RESP and U.S. Taxes: What U.S. Citizens Living in Canada Should Know

A Registered Education Savings Plan (RESP) is one of Canada’s most popular ways to save for a child’s post-secondary education. Contributions can attract valuable government grants, and investment income can grow tax-deferred for Canadian tax purposes.

However, RESP and U.S. taxes can become more complicated when the subscriber, beneficiary, or both are U.S. citizens or otherwise subject to U.S. taxation. The reason is simple: an RESP receives special tax treatment in Canada, but the United States does not necessarily follow the same rules.

For U.S. citizens living in Canada, understanding the cross-border treatment of an RESP can help prevent unexpected U.S. income and reporting issues.

How an RESP Works in Canada

An RESP is a Canadian registered account established to save for a beneficiary’s post-secondary education. Contributions to an RESP are not tax deductible. However, investment income generally accumulates inside the plan without current Canadian income tax.

RESPs may also receive government incentives such as the Canada Education Savings Grant (CESG) and, where applicable, the Canada Learning Bond (CLB). When the beneficiary attends an eligible post-secondary institution, the RESP can generally make two types of payments:

• withdrawals of the subscriber’s original contributions; and

• Educational Assistance Payments (EAPs), which generally consist of investment earnings and government education incentives.

For Canadian tax purposes, a return of contributions is generally not taxable. EAPs are generally taxable to the student receiving them. Because students often have relatively little other taxable income, the Canadian tax resulting from an EAP may be relatively low.

RESP and U.S. Taxes: Why the Treatment Is Different

The main cross-border issue is that U.S. citizens are generally subject to U.S. federal income tax on their worldwide income, even while living in Canada. Canada's decision to defer Canadian taxation inside an RESP does not automatically create the same tax deferral in the United States.

As a result, a U.S. person connected with an RESP should not assume that income accumulating inside the account can simply be ignored until money is withdrawn.

The U.S. tax treatment depends on the structure of the RESP, ownership of the account, the investments held inside it, and the U.S. tax status of the people involved.

Who Is the RESP Subscriber?

The subscriber is particularly important when considering U.S. tax consequences. The subscriber is the person who establishes the RESP and makes contributions to the plan. Depending on the circumstances, a U.S. subscriber may be treated as owning the RESP or its underlying assets for U.S. federal tax purposes.

This can potentially cause income earned within the account — such as interest, dividends and capital gains — to have U.S. tax consequences before a distribution is made from the RESP. For that reason, families with a U.S. citizen or U.S. resident subscriber should consider the U.S. consequences separately from the Canadian RESP rules.

What About Forms 3520 and 3520-A?

Historically, one of the biggest concerns surrounding RESPs was whether they were treated as foreign trusts for U.S. reporting purposes, potentially resulting in Forms 3520 and 3520-A.

The IRS provided significant relief in Revenue Procedure 2020-17. Under this guidance, certain eligible U.S. individuals with qualifying tax-favoured foreign trusts established to provide educational benefits may be exempt from the Form 3520 and Form 3520-A reporting requirements. This relief can apply to qualifying education savings arrangements when the requirements of Revenue Procedure 2020-17 are satisfied.

This is an important development for U.S. taxpayers with Canadian education savings accounts. However, the exemption from Forms 3520 and 3520-A does not necessarily mean that all U.S. tax or other information-reporting obligations associated with an RESP disappear. The particular plan and taxpayer should still be reviewed to determine whether the exemption applies.

Does the RESP Still Need to Be Reported on an FBAR?

Potential foreign account reporting should also be considered. A U.S. person may have to file an FBAR (FinCEN Form 114) when the aggregate value of foreign financial accounts in which the person has a financial interest or signature authority exceeds the applicable reporting threshold. Whether an RESP is reportable should therefore be reviewed as part of the taxpayer's overall foreign-account reporting position.

Importantly, the relief provided for certain foreign trusts under Revenue Procedure 2020-17 concerns the foreign trust information-reporting rules. It should not automatically be interpreted as an exemption from other U.S. reporting requirements.

What About Form 8938?

Form 8938, Statement of Specified Foreign Financial Assets, should also be considered.

U.S. taxpayers who meet the applicable filing thresholds must report certain specified foreign financial assets. The thresholds depend on filing status and whether the taxpayer lives in or outside the United States. An interest in an RESP may therefore need to be considered when determining whether Form 8938 is required.

Form 8938 and the FBAR are separate reporting regimes. Filing one does not automatically eliminate a requirement to file the other.

Investments Inside the RESP Matter

Another important issue is what the RESP owns. Many Canadian investment accounts hold Canadian mutual funds or exchange-traded funds (ETFs). For a U.S. taxpayer, certain non-U.S. pooled investments can potentially be classified as Passive Foreign Investment Companies, commonly known as PFICs.

PFIC ownership can create complicated U.S. tax and reporting requirements, including possible Form 8621 filing obligations. Therefore, when reviewing RESP and U.S. taxes, it is important to look beyond the RESP itself and examine the investments held inside the account.

A Canadian investment that appears straightforward from a Canadian tax perspective may have significantly different consequences under U.S. tax law.

Are RESP Contributions Tax Deductible in the United States?

RESP contributions are not deductible for Canadian income tax purposes, and contributing to an RESP generally does not create a U.S. income tax deduction either.

The primary Canadian benefits of an RESP are the tax-deferred accumulation of investment earnings and access to government education incentives rather than an upfront deduction for contributions.

What Happens When Money Is Withdrawn?

Canadian and U.S. tax treatment should be analyzed separately when money begins coming out of an RESP. For Canadian purposes, the subscriber's original contributions can generally be returned without tax, while EAPs containing investment earnings and government incentives are generally taxable to the beneficiary.

The U.S. treatment may not match this Canadian characterization. For example, if a U.S. taxpayer has already been required to recognize some of the RESP's investment income for U.S. purposes, simply taxing the Canadian EAP in the same manner for U.S. purposes could produce an incorrect result.

The taxpayer's prior U.S. reporting, ownership of the RESP, the identity and U.S. status of the beneficiary, and the components of the distribution should therefore be considered.

What If the Child Is Also a U.S. Citizen?

An additional layer of complexity arises when the RESP beneficiary is also a U.S. citizen.

A U.S. citizen child generally remains subject to U.S. federal income tax rules regardless of residence. Accordingly, distributions from an RESP may need to be reviewed from both the subscriber's and beneficiary's perspectives. This becomes particularly important when the subscriber and beneficiary do not have the same U.S. tax status.

For example, a Canadian parent who is not a U.S. person may establish an RESP for a child who is a U.S. citizen. That situation can produce different U.S. considerations from an RESP established and funded by a U.S. citizen parent.

Before Opening or Contributing to an RESP

U.S. citizens living in Canada do not necessarily need to avoid RESPs. The Canadian benefits, including government grants, can be valuable. However, cross-border families should understand the U.S. consequences before assuming that an RESP operates the same way on both sides of the border.

Before opening or substantially funding an RESP, consider:

• whether the subscriber is a U.S. person;

• whether the beneficiary is a U.S. person;

• how investment income inside the RESP will be treated for U.S. purposes;

• whether Revenue Procedure 2020-17 applies;

• whether FBAR or Form 8938 reporting may be required; and

• whether the RESP holds Canadian mutual funds, ETFs, or other investments that may create PFIC reporting issues.

The Bottom Line

An RESP can be an excellent Canadian education savings vehicle, but RESP and U.S. taxes require additional planning when U.S. citizens are involved. Canadian tax deferral does not automatically mean U.S. tax deferral, and relief from Forms 3520 and 3520-A does not necessarily eliminate other U.S. income tax and information-reporting obligations.

For U.S. citizens living in Canada, the best approach is to consider the U.S. consequences when the RESP is established — not years later when the child begins university and distributions start.

At Elefant Tax Bureau, we help U.S. citizens and cross-border families understand the interaction between Canadian accounts and U.S. tax and reporting requirements.