The 60(j) rollover: 15% or 40%?

[Edit Jan 2021: This post has a follow-up: Update: IRS doesn’t like lump-sum after all?]

In keeping with stereotypes, Canadian tax law is nice to US retirement plans, but the US does not reciprocate.

There are two flavours of rollover under paragraph 60(j) of the Income Tax Act (Canada).

• Subparagraph 60(j)(i) applies to a foreign pension plan attributable to services rendered while non-resident. The CRA normally considers a 401(k) plan to be a “pension plan” for purposes of the Act^[1]CRA Document 2004-0071271E5.
• Subparagraph 60(j)(ii) applies to a “foreign retirement arrangement”, which is defined narrowly^[2]Income Tax Regulations (Canada), § 6803 as a Individual Retirement Account (IRA) governed by § 408 of the US Internal Revenue Code.

In either case, the effect is to permit a deduction for a lump-sum payout from the 401(k) or IRA to the extent that the proceeds are transferred into a Registered Retirement Savings Plan (RRSP). The 60(j) deduction cancels out the inclusion of the distribution in income for the year^[3]Income Tax Act s. 56(1)(a)(i), and the transfer does not consume RRSP contribution room^[4]Income Tax Act s. 146(5)(a)(ii), so this looks like a tax-neutral rollover from the perspective of Canadian law.

The US is another story, and will happily tax a resident of a foreign country on income from sources within the US. So the next question is: what US tax obligation is created by a 60(j) rollover?

Let’s assume that at the time of the rollover, the taxpayer is a tax resident of Canada and not a US citizen or green card holder, but that they were living and working in the US at the time they (or their employer) originally made contributions to the 401(k) or IRA.

The bad news is that the Internal Revenue Code gives no recognition or special treatment whatsoever to Canadian (or other foreign) retirement plans. An RRSP is not an “eligible retirement plan” within the meaning of IRC § 402(c)(8)(B), so none of the exclusions that apply to rollovers in the domestic context^[5]§ 402(c)(1) for an employer plan; § 408(d)(3)(A) for an IRA are available. The US tax consequence of a 60(j) rollover is exactly the same as taking a lump-sum withdrawal from the US plan in cash and stuffing it under your mattress.

The good news is that the US-Canada tax treaty has a few things to say about “pensions”. For treaty purposes, both 401(k) plans and IRAs count as pensions^[6]Treasury Department Technical Explanation, Protocol 3 (1995), Art. 9 (amending treaty Art. XVIII): “The Protocol amends the present definition by substituting the phrase ‘other retirement … Continue reading. Article XVIII limits the US tax to 15% of the gross amount when a Canadian resident is the “beneficial owner of a periodic pension payment”^[7]US-Canada tax treaty Art. XVIII(2)(b).

The word “periodic” is a thorn in the side of our application of the treaty rate to a rollover—not least because both flavours of 60(j) take pains to exclude from their application any benefit “that is part of a series of periodic payments”^[8]Income Tax Act s. 60(j)(i); the phrase repeats in s. 60.01(a), incorporated by reference in s. 60(j)(ii).

But the meaning (or presence) of “periodic” in a Canadian statute has little bearing on how the US should (or will) interpret “periodic” in a treaty. Must we really give up on the treaty here? The question is a close one.

On the side of “no treaty rate for rollovers” we have:

• Sun Life “Strategies for Canadians with U.S. retirement plans”, June 2017 edition, p. 3 (“Lump sum withdrawals and full surrenders aren’t periodic, so they don’t benefit from the lower 15% rate”), reversing the position they took in the March 2015 version of the same paper.
• Advisor.ca “The true withholding tax for U.S. retirement accounts” (2016), noting ambiguity, quoting email from the Sun Life author that “The IRS appears to be clarifying its position that the withholding tax rate is 30%” (citing no ruling on point), and quoting international tax lawyer Roy Berg, who states that the treaty “reduces the U.S. tax on distributions from 30% to 15% only for periodic payments and not lump-sum payments” and cites PLR 9537028 on the definition of “periodic payment” for purposes of § 72 and § 3405.
• CRA Document 2011-0398741I7, in which the taxpayer took the position that the treaty rate did not apply to his IRA withdrawal, and claimed the Canadian foreign tax credit on that basis. The inquiry did not focus on the question of treaty rate application, but on the 10% early withdrawal penalty^[9]IRC § 72(t). But the Tax Services Office asserted as part of its own position that “A withdrawal from an IRA is a lump sum payment and is therefore not subject to the 15% [treaty] limitation”, a conclusion that was echoed by the Appeals Division and not challenged by the Income Tax Rulings Directorate in its conclusion that the penalty qualified for the foreign tax credit. This ruling would be incorrect if the treaty could have reduced the US tax payable.^[10]CRA Folio S5-F2-C1 ¶ 1.35

And on the other side we have:

• Sun Life’s original (2015) position.
• Feb. 2016 blog comment of international tax expert Michael Atlas (“I am advised that the U.S. will allow 15% tax rate… even for a lump-sum payment”).
• Richard E. Andersen’s exhaustive Analysis of United States Income Tax Treaties, painting a trend of IRS rulings evolving toward greater acceptance of lump-sum payments being embraced by treaty pension provisions, and concluding that current “U.S. treaty position is that the term ‘pension distributions and other similar remuneration’ includes single-sum distributions. … This approach has been applied to a lump-sum distribution … even when the treaty text contained the periodic payment requirement.” ^[11]Andersen, Analysis of United States Income Tax Treaties (Thomson Reuters/WG&L 2019), ¶ 14.02[2][b][ii] (citations omitted but discussed infra).

To evaluate these positions we must give primary weight to IRS rulings interpreting treaty pension provisions. On questions of US tax, the opinions of the CRA or of one advisor or another have less authority than the IRS’s stated position. We must also give relatively less weight to IRS interpretations of domestic law, even if the word “periodic” or some variation thereof happens to appear in the Internal Revenue Code.

It particularly strains credulity to suppose that the negotiators of the US-Canada treaty had any intention of conjuring the body of regulation and guidance connected to that clumsy term of art from IRC § 871, “fixed or determinable annual or periodical gains, profits, and income” (FDAPI), by the mere insertion of “periodic” into Article XVIII. Thus the Sun Life citation to Treasury Regulation § 1.1441-2(b)(ii), used in both versions to support opposing conclusions, is laughably flimsy. Any importance periodicity may or may not have to FDAPI withholding has nothing to do with the treaty.

With respect, Berg’s citation to PLR 9537028 is similarly misguided. That ruling invokes the periodicity requirement in the context of IRC § 871(f), which is an exclusion for annuities connected to “personal services performed outside the United States”^[12]IRC § 871(f)(1)(A)(i) (emphasis added). This is far afield of treaty limits on rollovers by former US residents, for whom § 871(f) is not in play.

I think that if the Sun Life author consulted the Andersen treatise, he might well conclude that he was right in 2015 and wrong in 2017.

There was evidently a time when the IRS sometimes balked at extending treaty “pension” status to lump-sum payments, but these rulings were made under the pre-1986 Code which treated such payments as capital gain to the extent exceeding contributions. Thus, for example, Rev. Rul. 58-247 held that a full distribution from an employee plan fell under the purview of the capital gains article and not the pensions article of the 1942 US-Canada treaty.

Even in that era, the IRS applied the US-Canada treaty’s pension provisions to a lump-sum in Letter Ruling 8205052, reasoning that “the election by the parties to exercise their right as beneficiaries… to receive periodic payments due… in a single, lump-sum distribution will not change the character of the income received.”

To support his conclusion that IRS now views “periodic” as non-restrictive in treaty pension language, Andersen cites Letter Rulings 8901053, 8904035, and 9041041, which address pension provisions in the US treaties with Switzerland and Germany. In all three, the position is explicit, consistent, and principled:

“The definition of a pension as a periodic payment does not preclude a lump sum payment from qualifying as a pension. In the absence of a specific provision covering lump sum payments, the term ‘periodic’ is simply descriptive of a pension payment generally, not a restriction on the manner of payment. A pension payment in the form of a lump sum payment is made in consideration for services rendered and is in the nature of a periodic payment as intended by the Convention.”^[13]Letter Ruling 9041041 (emphasis added)

Even Andersen’s newer citations are rather dated. But the IRS has not given subsequent signals of any reversal; the same position is echoed again in Letter Ruling 200416008: “The word ‘periodic’ in Article 18(4) [of the US-Australia treaty] does not preclude the application of Article 18(1) to lump sum distributions.”

On balance, the available evidence indicates that the IRS will accept the 15% treaty rate for a lump-sum withdrawal from a 401(k) or IRA by a resident of Canada. The reasoning in Letter Ruling 9041041 illustrates that this position is within the range of permissible interpretation of the treaty language.

Of course, a private letter ruling does not bind the IRS to the same position in any other case, and the Tax Court would grant it no precedential weight. But even if such a position were challenged and defeated, these rulings likely constitute “substantial authority” for the avoidance of the § 6662 understatement penalty^[14]Reg. 1.6662-4(d)(3)(iii) allowing private letter rulings as “authority” for purposes of the determination—but see caveats in clause (ii).

Having established that the treaty limits the US tax to a maximum of 15%, we must still settle another question: what rate of tax would apply without the treaty? Certainly it would be foolish to pay the treaty rate if the Code allowed a lesser amount.

The oversimplified answer is that the rate of tax under the Code is 30%, plus another 10% if the taxpayer is below the age of 59½. These are, respectively, the rate imposed by IRC § 871(a)(1) on a nonresident alien’s FDAPI that is “not effectively connected with the conduct of a trade or business within the United States”, and the § 72(t) early withdrawal penalty.

The full answer depends on a closer examination of the meaning of “effectively connected with… a trade or business”. But this post is long enough, so I will leave that to a sequel.