendment. The old election under Article XXIX(5) applied only to income reasonably attributable to contributions made to the RRSP while a resident of Canada. The new election under Article XVIII(7) applies to any income earned but not distributed by the RRSP.

In Rev. Proc. 89-45, the IRS set out the information needed to make the old election. Even though the provision on which it was based has been deleted from the Treaty, the revenue procedure provides insight as to certain information that might be required when making an election under Article XVIII(7).

The election under Rev. Proc. 89-45 was made on the participant's U.S. income tax return by attaching a statement with the following information for each RRSP owned:

1. The name of the plan trustee and the plan account number.

2. The plan's total earnings for the year.

3. The total contributions made to the plan while the taxpayer was a Canadian resident, as of the end of the current tax year (including rollover amounts).

4. The total contributions made to the plan in all tax years (including rollover amounts).

5. The amount of earnings deferred for the current year, determined by multiplying the plan's total earnings for the year by a fraction, the numerator of which was the total contributions made to the plan while a Canadian resident and the denominator of which was the total contributions made to the plan in all tax years.

6. The balance in the plan at the end of the current tax year.

It appears that items 3 and 4 and the determination of earnings deferred under item 5 are no longer relevant, since Article XVIII(7) now states that the deferral election applies to any income earned in the RRSP. Until further guidance is issued by the Service, tax prepares making the election to defer the annual earnings of an RRSP from U.S. income taxation, for tax years beginning after 1995, should consider doing so under Article XVIII(7), rather than Rev. Proc. 89-45.

The revenue procedure further provided the old election was to be attached to the participant's timely filed U.S. income tax return (including extensions). The old election could not be revoked unless the IRS consented and the revocation applied to all RRSPs. A separate old election was required if a spouse was a participant in an RRSP. Once the old election had been made, a statement had to be attached to the participant's U.S. income tax return in each year subsequent to the election, stating

--the last tax the old election was made, and

--the balance in the plan at the end of the current tax year.

Appearances Can Be Deceiving

As cross-border economic activity increases, preparers of U.S. income tax returns for taxpayers with RRSPs need to be aware of the U.S. income tax implications for what appears to be earnings exempt from taxation. Most taxpayers have no reason to suspect that earnings from their tax-deferred RRSP might be subject to taxation in the U.S. Tax prepares should also recognize that the election under Rev. Proc. 89-45 is based on an obsolete Treaty provision; practitioners who have clients with RRSPs should be watching for guidance from the Service on the election under Treaty Article XVIII(7).