Update: IRS doesn’t like lump-sum after all?

In a previous post on the rollover of a US retirement plan to an RRSP, I argued that the IRS viewed “periodic” as non-restrictive in treaty pension provisions.

The consequence being: When Article XVIII paragraph (2)(b) of the US-Canada tax treaty limited the US tax on a Canadian resident’s “periodic pension payment” to 15%, that limit also applied to lump-sum payments (such as a full liquidation) from a 401(k) plan or an Individual Retirement Account (IRA).

But the IRS recently clarified their position on the US-Canada treaty, and it is decidedly not the one they took in Letter Ruling 9041041, where they reasoned that “the term ‘periodic’ is simply descriptive of a pension payment generally”.

Instead they quietly revised Tax Treaty Table 1 in Feb 2019 to insert a straightforward assertion in footnote ii:

“In Canada, the 15% rate does not apply to a lump-sum payment.”

That’s a blow to RRSP rollovers under subsection 60(j) of the Income Tax Act (Canada), which involve a lump-sum withdrawal from a US plan. Such a withdrawal is likely to face a higher rate of US tax without treaty protection.

In some cases, it might still be possible to do a tax-neutral 60(j) rollover. Canada considers the full US tax liability to be “non-business income tax paid to a foreign country” for purposes of the Canadian foreign tax credit, even if it exceeds the treaty rate^[1]CRA Document 2011-0398741I7. But the taxpayer’s income from other sources in the year of the rollover would need to produce sufficient Canadian tax to fully utilize the credit. More US tax makes this a higher bar to clear.

Anyone wishing to claim, contrary to the IRS’s footnote, that the 15% treaty rate applies to their lump-sum withdrawal in Canada, may wish to explain their interpretation of the treaty on a Form 8275 disclosure with their return, to preserve a potential “reasonable basis” defense against the 20% accuracy penalty^[2]Reg § 1.6662-3(c)(2) if they don’t prevail on the merits of their position.

The IRS’s revisions to Tax Treaty Table 1 suggest that they are taking a piecemeal approach to parsing treaty language, rather than applying interpretive principles consistently between countries. The United Kingdom gets a similar “no lump sum” callout in the same footnote. But there’s no indication that they are reversing course on Australia, where they took the opposite stance^[3]Letter Ruling 200416008.

If there’s anything good to be said for the IRS’s newly-elucidated position on the Canada treaty, it’s that it reciprocates Canada’s own interpretation in the mirror situation. A US resident seeking treaty benefits on a lump sum payment from a Canadian pension plan or RRSP will have their hopes dashed by section 5 of the Income Tax Conventions Interpretation Act (Canada):

“periodic pension payment” means… a pension payment other than
(a) a lump sum payment… under a registered pension plan,
(b) a payment before maturity… under a registered retirement savings plan, …

Perhaps someone at the IRS noticed that Canada wasn’t playing nice here.