Tax-Free Savings Accounts—a caution for U.S. citizens and those with foreign investments

The Tax-Free Savings Account (TFSA) which was introduced this year is a great new investment vehicle, as all of the income earned within the TFSA is tax-free. However, Canadian residents who are also US citizens or green card holders should be aware that any income earned in a TFSA will be subject to US tax on their US return (US citizens who are also Canadian residents are required to file a tax return in both countries). Depending on the tax situation of the particular individual, the US income tax on the TFSA income may be offset with foreign tax credits. Before investing in a TFSA, a US citizen or green card holder residing in Canada should carefully review both the US and the Canadian tax implications.

Another issue to be aware of is the tax implications where a TFSA invests in shares of foreign companies that pay dividends. Although the TFSA is not subject to tax on the dividend income received from a foreign company, it can still be subject to foreign withholding tax on the dividend (the rate is 15% for US stocks). This foreign tax is non-recoverable and no tax credit is available. These rules apply regardless of whether the investor is a US citizen or not. Therefore, investments in foreign companies may be better off in a regular investment account where a foreign tax credit for the withholding tax can be claimed against the Canadian income tax.