Tread carefully recommending a registered education savings plan to a U.S. citizen or “green card” holder.

“RESPs are not a great idea for these people,” says cross-border tax expert Harry Uhrig, tax partner with chartered accountants BDO Dunwoody LLP in Mississauga, Ont.

American citizens face taxes on their worldwide income even if they live and work in Canada full-time. The same goes for non-citizens who hold permits that entitle them to live and work in the U.S. — even if they don’t. Often, both groups find that exemptions and credits for Canadian taxes paid offset their U.S. tax liabilities, but they still must file annual tax returns with Uncle Sam’s Internal Revenue Service.

RESPs are problematic because of U.S. anti-deferral rules that are “incredibly punitive,” Uhrig says. While the U.S. recognizes the tax shelter for RRSPs, it does not extend that recognition to RESPs.

This means RESP earnings can potentially be subject to double taxation. First, the adult who sets up and funds the plan — the subscriber — must report the plan’s income annually and face U.S. taxation on it. Second, withdrawals made by the beneficiary for post-secondary education face Canadian taxation, although many students owe little or nothing because of their low income.

There is a further wrinkle, Uhrig adds. If the beneficiary student is an American citizen, the U.S. will tax withdrawals using a formula that nullifies the plan’s tax-sheltered compounding. “Basically, [the IRS goes] back and taxes each year’s earnings, adding an interest factor,” Uhrig says. That’s even though the plan’s subscriber has already faced U.S. taxes on those earnings. While the student will get credit for any Canadian taxes paid, the retroactive calculation means there might still be U.S. taxes owing.

Americans and green card holders who sponsor RESPs also face additional paperwork in preparing their U.S. tax returns. The IRS considers an RESP to be a foreign “grantor trust” and requires the filing of forms 3520 and 3520-A.

There is a way around this, Uhrig says. Affected taxpayers should arrange for the RESP to be sponsored by a relative or other trusted person who is outside the U.S. tax net. For example, if an American is married to a Canadian, the Canadian’s parents could sponsor the RESP.

Why can’t the RESP simply be set up by the Canadian spouse with no involvement by his or her American mate?

That won’t work, Uhrig explains, because the American’s U.S. tax return must be filed as joint or as “married but filing separately.” The American cannot file as a single taxpayer.
So, one way or the other, the IRS views the couple as a unit.

But while using in-laws, a sibling or someone else to sponsor the RESP can avoid the U.S. anti-deferral rules, it might create another problem.

Suppose John and Mary give John’s mother, Mildred, money to sponsor an RESP for their child. If the child does not pursue post-secondary education, Mildred — not John or Mary — gets to reclaim the contributions. She could also roll up to $50,000 of the plan’s earnings into her RRSP if she has enough contribution room and/or take RESP earnings as income taxed at her marginal rate with a 20% penalty to offset the deferral the plan enjoyed. Either way, it’s now Mildred’s money — not John’s and Mary’s.

What if Mildred agrees up front to reimburse John and Mary should that happen? That is risky, Uhrig warns: “The U.S. might then consider the whole setup a sham, look through it, deem the [American] parent to have been the subscriber and then tax the money.”

An article, The Tax Consequences of RESPs for U.S. Persons, is on the BDO Dunwoody Web site at www.bdo.ca. IE