Canadians have taken advantage of the tax-free savings account (TFSA) since its introduction in 2009. Yet, there can be tax consequences for Canadians who hold foreign investments in TFSAs. In addition, U.S. persons may face tax consequences when investing within a TFSA.
Let’s first look at your Canadian (and non-U.S.) clients and how tax can apply to their TFSA investments.
It’s possible to hold foreign investments in a TFSA and have no Canadian tax apply on dividends paid to the account. However, withholding tax applies.
For instance, the Internal Revenue Service (IRS) generally applies withholding tax of 15% (30% in some cases) on dividends paid to a TFSA. If your client invests in a stock that pays a $400 dividend with 15% withholding tax, $340 would be deposited to their TFSA. The client would be unable to recoup the withholding tax in the form of a foreign tax credit because no tax would be paid in Canada. This means they essentially lose a portion of the dividend.
If, on the other hand, your client holds the U.S. dividend-paying stocks in a non-registered account, they’ll have access to a foreign tax credit. (With the non-registered account, if the investment has a cost basis greater than $100,000 at any time in the year, the client must complete the T1135 Foreign Income Verification Statement.)
Another option is to have your client hold U.S. dividend-paying stocks in a retirement account. When U.S. dividends are paid to an RRSP or RRIF, withholding tax doesn’t apply because the IRS recognizes the account as a tax-deferred retirement account under the Canada-U.S. tax treaty.
Now, let’s look at issues that can arise for a U.S. person.
A TFSA isn’t considered tax-free in the U.S., so U.S. persons must pay U.S. income taxes annually on the account’s income and capital gains.
Information disclosures are also necessary. A TFSA is considered a foreign trust, and the IRS requires that Form 3520 Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts and Form 3520A Annual Information Return of Foreign Trust with a U.S. Owner be filed annually. A tax preparer will likely charge an additional fee to file these forms.
(Note that RESPs and RDSPs are also considered foreign trusts, but the 3520 and 3520A reporting requirement was eliminated for those accounts in 2020.)
If the client’s non-U.S. accounts total more than US$10,000 at any time during the year, a Report of Foreign Bank and Financial Accounts (FBAR) Form 114 must be completed detailing all foreign accounts they hold including the TFSA. Depending on the client’s net worth, other IRS information disclosures may be required.
If the TFSA invests in a passive foreign investment company (PFIC), additional reporting will be required. A PFIC is a non-U.S. corporation that has passive income of 75% or more of its gross income, and 50% or more of the corporation’s assets produce passive income, which generally includes rents, annuities, interest, dividends, royalties and capital gains. Canadian mutual funds and ETFs are considered PFICs.
U.S. persons holding PFICs would generally be required to file IRS Form 8621 Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund annually with their U.S. tax return. To assist with the reporting requirement, some Canadian investment firms provide annual information statements (AIS), which allow the investor to make a qualified electing fund (QEF) election and obtain preferential tax treatment, avoiding high tax rates and interest charges. With the QEF election, income generated in the PFIC is generally taxed as ordinary income, and capital gains are taxed as capital gains, which allows them to be treated more tax-efficiently.
Another benefit to the QEF election is that income and capital gains are taxed in the year they’re received and not allocated to previous years.
The QEF election is available only if the Canadian mutual fund provides the AIS.
The fact that the investment income in the TFSA is taxable in the U.S. but cannot be recouped in Canada as a foreign tax credit makes the TFSA less attractive for U.S. persons living in Canada.
Even though the TFSA is generally an excellent account type for tax-free savings, it’s not a perfect fit for everyone. It’s important that your clients are aware of the tax issues that could arise, whether they’re invested in U.S. dividend-paying stocks or if they’re a U.S. person.