The TFSA and US tax: why “tax-free” stops at the border

Every Canadian bank recommends it, every personal-finance column starts with it, and the contribution room accumulates from the year you turn 18. For a Canadian, the TFSA is close to a free lunch. For a US citizen living in Canada, it is the account most likely to cost money — and the loss is quiet, because nothing in Canada ever flags it.

The wrapper does not cross the border

US citizens are taxed on worldwide income regardless of where they live. A foreign account shelters income from US tax only when US law says so — as it does, for instance, for a Canadian RRSP. Nothing says so for a TFSA. It is not a pension, the 1980 Convention's pension article does not reach it, and the saving clause in Article XXIX preserves the United States' right to tax its own citizens as though the treaty had not been signed.

So the income inside is simply your income. Interest is interest, dividends are dividends, a realised gain is a capital gain — reported in the year it arises, on a return you were already required to file.

And then there is what is inside it

Most TFSAs are not cash. They hold Canadian mutual funds, TSX-listed ETFs, or a bank's managed portfolio — which is to say, non-US pooled investment vehicles. Those commonly meet the §1297 tests, so the holdings raise a Form 8621 question of their own, generally one per fund per year, on top of the current taxation of the income.

The Form 3520 question, stated honestly

You will find confident answers in both directions. The cautious reading is that a TFSA is a foreign grantor trust, which would put it in Form 3520 / 3520-A territory. The competing reading is that a self-directed TFSA at a brokerage is a custodial arrangement rather than a trust, and that the contract's own terms decide it.

Rev. Proc. 2020-17 is often cited here and it does not help. Its exemption from Forms 3520 and 3520-A reaches trusts operated exclusively or almost exclusively to provide pension or retirement benefits, or medical, disability or educational benefits — with withdrawals conditioned on those benefits, or penalised. A TFSA has no purpose restriction and no withdrawal condition at all: you can take the money out on any Tuesday for any reason. It fails those tests on its face, whatever its contribution figures, so the contribution limits everyone quotes never come into play.

That leaves the prior question standing on its own: is the arrangement a trust for US purposes at all? A self-directed TFSA at a brokerage is arguably a custodial account rather than a trust, and the contract's own terms decide it. That is a real question with a real answer for your specific TFSA — it is simply not one a safe harbour disposes of.

Reporting, which is not optional either way

• FBAR. A TFSA is a foreign financial account. It counts toward the $10,000 aggregate, and the threshold is measured across every non-US account you hold anywhere — not just the Canadian ones.
• Form 8938. The balance counts toward the specified-foreign-financial-asset thresholds ($300,000 for a single filer abroad at any point in the year).
• Form 8621. Generally one per PFIC per year, for the funds inside.

Working out where you stand

1. Pull the TFSA annual statement and list every holding with its ticker or fund code.
2. Separate cash, GICs and direct equities from pooled funds — only the pooled funds raise the PFIC question.
3. For each fund, note whether it is a Canadian mutual fund trust, a TSX-listed ETF, or a US-listed ETF.
4. Total the income the account earned by year — interest, dividends, realised gains — because that is what belongs on the 1040.
5. Check the wrapper's own terms against Rev. Proc. 2020-17 before assuming a Form 3520 obligation either way.
6. Decide the go-forward question separately from the historical one: what to do next year is not the same problem as what to do about the last six.

The uncomfortable conclusion for many dual citizens is that the TFSA is the wrong wrapper for them specifically — not because it is a bad account, but because its entire benefit is a Canadian tax exemption that their other citizenship ignores while adding reporting on top.