11 July 2006 Ministerial Correspondence 2006-0186661M4 - Taxation of Roth IRA

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Taxation of Roth IRA

Position: Depends on whether the Roth IRA is a trust, an annuity or a custodial account.

Reasons: See body of letter
FINANCE: Informal discussions with Finance

Signed on July 11, 2006

XXXXXXXXXX

Dear XXXXXXXXXX:

I am writing in reply to your letter addressed to your Member of Parliament, XXXXXXXXXX, concerning how Canadian tax applies to individual retirement accounts or individual retirement annuities (IRAs), including Roth IRAs. I received a copy of your letter from XXXXXXXXXX on May 3, 2006.

While you have provided some background information, unfortunately I cannot comment on the specifics of your situation without having more details. I can, however, offer the following general comments on the taxation of IRAs and Roth IRAs in Canada.

With respect to the taxation of IRAs, an IRA can be characterized for Canadian tax purposes as a foreign retirement arrangement, a pension plan, an employee benefit plan, a retirement compensation arrangement, a salary deferral arrangement, or some other form of arrangement depending on the terms of the IRA and how it is used in a given situation.

A "foreign retirement arrangement" is defined in subsection 248(1) of the Income Tax Act as a plan or arrangement prescribed by section 6803 of the Income Tax Regulations. Section 6803 prescribes plans or arrangements to which subsection 408(a), (b) or (h) of the U.S. Internal Revenue Code applies. For purposes of this letter, it will be assumed that one of these subsections applied to your IRA and, therefore, your IRA would have been treated as a foreign retirement arrangement under the Act.

Clause 56(1)(a)(i)(C.1) of the Act includes in the income of a taxpayer resident in Canada in a year all amounts received as, on account or in lieu of payment of, or in satisfaction of, the amount of any payment out of or under a "foreign retirement arrangement" established under the laws of the U.S., except to the extent that the amount would not, if the taxpayer were resident of the U.S., be subject to income tax in the U.S.

As you have explained, the payment from the IRA upon the conversion in 2004 was taxable in the U.S. Therefore, the payment was included in your income for Canadian tax purposes as well. However, I understand that you would have been entitled to a foreign tax credit for taxes already paid to the U.S. on this amount, to the extent permitted by subsection 126(1) of the Act. The Canada-U.S. Income Tax Convention (1980) does not prevent Canada from taxing the payment from your IRA.

Whether the taxation of amounts received from an IRA by a resident of Canada as described above is appropriate in policy terms has to be decided by the Department of Finance Canada. I understand that they will respond to you directly on this matter.

With respect to the taxation of Roth IRAs, the Roth IRA was introduced in the U.S in 1998. The Roth IRA is a retirement plan, with many of the same features as a regular IRA. However, the main distinguishing features of the Roth IRA are that payments into the plan are not tax-deductible, and the earnings within the plan generally are not taxed in the U.S.; that is, earnings are not taxed as they are earned, or when they are withdrawn from the plan. The Roth IRA is governed by section 408A of the Internal Revenue Code and is therefore not a "foreign retirement arrangement" and is not subject to clause 56(1)(a)(i)(C.1) of the Act. As a result, withdrawals from the plan are generally not taxable in Canada either, with some exceptions.

However, the earnings within the Roth IRA are taxable in Canada on an annual basis, again with some exceptions. The mechanism by which the earnings in a Roth IRA are taxed in Canada depends on whether the plan is a trust, a custodial account, or an annuity. For purposes of this letter, we will assume that you are both the only contributor and the only owner of the Roth IRA.

When a Roth IRA is a non-resident, non-discretionary trust, paragraph 94(1)(d) of the Act will apply, beginning with the tax year in which the contributor has been resident in Canada for more than 60 months, whether or not the time is consecutive. Until that point, the earnings of the Roth IRA trust may be accumulated and added to the capital of the trust. Withdrawals of capital from the trust are not taxable to the beneficiary. A withdrawal of income, on the other hand, would be required to be included in the beneficiary's income under subsection 104(13) of the Act.

Once the contributor/beneficiary has been resident in Canada for more than 60 months in total over his or her lifetime, paragraph 94(1)(d) of the Act will apply to deem the Roth IRA to be a controlled foreign affiliate of the beneficiary for that tax year. As a result, the beneficiary will be required to include in his or her income in each tax year the foreign accrual property income (FAPI), as defined in subsection 95(1) of the Act, earned by the Roth IRA in that year, when the FAPI of the trust is more than $5,000 in that year.

If the income of the Roth IRA trust is payable to the beneficiary in the year, it will be included in his or her income under subsection 104(13) of the Act, and will not be included in the FAPI of the trust by virtue of subsection 94(4).

A Roth IRA can be set up as an individual retirement annuity, in which case it must be an annuity contract or an endowment contract purchased from a life insurance company.

When the beneficiary holds a Roth IRA that is an annuity contract, he or she must include in his or her income each year amounts described in subsection 12.2(1) of the Act, unless the Roth IRA meets one of the exceptions in that subsection.

The Canada Revenue Agency (CRA) considers custodial accounts to be equivalent to bank accounts. If the Roth IRA is a custodial account, interest credited or added to the account will be taxable in the beneficiary's hands under paragraph 12(1)(c) or subsection 12(4) of the Act.

Under U.S. rules, payments or distributions from a Roth IRA that are made during the five-year period beginning with the first taxable year for which a contribution was made to a Roth IRA do not qualify for tax-free treatment. As a result, it is expected that most taxpayers would not have made withdrawals in the period between 1998 and 2003.

Whether the Roth IRA is a trust, a custodial account, or an annuity, the CRA has determined that a Roth IRA is an "other retirement arrangement," and therefore a "pension" under Article XVIII of the Treaty. In the limited circumstances where withdrawals from the Roth IRA are taxable under the Act, Article XVIII(1) will apply. Article XVIII(1) states that pensions arising in the U.S. are exempt from taxation in Canada if they would be excluded from taxable income in the U.S. if the recipient were a resident there.

With regard to the annual earnings of the Roth IRA, the beneficiary can elect under paragraph 7 of Article XVIII to defer taxation in Canada, under rules established by the CRA, with respect to any income accrued in the Roth IRA but not distributed by the plan, until such time as and to the extent that a distribution is made from the plan. For greater certainty, it is our view that if an election is made to defer the earnings under Article XVIII(7), Article XVIII(1) would not apply to exempt the earnings from taxation in Canada when the earnings are withdrawn from the Roth IRA.

The CRA is in the process of establishing the rules under Article XVIII(7) of the Treaty under which a beneficiary of a Roth IRA can defer taxation of the accrued income until such time as a distribution is made from the plan. In the meantime, the beneficiary of a Roth IRA can make a "protective claim" in order to defer taxation in Canada of the earnings in a Roth IRA in a tax year.

A protective claim is a written declaration by a taxpayer, filed with his or her return of income for a particular tax year, which specifies that the taxpayer wishes to make an election pursuant to Article XVIII(7) of the Treaty to defer taxation of any income accrued in his or her Roth IRA in that year. Along with the written declaration, the taxpayer is required to include the following items of information as part of the protective claim:

• Plan name, account number, name of trustee, and date of establishment,
• Capital contributions made to date, current balance of the plan,
• The amount deferred in the current year, and
• Cumulative deferred earnings to date.

On July 18, 2005, draft legislation was released that proposes to amend the non-resident trust rules, effective for trust tax years that begin after 2002. The changes to the non-resident trust rules were first announced in the 1999 Federal Budget. Draft legislation was released on June 22, 2000, then amended on October 11, 2002, October 30, 2003, and July 18, 2005.

Under the proposed legislation, a trust that is subject to new subsection 94(3) of the Act will be deemed to be resident in Canada for certain purposes of the Act, and will be subject to tax under Part I of the Act on its worldwide income for the year. Both the contributor and the trust will be jointly and severally, or solidarily, liable for the tax owing by the trust. Again, these rules will not apply until the year in which the contributor has been resident in Canada for more than 60 months over his or her lifetime. When the Roth IRA is deemed to be resident in Canada pursuant to the proposed non-resident trust legislation, it will not meet the conditions of paragraph 7 of Article XVIII of the Treaty, and no election will be available.

However, new subsection 94(3) will not apply if the trust is an "exempt foreign trust," as defined in new subsection 94(1) of the Act. Under the October 30, 2003 version of the draft legislation, a Roth IRA would not have been considered to be an exempt foreign trust. Under the July 18, 2005 version of the draft legislation, a Roth IRA could be an exempt foreign trust under paragraph (g) of that definition in limited circumstances. If the Roth IRA is determined to be an exempt foreign trust, it will not be subject to proposed subsection 94(3) of the Act.

A determination of whether a Roth IRA trust is subject to the new non-resident trust provisions cannot be made until the proposed non-resident trust legislation is enacted.

If you have any further questions, I invite you to contact Ms. Sherry Thomson of the Income Tax Rulings Directorate at 613-957-2122.

I trust that the information provided will be of assistance.

Sincerely,

						The Honourable Carol Skelton, P.C., M.P.

c.c.: XXXXXXXXXX
House of Commons
Ottawa ON K1A 0A6

Sherry Thomson
2006-018666