TFSA and U.S. Taxes: Why This Canadian Account Can Be Complicated
The Tax-Free Savings Account (TFSA) is one of Canada's most popular savings and investment vehicles. For Canadian tax purposes, its appeal is straightforward: contributions are made with after-tax money, investment income generally grows tax-free, and withdrawals are generally tax-free.
For Americans living in Canada, however, TFSA and U.S. taxes can be a much more complicated combination. U.S. citizen or other U.S. taxpayer cannot assume that an account that is “tax-free” in Canada is also tax-free in the United States. Unlike an RRSP or RRIF, a TFSA does not receive the same special retirement-plan treatment under the Canada–U.S. Income Tax Treaty. That difference can result in U.S. taxable income, foreign-account reporting and, depending on the investments held inside the TFSA, additional forms such as Form 8621.
How a TFSA Works in Canada
A TFSA is a Canadian registered account that can hold many different types of investments, including:
cash and GICs;
stocks;
bonds;
mutual funds; and
exchange-traded funds (ETFs).
Unlike an RRSP contribution, a TFSA contribution is not deductible from Canadian taxable income. Instead, the principal Canadian tax advantage comes later: interest, dividends and capital gains earned inside the account are generally tax-free, and withdrawals are generally not included in Canadian taxable income. That makes the TFSA relatively simple from a Canadian tax perspective. For a U.S. taxpayer, the analysis is different.
Does the United States Recognize the TFSA as Tax-Free?
Generally, no. The United States taxes U.S. citizens and residents on their worldwide income, subject to applicable exclusions, credits, deductions and treaty provisions.
A TFSA does not receive the same specific treaty-based tax deferral available to qualifying Canadian RRSPs and RRIFs. Therefore, simply holding an investment inside a TFSA does not generally make the investment income exempt from U.S. federal income tax. This can create one of the most important differences between a Canadian and U.S. tax return. An amount may be tax-free in Canada but taxable in the United States.
What TFSA Income May Be Taxable in the United States?
The answer depends largely on what the TFSA holds. For example, a U.S. taxpayer may need to consider:
Interest — Interest generated by cash, GICs or similar investments may be reportable for U.S. tax purposes even though it is sheltered inside the TFSA in Canada.
Dividends — Dividends received on investments held in the TFSA may also have to be reported on the U.S. return.
Capital gains — Sales of securities inside a TFSA can potentially generate U.S. taxable capital gains even though Canada generally does not tax those gains within the account.
The practical result can be surprising. A Canadian taxpayer may receive no T3 or T5 requiring the TFSA's investment income to be included on the Canadian T1 return, while the same activity may still need to be tracked for the taxpayer's U.S. return.
A Simple Example
Suppose Emma is a dual U.S.–Canadian citizen living in Toronto. She has a TFSA containing Canadian stocks and cash investments. During the year, the account earns:
$1,000 of interest;
$2,000 of dividends; and
$4,000 of gains from securities she sells during the year.
For Canadian purposes, these amounts would generally remain tax-free inside her TFSA. But Emma should not simply exclude them from her U.S. return because they occurred inside a Canadian TFSA.
The U.S. tax treatment of each item needs to be determined separately. This is why keeping appropriate records for investments held inside a TFSA can be especially important for U.S. taxpayers.
Canadian Mutual Funds and ETFs Can Create Another Problem: PFICs
For U.S. taxpayers, one of the most complicated issues can arise when a TFSA contains Canadian mutual funds or ETFs. Many non-U.S. mutual funds and ETFs may fall within the U.S. definition of a Passive Foreign Investment Company, commonly called a PFIC.
PFIC rules are separate from the question of whether the investment is held inside a TFSA.
A U.S. person who owns shares of a PFIC may have a Form 8621 filing requirement and may be subject to special U.S. taxation rules.
Depending on the circumstances, PFIC taxation may involve:
the default Section 1291 excess-distribution regime;
a Qualified Electing Fund (QEF) election, when available; or
a mark-to-market election for qualifying marketable stock.
These rules can be substantially more complicated than the normal U.S. taxation of stocks and investment funds.
Form 8621 Can Apply to Investments Inside a TFSA
Form 8621 is the Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.
A U.S. person may be required to file Form 8621 for a PFIC under several circumstances, including certain distributions, dispositions, elections and annual PFIC reporting requirements. Importantly, a TFSA should not automatically be treated like a U.S. IRA or other U.S. tax-exempt retirement account for purposes of these rules.
Therefore, when a U.S. taxpayer holds Canadian mutual funds or ETFs through a TFSA, the underlying investments should be reviewed to determine whether the PFIC rules apply. This is one reason why the question: “Do I have a TFSA?” is often not enough for U.S. tax preparation.
The next question should be: “What investments are inside the TFSA?”
Does a TFSA Require Form 3520 or Form 3520-A?
This has historically been one of the most confusing areas of U.S. reporting for Canadian TFSAs. Forms 3520 and 3520-A are associated with certain foreign trusts and transactions involving foreign trusts.
A TFSA can be established under different legal arrangements, including an arrangement in trust. As a result, taxpayers and practitioners have historically had to consider whether a particular TFSA could fall within the U.S. foreign-trust reporting rules.
IRS Revenue Procedure 2020-17 provides an exemption from certain foreign-trust information-reporting requirements under Internal Revenue Code Section 6048 for qualifying tax-favored foreign trusts that meet specified requirements. However, taxpayers should be careful about treating this as a blanket rule that every Canadian TFSA is automatically exempt from Forms 3520 and 3520-A. The particular account structure and applicable U.S. rules should be reviewed.
Even where foreign-trust reporting is not required, that does not automatically eliminate U.S. income-tax reporting, FBAR, Form 8938 or PFIC reporting.
Does a TFSA Go on the FBAR?
A TFSA may also need to be considered for FBAR — FinCEN Form 114. The FBAR generally applies when a U.S. person has a financial interest in, or signature or other authority over, foreign financial accounts and the aggregate value of all reportable foreign accounts exceeds US$10,000 at any time during the calendar year. The US$10,000 threshold is not applied separately to each account. For example, suppose a U.S. citizen living in Canada has:
Canadian chequing account — US$4,000;
Canadian savings account — US$3,000; and
TFSA — US$8,000.
The combined foreign-account value is US$15,000. Even though none of the individual accounts exceeds US$10,000, the aggregate exceeds the FBAR threshold.
The TFSA therefore needs to be considered as part of the taxpayer's overall foreign-account reporting analysis.
What About Form 8938?
A TFSA may also be relevant to Form 8938, Statement of Specified Foreign Financial Assets, when the taxpayer exceeds the applicable reporting threshold. Form 8938 is part of the U.S. FATCA reporting regime and is filed with the federal income tax return. Its thresholds vary depending on filing status and whether the taxpayer qualifies as living abroad.
For example, for a qualifying unmarried taxpayer living outside the United States, Form 8938 generally becomes relevant when specified foreign financial assets exceed S$200,000 on the last day of the year, or US$300,000 at any time during the year.
For qualifying married taxpayers filing jointly while living abroad, the corresponding thresholds are generally US$400,000 on the last day of the year, or US$600,000 at any time during the year.
FBAR and Form 8938 are separate reporting regimes. Filing an FBAR does not automatically eliminate a Form 8938 requirement, and vice versa.
Can You Claim a Foreign Tax Credit for TFSA Income?
This is another area where TFSAs can become awkward. Foreign tax credits generally help prevent the same income from being taxed twice by Canada and the United States.
But consider what happens inside a TFSA. Canada generally imposes no Canadian income tax on the investment income earned inside the account. The United States, however, may tax that income.
If no Canadian income tax was paid on the TFSA income, there may be no corresponding Canadian tax available as a foreign tax credit against the U.S. tax attributable to that income. This is one reason the U.S. tax cost of a TFSA can be more noticeable than taxpayers initially expect.
The foreign tax credit position should nevertheless be analyzed using the taxpayer's complete circumstances rather than account-by-account assumptions.
Should a U.S. Citizen Avoid a TFSA?
There is no universal answer. A TFSA is not automatically a “bad” account simply because the owner is a U.S. citizen. The tax and compliance consequences depend on factors such as:
what the TFSA holds;
how much income it generates;
whether securities are bought and sold;
whether foreign mutual funds or ETFs are held;
whether PFIC reporting applies;
the taxpayer's overall Canadian and U.S. tax position; and
the cost and complexity of the additional U.S. compliance.
A TFSA holding cash or relatively simple investments can present a very different U.S. compliance situation from a self-directed TFSA containing several Canadian mutual funds or ETFs. For cross-border taxpayers, the investment selection inside the TFSA can be just as important as the account itself.
What If You Already Have a TFSA?
Discovering that a TFSA may have U.S. tax consequences does not necessarily mean the account must immediately be closed. Instead, the first step is usually to understand what has actually occurred. A useful review may include:
When was the TFSA opened?
When did the owner become subject to U.S. taxation?
What investments have been held in the account?
What interest, dividends and gains were generated?
Were any Canadian mutual funds or ETFs held?
Was the TFSA included on required FBARs?
Was Form 8938 required?
Were any additional U.S. information returns potentially applicable?
The answers help determine whether there is an actual U.S. tax or reporting issue and what corrective options, if any, should be considered.
Moving From Canada to the United States With a TFSA
A TFSA deserves particular attention before moving to the United States. Canada may continue to recognize the tax-free nature of qualifying TFSA income under Canadian rules, but becoming a U.S. tax resident can introduce U.S. taxation and reporting.
Similarly, a U.S. citizen moving to Canada should understand the U.S. consequences before assuming that opening a TFSA will provide the same tax benefits that it provides to a Canadian taxpayer who is not subject to U.S. taxation.
Cross-border planning is generally easier before investments are purchased than after several years of transactions need to be reconstructed.
TFSA vs. RRSP for a U.S. Citizen
For Canadian tax purposes, both accounts provide valuable tax advantages, but their U.S. treatment differs significantly.
An RRSP can benefit from special U.S. tax-deferral treatment under the Canada–U.S. Income Tax Treaty and IRS Revenue Procedure 2014-55. A TFSA generally does not receive comparable treaty protection. That distinction is fundamental.
The words “registered” and “tax-free” describe the account under Canadian law. They do not automatically determine how the United States will tax the account.
The Bottom Line
For Canadians who are not subject to U.S. taxation, a TFSA can be a straightforward and highly tax-efficient savings vehicle. For U.S. citizens and other U.S. taxpayers living in Canada, it can be more complicated.
The TFSA's Canadian tax exemption generally does not automatically extend to U.S. federal income tax. Interest, dividends and gains may therefore require U.S. tax analysis even when Canada imposes no tax.
Canadian mutual funds and ETFs held inside the TFSA may create additional PFIC and Form 8621 considerations. The account may also need to be considered for FBAR and Form 8938 reporting.
