FI40, you are correct that your question is complicated, and it doesn't help that most of the existing literature on this topic is incorrect in some way or another. As I just noted in
another post, secondary sources do not have the force of law and are mainly useful as a starting point for research. You need to verify the claims in secondary sources by reading the primary sources (e.g. treaties, statutes, and case law). My posts here are, of course, also secondary sources of information and you similarly cannot rely on them.
The
publication you linked to ("Sunlife Publication") contains serious errors.
A plan commonly referred to as a 401(k) plan must hold assets in "a trust created or organized in the United States". 26 USC § 401(a). For the purpose of this post, the operative phrase there is "in the United States". In the case of a distribution from such a trust "in the United States" to a nonresident alien, the distribution is generally subject to a 30% tax "to the extent the amount so received is not effectively connected with the conduct of a trade or business within the United States". 26 USC § 871(a)(1). If the payee is "at no time during the taxable year ... engaged in trade or business in the United States", then the amount is not "effectively connected with the conduct of a trade or business within the United States" and the 30% tax applies. 26 CFR 1.871-7.
In furtherance of the above, when the distribution is made to a nonresident alien not engaged in a US trade or business, the payor is generally required to withhold
30% of the proceeds and remit them to the IRS. 26 USC § 1441(a). However, the provisions of the Internal Revenue Code are applied "with due regard to any treaty obligation of the United States which applies to such taxpayer". 26 USC § 894(a)(1). Assuming that the payee is a resident of Canada, the relevant treaty provides that the tax withheld is reduced to 15% if (
and only if) the recipient of the distribution(s) is "the beneficial owner of a periodic pension payment".
Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital, Article XVIII, § 2(a).
The Sunlife Publication at page 2 claims that in the case of a distribution from a 401(k) plan to a nonresident alien who is a resident of Canada not engaged in a US trade or business, the withholding rate is
always reduced to 15%. Unfortunately, this claim has no basis in law. The only authority cited by the Sunlife Publication for this proposition is 26 CFR 1.1441-2(b)(ii), but this regulation merely defines the term "fixed or determinable annual or periodical" for the purpose of "chapter 3 of the Internal Revenue Code and the regulations thereunder". This regulation has nothing to do with the meaning of "the beneficial owner of a periodic pension payment" as used in the treaty provision above. To be clear then, the withholding rate on the distribution, assuming that the payee is a nonresident alien who is a resident of Canada and not engaged in a US trade or business, will be 30% unless the payee is "the beneficial owner of a periodic pension payment", in which case it will be reduced to 15%. There is no precedential authority on the meaning of "the beneficial owner of a periodic pension payment" and certainly no authority suggesting that all recipients of the distributions from a 401(k) plan fall within the meaning of this phrase. In conclusion, the payee may have to pay a 30% tax to the US on the distribution, not necessarily the 15% claimed by the Sunlife Publication.
In addition to the above, and assuming that the payee is a resident is Canada, the 401(k) distribution will also have to be included in the payee's income for Canadian tax purposes. Income Tax Act,
RSC 1985, c 1 (5th Supp) ("ITA"), § 56(1)(a)(i).
Fortunately, there are a few pieces of good news.
First, the 10% additional tax that you mention for distributions from a qualified retirement plan (you call it a "penalty") does not apply to a distribution made to a beneficiary after the death of the employee whose account it was. 26 USC § 72(t)(2)(A)(ii).
Second, the payee
may be able to claim a tax credit in Canada for all or part of the 30% (or possibly 15%) tax that was paid to the US, depending on the overall Canadian tax profile of the payee and subject to all relevant statutory requirements. ITA § 126.
Third, the payee
may be able to contribute the 401(k) proceeds to an RRSP and claim a deduction for same. Subject to various conditions, there is a Canadian deduction available for income that is "a superannuation or pension benefit ... payable out of or under a pension plan ...
attributable to services rendered by the taxpayer or a spouse or common-law partner or former spouse or common-law partner of the taxpayer in a period throughout which that person was not resident in Canada". ITA § 60(j)(i). I bolded some of the most salient requirements, but there are also many other conditions not discussed here.
I hope this information is helpful, but as you surmised, this is a complicated topic, and this post is only a secondary source of general information intended to help with your research and is not a substitute for familiarising yourself with the primary sources, which contain other requirements not described here. The payee may benefit from retaining counsel to assist with this matter.