Just before the April 15 tax filing deadline for American citizens, the Internal Revenue Service dropped a bomb which scared or confused the 100,000 Americans believed to hold Canadian Registered Retirement Savings Plans.

These include expatriate Canadians living in the United States, and U.S. citizens and green-card holders living in Canada.

On April 11, when 90% of Americans would already have filed this year's taxes, the IRS issued Notice 2003-25, requiring U.S. citizens receiving withdrawals from Canadian RRSPs to fill out a complex six-page form called the 3520 [Annual Return to Report Transactions with Foreign Trusts and Receipts of Certain Foreign Gifts.]

The new rules are being applied retroactively to this year's returns, although the deadline was extended to August 15.

If the U.S. citizen or resident files certain simplified forms and elects deferral of taxation through the Canada/U.S. income tax treaty, they won't have to file form 3520 for contributions or form 3520-A for ownership of an RRSP.

Failure to file these simplified forms can result in penalties of 35% of all contributions to RRSPs and 5% of the balance in the RRSP,

Form 3520 must also be filed for any withdrawals from RRSPs, which includes drawdowns for Home Buyers Plans, Lifelong Learning Plans and rollovers to Registered Retirement Income Funds, but not rollovers between RRSPs.

David Ingram, a Vancouver consultant with almost 2,000 clients affected by the new red tape, describes the changes as "a secondary U.S. Treasury backlash" to Canada's lack of military support for the Iraq invasion. The U.S. consulate and IRS deny this interpretation.

When the Post revealed the IRS changes in mid-April, Ingram was so flabbergasted at the onerous requirements he thought it was an April Fool's joke. His subsequent investigation revealed it was no joke, although he found few U.S. tax officials aware of the changes.

The 1980 tax treaty and a 1996 amendment clearly exempted Canadian RRSPs from U.S. taxation, he says. But after 9/11, the U.S. Treasury started looking more seriously at money laundering, he says.

The 2001 instructions for form 3520 removed the withdrawal exemption for RRSPs, but left the deposit exemption in place. "With Canada's failure to support the U.S. in Iraq, a natural next step would be to remove the last exemption of deposits. The people at Treasury suddenly felt Canada is not trustworthy."

Until April 11, Canada was considered the friendliest nation. "If you were an American in Australia, France or Germany, with a foreign pension plan, you always had to file 3530. Now Canada has to be treated like the rest of the world."

Ingram found the new rules also apply to Registered Pension Plans and RRIFs. He says the IRS author of 2003-25 advised clients to write RRSP, RPP or RRIF across the top of form 3520, which is required for each RRSP, RPP or RRIF held, regardless of value.

The law is unclear on reporting requirements on RPPs and pension plans, says Jim Yager, partner with KPMG's U.S./Canada tax practice. He believes an exemption for these distributions may yet be granted but "if not, the scope for reporting will be huge since it will not be directed at just Canadian plan distributions."

Yager says the reporting requirements for RRSPs are part of a broader crackdown by the IRS against offshore tax havens. As treasurer of the American Chamber of Commerce in Canada, Yager says he first noticed a change in the IRS's position with the filing instructions for form 3520 in the 2001 tax year. That conflicted with the 2000 instructions, which exempt transfers in or out of RRSPs.

One U.S. citizen who has lived in Canada 20 years and files U.S. returns says he's baffled by the IRS's position, which he describes as "nonsensical, counter-productive, wasteful and pointless."

"The requirement is a lose-lose proposition for the U.S. government." IRS costs will rise but little extra revenue will be raised by its efforts in Canada.

"Chronic non-filers get one more reason to stay underground. U.S. tax filers can't use RRSPs for tax evasion because Canadian government strictly controls the flow of money and its reporting."

The IRS has long had a problem getting Americans resident in Canada and green card holders to file tax returns. "This requirement simply creates another disincentive."

Thanks to the foreign exemption on earned income and the foreign tax credit, few Americans and green card holders in Canada owe U.S. tax, so the exercise is a wasteful paper chase.

The previous reporting procedure at least provided the IRS and tax filers with a paper trail; retirees making withdrawals faced no U.S. tax on capital coming out since the U.S. granted no deduction for contributions going in.

Cross-border tax specialist David Lesperance of Burlington, Ont.-based Global Relocate Consultants says the new rules reflect renewed "IRS avarice." The American consulate has a similar view: "It's just the IRS trying to get every nickel and dime out of everyone."

Lesperance says large financial institutions known as "qualified intermediaries" play a greater role alerting the IRS to American citizens in Canada with U.S. tax filing obligations. "With the Patriot Act, qualified intermediaries and increased co-operation between the U.S. and Canada, it's like shooting fish in a barrel to collect in Canada."

One qualified intermediary who didn't want to be named says financial institutions are still assessing their obligations and potential liabilities. "It's unclear at this point what [Canadian] financial institutions will have to do .... [We] may have to make an interpretation of tax law in some way."

Kevyn Nightingale, an accountant with Toronto-based International Tax Services Group, says those scared by the new rules need to "calm down."

In an article published by CCH Reports entitled "IRS says Boo, Scared Yet?", Nightingale says the problems can be avoided by giving the IRS some basic information and a declaration the taxpayer elects to defer U.S. taxation on income earned inside plans but not distributed in the year.

Why then the panic? "The IRS determined that many people who have RRSPs are not reporting," says Nightingale. "For people already reporting, there's nothing to fear and nothing extra to do. For those not reporting, it's not hard to hop on board."

They have till Aug. 15 to do so.

jchevreau@nationalpost.com