On October 7, 2014 the IRS released Revenue Procedure 2014-55, which purports to make US tax filing easier for US citizens or residents who own Canadian Registered Retirement Savings Plans (“RRSPs”) or Registered Retirement Income Funds (“RRIFs”). Almost immediately, journalists and commentators breathlessly heralded the development as a softened and practical solution for individuals that own these Canadian retirement plans.
You can’t blame the commentators for their ebullience: the prior procedures for electing tax deferral were complex, expensive, and produced uncertain results. Further, even the IRS’s press release hinted at merciful relief: IRS Simplifies Procedures for Favorable Tax Treatment on Canadian Retirement Plans and Annual Reporting Requirements. Close examination of the new procedures, however, reveals a mixed offering of good, bad, and outright confusion.
Background on electing tax deferral for RRSPs and RRIFs: the harsh “Old Rules”
Article XVIII(7) of the United States – Canada Income Tax Convention (the “Treaty”) provides that an individual may defer taxation on income accumulated in RRSPs and RRIFs, however, the individual must make an affirmative annual election in order to avail himself of the tax-free accumulation. Starting in 2004, the election to defer income in these Canadian retirement plans was made annually on the US form 8891 and included with a timely filed US income tax return.
If the individual had not timely filed US returns, or if he has missed a few years, he could not remedy this problem by simply filing the delinquent forms 8891. The only solution to the problem of unfiled (or late-filed) forms 8891 was to apply to the IRS for permission to make a late election to defer income.
Treasury Regulation 301.9100-1(c) gives IRS the discretion to grant a taxpayer a reasonable extension of time to make a regulatory election (such as the election to defer income tax on the form 8891) provided:
1. The taxpayer pays the user fee, which is $6,900 for 2014;
2. The taxpayer acted reasonably and in good faith; and
3. Granting the extension will not prejudice the interests of the US Government.
These requirements are deceptively difficult to satisfy and do not guarantee that the IRS will grant the taxpayer the ability to make the late election. I address these requirements in greater detail below.
The process of making the application was complex and expensive. The combination of professional fees and the user fee could easily exceed the taxes saved by making the election.
New Procedures to elect tax deferral for “Eligible Individuals”… the good news for some
The good news provided in the Revenue Procedure is that “Eligible Individuals” are no longer required to file form 8891 to ensure that, for US purposes, the income in an RRSP or RRIF grows tax free. The even better news is that (again for Eligible Individuals) the individual does not need to apply for a ruling in order to make a late election to defer income these Canadian retirement plans.
In order to defer the income in an RRSP or RRIF the Eligible Individual need only make an election when there is a distribution from one of these types of plans. The Revenue Procedure does not provide the details as to how this election will be made, presumably that will follow at a later date.
Who is an “Eligible Individual?”… the bad news for many Canadians
Clearly, Eligible Individuals will benefit from the procedures set forth in Rev. Proc. 2014-55, however, close examination shows that many Canadians will not qualify.
According to Section 4.01 an Eligible Individual is a beneficiary of a Canadian RRSP or RRIF who, inter alia:
Has satisfied any requirement for filing a US Federal income tax return for each taxable year during which the individual was a US citizen or resident.
I’ve added emphasis to the two critical terms in the definition. First, in order to be classified as an Eligible Individual, the taxpayer must have satisfied any filing requirements. Note the operative term is “any” and not “all.” This is a taxpayer-friendly term because it does not require the individual seeking Eligible Individual status to have filed each and every of the multiple forms and returns typically required of US citizens living abroad. The individual must demonstrate only that he made some attempt at compliance.
Second, in order to be classified as an Eligible Individual, the taxpayer must have made some attempt at compliance for each taxable year. This second term is problematic for many US citizens living in Canada because many (and in my practice I would say “most”) have missed tax filing and reporting for one or more years. As a result, these US citizens residing in Canada will not be classified as Eligible Individuals and therefore will not be entitled to the simplified procedures outlined in the Revenue Procedure unless they go back and make some attempt at compliance for each and every year.
Consequences of not being an “Eligible Individual”… welcome back to the harsh ‘Old Rules’
Section 4.04 of the Revenue Procedure provides that those individuals who have not satisfied any US tax filing obligation for each year must seek the consent of the IRS in order to elect deferral of the income generated by RRSPs and RRIFs. How does one obtain the consent of the IRS in order to make this election? By following the old rules found in Treasury Regulation 301.9100-1(c) discussed briefly above.
Recall that the IRS may grant relief under Treasury Regulation 301.9100 provided:
1. The taxpayer pays the user fee ($6,900 in 2014); and
2. The taxpayer acted reasonably and in good faith; and
3. Granting the extension will not prejudice the interests of the US Government.
As I noted earlier, these requirements can be deceptively difficult to satisfy for several reasons.
The taxpayer must have acted reasonably and in good faith
Treasury Regulation 301.9100-3(e) provides that the taxpayer must submit evidence that supports his assertion that he acted in good faith. This evidence must include an affidavit from the taxpayer that explains the events leading to the failure to make the election to defer income and his subsequent discovery of the failure. Further, this evidence may also require affidavits from other individuals (including advisors) who know about the events leading to the failure to make the election and the discovery thereof.
Per 301.9100-3(b)(1) the individual will be treated as acting reasonably and in good faith if:
1. The taxpayer applies for an extension before the IRS discovers the failure to make the election;
2. Intervening events beyond the taxpayer’s control caused the taxpayer to fail to make the election;
3. After exercising reasonable diligence, the taxpayer did not realize that an election was necessary;
4. The taxpayer relied on the written advice of the IRS; or
5. The taxpayer relied on a qualified tax professional who failed to make, or advise the taxpayer to make, the election.
While the term “qualified tax professional” is not defined in the Internal Revenue Code or Treasury Regulations, the final element may be difficult to satisfy for many individuals residing in Canada because 301.9100-3(b)(2) provides that it is not reasonable to rely on a tax professional who was not competent to render advice on the election. It is an open issue whether a Canadian tax professional who has no US training or experience would satisfy this last element.
301.9100-3(b)(3) further provides that in certain circumstances the taxpayer will be deemed to not have acted reasonably and in good faith:
1. If the failure to make the election could have exposed the taxpayer to the accuracy-related penalties under Section 6662 of the Internal Revenue Code;
2. The taxpayer was informed in all material respects of the election and related tax consequences, but chose not to make the election; or
3. Uses hindsight in requesting relief.
The Interest of the US Government is not prejudiced by granting the election
While it can be difficult to substantiate that the taxpayer acted reasonably and in good faith, it can be even more difficult to establish that the interests of the US Government will not be prejudiced. Treasury Regulation 3019100-3(c)(1)(i) provides that the US Government’s interests will be prejudiced if:
Granting the relief would result in the taxpayer having a lower tax liability for the tax years to which the election applies.
In other words, if allowing the individual to make a late election to defer the tax on income generated by an RRSP or RRIF will result in lowering his US tax liability, the request will be denied. Frequently the individual will have excess US foreign tax credits in the applicable years, the use of which should result in no additional tax owing to the US. In those cases the election should be granted, however, that result is far from certain.
“Eligible Individuals” face new, confusing filing obligations
Before the new rules set forth under the Revenue Procedure, beneficiaries of Canadian RRSPs and RRIFs were required to file the form 8891 annually in order to defer the income generated by these plans. From 2004 through 2012 there was no additional penalty for failing to file the form 8891, the taxpayer simply was simply not allowed to defer the income generated by the plan in that year (unless he requested a ruling, see above). Starting in 2012, however, and pursuant to section 6038D of the Internal Revenue Code, beneficial interests in RRSPs and RRIFs were required to be reported on the form 8938 unless the form 8891 was filed. 1.6038-7T(a)(1).
Now that beneficiaries of these Canadian retirement plans may no longer use the form 8891 they must report their ownership on the form 8938. Unfortunately, the form 8938 contains $10,000 failure to file penalty. While the Revenue Procedure makes this result clear in Sections 2, 5.01, and 5.02, it doesn’t address the enhanced penalty structure that may apply.
The enhanced penalty structure is even more onerous than the failure to file penalty. If the IRS notices that the form 8938 was not filed properly, it will send a notification to the taxpayer. If the taxpayer does not respond to the IRS’s inquiry within 90 days Section 6038D(d)(2) imposes an additional $10,000 penalty for each 30 day period that elapses following the notice. Fortunately, these enhanced penalties are capped at $50,000 per year. Worse still, the willful failure to file form 8938 may result in criminal penalties per Treasury Regulation 1.3038D-8T(f)(2).
RRSPs and RRIFs are foreign trusts however exempt from filing as such
In Notices 2003-25 and 2003-57 the IRS concluded that these Canadian retirement plans were foreign trusts and therefore subject to reporting on the forms 3520 and 3520-A per section 6048. Notice 2003-75 exempted RRSPs and RRIFs substituted the new form 8891 for forms 3520 and 3520-A. In Section 5 the Revenue Procedure acknowledges the IRS’s position that these retirement plans are foreign trusts, however continues to exempt them from reporting on the forms 3520 and 3520-A.
Revenue Procedure 2014-55 causes confusion and requires clarification
There is little question that IRS intended the Revenue Procedure to be taxpayer favorable, one need look no further than the title of the press release for evidence of this. However, there are certain omissions and inconsistencies that require clarification.
Conflicting direction regarding taxability of distributions from RRSPs and RRIFs
Sections 6 and 4.02 provide that accrued income on RRSPs and RRIFs must be reported by the individual for US tax purposes. Further, Section 6 provides that the accrued income must be reported consistent with §72 of the Code. In other words, only the income from RRSPs is taxable in the U.S. when it is distributed.
This result is directly contrary to the example in Section 7, which provides that the entire amount of the distribution is subject to taxation in the U.S. This result makes sense if the contribution to the RRSP is deductible for U.S. purposes but makes no sense if the contribution is not deductible.
The Revenue Procedure needs to be clarified to make clear that:
1. If contributions to the RRSP or RRIF are deductible for U.S. purposes (Article XVIII:8 of the Treaty) then the entire amount of distributions from the RRSP will be includable in income for U.S. purposes, which is consistent with Section 7 and the taxation of US retirement plans such as Individual Retirement Plans, 401K plans, etc.;
2. Only if the contribution to the RRSP is nondeductible for US purposes should the income be subject to U.S. tax. This would be consistent with Sections 6 and 4.02.
Admittedly, Section 4.01 makes clear that the Revenue Procedure addresses only income accrual and not the deductibility of such contributions for US purposes. However, as noted above the manner in which it addresses the US taxability of such distributions is inconsistent and requires this clarification.
The effect of the Revenue Procedure on other IRS voluntary disclosures programs
The Offshore Voluntary Disclosure Program (“OVDP”), Streamlined Domestic Offshore Procedures, and Streamlined Foreign Offshore Procedures provide taxpayers a clear protocol for becoming compliant with tax and filing obligations when there have been prior-period omissions. All three of these voluntary disclosure protocols afford the participant the ability to make late elections regarding RRSPs and RRIFs by following certain rules.
What is unclear, however, is the manner in which these protocols will work with Revenue Procedure 2014-55, if at all. If the Revenue Procedure supplants the procedures found in the voluntary disclosure programs, many Canadians will be left in the unenviable position of having to request a ruling in order to defer the income generated by these common Canadian retirement plans, which will add cost, complexity, and uncertainty to their participation.
In simple terms the new US procedures for electing US tax deferral for Canadian RRSPs and RRIFs do not live up to their billing. While the rules under Revenue Procedure 2014-55 do afford a better option for Eligible Individuals, many Canadian residents will not qualify because they have not filed any returns for one or more tax years. As such, these individuals will be left with little choice but to seek leave to file a late election pursuant the complex, expensive, and uncertain ruling procedure.