January 30, 2020
POTENTIAL PITFALLS FOR CANADIAN RESIDENTS WITH U.S. ROTH IRAs
The ownership of a United States Roth IRA (Roth) pension plan presents many unresolved Canadian tax complexities for a U.S. citizen moving to, or from, Canada, or for a Canadian who previously resided in the U.S. and returned to Canada.
Canada Revenue Agency (CRA) Income Tax Technical News No. 43 provides helpful guidance on the Canadian taxation of Roths and the related application of the tax treaty between Canada and the United States. It distinguishes between three different types of Roth vehicles, namely:
- Custodial accounts,
- Roth IRA trusts, and
- Annuity or endowment contracts.
Absent tax treaty considerations, Canada taxes the owner of a custodial Roth annually on the earnings inside the plan because the Roth is not considered a “foreign retirement arrangement” under Canadian domestic tax law. Also, in limited circumstances, any appreciation in the value of the assets of a custodial Roth may be taxed in Canada when the owner departs Canada. These results may occur despite the fact the earnings and appreciation are generally tax-free in the U.S.
TAX TREATY RELIEF
Article XVIII(7) of the tax treaty between the two countries attempts to rectify this mismatch by permitting the Roth owner to make a Canadian election to defer current Canadian tax on the Roth’s earnings. A valid Canadian election results in the Roth being considered a “pension” for tax treaty purposes, provided no contribution is made to the Roth after December 31, 2008, while a resident of Canada (the latter is referred to as a “Canadian contribution”). An individual who becomes a resident of Canada after December 31, 2009, should make the election by the due date of his/her first Canadian income tax return.
This International Tax Alert addresses only the following three Canadian tax issues associated with Roths that are custodial accounts:
- Canadian penalties for noncompliance with reporting requirements for Roths,
- The present unsettled Canadian tax implications for certain Roth rollovers, and for Roths inherited after moving to Canada, and
- The present unsettled status of Canada’s departure tax on individuals who relinquish Canadian residency while owing a Roth.
CRA is presently reviewing an update to Income Tax Technical News No. 43, which is expected to address the three issues above, as well as other Roth matters.
1. Canadian Penalties for Noncompliance with Roth Reporting Requirements
Absent a valid Canadian election described above, the Canadian resident individual may be required to annually file Form T1135 (Foreign Income Verification Statement), Form T1141 (Information Return re Transfers or Loans to a Non-Resident Trust, and/or Form T1134-B (Information Return re Controlled Foreign Affiliates), and possibly Form T1142 (Information Return re Distributions from a Non-Resident Trust). The exemption provided on those forms for a “U.S. Individual Retirement Account” does not apply to Roths. The various potential penalties for noncompliance can be significant.
Fortunately, in Income Tax Technical News No. 43, CRA advised that the foregoing forms are not required for a Roth if a valid treaty election was made, and there were no Canadian contributions.
2. The Canadian Tax Status of Roth Rollovers and Inherited Roths
As explained above, the tax treaty election for a Roth is no longer valid if there is a Canadian contribution. CRA Income Tax Technical News No. 43 states “a Canadian contribution does not include rollover contributions from (emphasis added) another Roth IRA or Roth 401(k) arrangement that qualifies as a “pension” under Article XVIII”. What does that mean?
Example 1: It seems clear that a validly elected Roth #1 of an individual can be rolled over to Roth #2 for that individual, assuming a valid election had been made for Roth #2 and there were no “other” Canadian contributions. In this case, the original election for Roth #2 will continue in effect.
Example 2: Assume the same facts as Example 1, except a valid election was not made for Roth #1. In that case the rollover is not from another elected Roth. CRA Income Tax Technical News No. 43 is not clear as to whether that would constitute a Canadian contribution, thus denying benefits to the amount rolled over and perhaps terminating the election for Roth #2. CRA’s planned update to Income Tax Technical News No. 43 is expected to revisit the rollover issue in more depth.
Adding to the complexity is the issue of whether an inherited Roth may be treated as a valid rollover. Inherited Roths could possibly be further separated into the following sub-categories:
- Roths inherited from a non-spouse, and
- Roths inherited from a spouse.
One view is that the inheritance of a Roth from a non-spouse may be similar to Example 2 above, and could be treated as a Canadian contribution. However, a spousal rollover may be treated differently. In the U.S., it is permitted, and common (though not required), for the surviving spouse to consider the decedent’s Roth as his/her own. Thus, the update to CRA Income Tax Technical News No. 43 may clarify whether special treatment is available for an inherited spousal Roth.
3. Roths and Canada’s Departure Tax
CRA Form T1243 (Deemed Disposition of Property by an Emigrant of Canada) provides an exemption from departure tax for property inherited after becoming a Canadian resident, provided the inheriting individual was a resident of Canada for 60 months or less during the 10-year period before departing Canada.
In other cases, it seems possible that the assets in a Roth custodial account, and for which a valid treaty election is not presently in effect, would be subject to departure tax, subject to Canada’s other cross-border tax rules, including any potential increase in Canadian adjusted cost base for assets owned at the time of adopting Canadian residency.
Although it may seem logical that a Roth custodial account for which a valid treaty election is in effect should be exempt departure tax, for definitive guidance we must await the update to Income Tax Technical News No. 43.
As indicated at the outset, the comments in this International Tax Alert apply only to Roths that are custodial accounts. Different rules may apply to Roths that are Roth IRA Trusts, or Annuity or Endowment contracts.
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