7 December 1991 Income Tax Severed Letter - Tax treatment where a Canadian resident rolls an American 401(k) plan into an American individual retirement account

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.

U.S. Pension Plans

We have been asked by the Enquiries and Taxpayer Assistance Division to reply to your memorandum of April 12, 1991, concerning the above noted topic. We apologize for the delay in responding. Your concerns relate to Canadian residents who have been contributing the 401(k) plans in the United States and who are entitled to rollover the entire amount in these plans to Individual Retirement Accounts ("IRA'S") free of United States income tax. Upon receipt of the annuity payments from the IRA, differing tax consequences arise depending on whether the 401(k) plans are employer funded or employee funded. You refer to instructions contained in ASG-89-6 (January 30, 1989) and technical interpretations contained in Rulings Directorate memoranda of November 29 and July 27, 1990 and in Source Deduction Division's memorandum of December 10, 1990.

Throughout this memorandum reference will be made to "employer funded" and "employee funded" 401(k) plans. In your memorandum you refer to a plan which was originally employer funded but which in the early 1980's became solely employee funded. This type of plan must be treated as if it were two separate arrangements and the consequences on withdrawal from the IRA will depend on whether the source of funds in the IRA is contributions during the taxation year(s) it was employer funded (i.e. an employee benefit plan) and earnings thereon, or contributions during the taxation year(s) it was employee funded and earnings thereon.

You have made various statements and asked several questions which we set out below with our comments thereon (reference is made to your lettered paragraphs on pages 2 and 3):

• 1. Paragraph A
• (1) You state that Canada does not recognize income from an employer contributed 401(k) plan as pension income and therefore the exemption under Article XVIII of the Canada U.S. Tax Convention (the "tax convention") will not apply on a rollover from such a plan to an IRA.

The Department's position on 401(k) plans is set out in (7) of ASG-89-6 on page 8: "The Department considers that a 401(k) plan is a U.S. pension plan". The fact that it is employer funded and, therefore, an Employee Benefit Plan ("EBP") for purposes of the Income Tax Act does not prevent it from also being characterized as a pension plan. Paragraph 56(1)(a) of the Income Tax Act (the "Act") lists benefits under an EBP as being superannuation or pension benefits which are excluded from consideration under that provision. If EBP benefits could not be pension benefits, there would be no need to except them from tax under paragraph 56(1)(a).

XXX The rollover under paragraph 60(j) of the Act is not available for EBP benefits (unless related to employment when the taxpayer was a non-resident) because they do not qualify under paragraph 60(j), i.e. they are not pension benefits "included in computing the income of the taxpayer by reason of subparagraph 56(1)(a)(i)".

To conclude, in our opinion, amounts from an employer contributed 401(k) plan would be considered pension for purposes of the tax convention and exempt from Canadian taxation on rollover to an IRA.

• (2) Where subparagraph 6(1)(g)(iii) does not apply because the EBP benefits relate to services performed while resident in Canada, annuity income subsequently received from an IRA to which the employer contributed 401(k) plan amounts were rolled should be taxed as employment income under paragraph 6(1)(g) of the Act if the income is employer contributions made to the plan before January 1, 1988, or earnings thereon. (See our letter of July 27, 1990 for further explanation.)

Our comments in the July 27th letter concerning contributions to a 401(k) plan after December 31, 1987 are no longer valid since new section 6802 of the Income Tax Act Regulations (not yet proclaimed but being administered by the Department as if law) prescribes foreign pension plans (such as employer contributed 401(k) plans), and excludes them from the definition of a Retirement Compensation Arrangement ("RCA") in subsection 248(1) of the Income Tax Act. (We are assuming, for purposes of this opinion, that an employer contributed 401(k) plan satisfies the four conditions set out in paragraph 6802(e) of the Regulations.) Therefore, amounts contributed after December 31, 1987 through December 31, 1990, will be considered to have been made to an EBP with the tax consequences upon withdrawal as noted above.

After 1990 sponsors of employer contributed 401(k) plans may elect to be exempt from the RCA rules and report a PA with respect to the Canadian employee's benefits under the foreign plan. This proposal will be contained in draft regulations to be released later and was announced by the Department of Finance May 24, 1991. If an election is made, amounts received from such an employer contributed 401(k) plan will be treated as employment income taxable under subparagraph 6(1)(g) of the Income Tax Act. If no election is made, the 401(k) plan will be considered an RCA as at January 1, 1991 and if this occurs, our comments in the July 27, 1990 letter concerning post-December 1987 contributions should be applied.

With respect to amounts out of an IRA (whether its source is an employee or employer funded 401(k) plan) received after July 13, 1990, new clause 56(1)(a)(i)(C.1) of the Income Tax Act will tax these amounts as pension income, if such amounts would have been taxable in the United States if the recipient were resident there. For more detail, please see the Assessing and Enquiries Directorate memorandum of March 21, 1991.

• 2. Paragraph B

Canada recognizes the 401(k) plan as a pension plan as explained above. Amounts may therefore be rolled over to an IRA and exempted from income tax pursuant to Article XVIII of the tax convention. Amounts received out of such an IRA will retain their character prior to July 14, 1990, as amounts out of an EBP (if employer contributed), or as pension income (if employee contributed). A deduction under 60(t) is not available since no amounts will be considered to have been received out of an RCA.

After July 13, 1990, the instructions contained in the above-noted March 21, 1991 memorandum should be followed with respect to amounts out of an IRA whether received from an employer or employee contributed 401(k) plan.

• 3. Paragraph C

The timing of exclusion and inclusion of income from the 401(k) plan and the IRA is matched in Canada and the United States and, therefore, the foreign tax credit can be claimed.

• 4. Paragraph D

No deduction is available under paragraph 60(t) as explained above.

• 5. Paragraph #

The client should be taxed on his contributions to an employee contributed 401(k) plan; a deduction under 110(1)(f) will be available on the rollover from the 401(k) plan to the IRA. However, the taxpayer will be taxed again on all amounts from an IRA under subparagraph 56(1)(a)(i) on or before July 13, 1990, and, more particularly, clause 56(1)(a)(i)(C.1) after that date.

The foregoing addresses the concerns you have outlined in your memorandum but you should be aware that the recent Tax Court of Canada case, Abrahamson v. M.N.R. [[1991] 1 C.T.C. 2061] (91 DTC 213), rejected the Department's position on the taxability of proceeds out of an IRA. The taxpayer had rolled over his U.S. (employer contributed) pension income into an IRA in 1975 and withdrew a lump sum amount in 1986 which the Department assessed as pension income subject to tax under paragraph 56(1)(a). The Court disagreed, however, and held that the IRA was an inter vivos trust, the income of which should be taxed annually under such provisions as subsections 75(2) and (3) and sections 94 and 104. The judge also found that the exemption from taxation contained in the Canada-U.S. Tax Convention (1980) did not apply to a 1975 rollover and possibly the withdrawal from the U.S. pension plan in 1975 had been a taxable event in Canada. To conclude, the Court found that the amount withdrawn in 1986 was a return of capital and no income tax could be levied in Canada.

The Abrahamson decision is not being appealed but will not have any effect for withdrawals from IRA's after July 13, 1990. However, for withdrawals on or before that date a taxpayer may have a strong argument based on the reasoning of that case. If the rollover from the 401(k) or other pension plan to the IRA occurred after the coming into force date of the tax convention (October 1, 1984 with respect to pension income), we can argue that because the withdrawal was tax exempt in Canada, the later withdrawal attracts tax. In other words, the instructions in ASG-89-6, our comments in our memorandum of July 27, 1990 (excluding the comments pertaining to RCA's), and the comments in Source Deduction Division's memorandum of December 10, 1990 (excluding the comments pertaining to RCA's) are valid and Abrahamson should be distinguished from cases where the facts are not identical.

We trust this will assist.