US Taxpayers and Canadian Mutual Funds: Reducing the Tax Risk
There is concern among tax and investment professionals that many
Canadian mutual funds and exchange-traded funds (ETFs) could be
considered passive foreign investment companies (PFICs) for US tax
purposes. Whether a particular fund is considered a PFIC depends on its
specific facts and circumstances — information that may not be available
to most investors — and few Canadian fund companies have provided
investors with definitive guidance on this issue. Because PFIC status
can significantly reduce a fund’s after-tax return, investors who are US
citizens, green-card holders, and US residents (“US taxpayers”) need to
consider practical risk-avoidance strategies.
Absent certain elections described below, income and capital gains
derived from PFICs are generally characterized as ordinary income for US
tax purposes; the preferential tax rates for qualified dividends and
long-term capital gains do not apply. In addition, some or all of the
income or gain derived from a PFIC may be considered an excess
distribution — generally, the result of uneven distributions from a PFIC
or a capital gain when the fund is sold — which is treated as having
been earned equally over each year that the taxpayer owned the
investment, with interest charged on the portion of the tax liability
treated as having been earned in a prior tax year.
When a US taxpayer receives a distribution from or disposes of shares
of a PFIC, an additional information return must be filed for each
PFIC. Final regulations issued on December 30, 2013 introduce an annual
filing requirement for PFIC owners beginning in 2013 if the value of all
PFICs owned by a taxpayer exceeds $25,000. These additional filings can
significantly increase the cost of preparing a US tax return.
In general, elections do not completely solve these problems. A
qualified electing fund election causes the taxpayer to be taxed on his
or her pro rata share of the ordinary income and capital gains earned by
the PFIC (similar to the flowthrough taxation of a partnership
investment), but the information required to make the election is often
not available from the fund. Further, the election normally must be made
in the first year of investment in the PFIC, and awareness of the PFIC
problem often arises much later. A mark-to-market election causes
unrealized gains or losses to be realized each year for US tax purposes,
but may result in double taxation because of a poor alignment of
Canadian and US taxes for foreign tax credit purposes.
One practical strategy is to avoid the PFIC risk entirely by
investing in funds organized in the United States and traded on a US
stock exchange. For example, many ETFs that have a global or other
non-Canadian focus are also listed in the United States, and the foreign
exchange conversion fees incurred are likely to be small relative to
the tax and reporting costs resulting from PFIC status. Also, direct
investment in stocks or bonds generally does not raise a PFIC concern.
Alternatively, if only one spouse is a US taxpayer, the US spouse
could consider loaning money to the non-US spouse. The non-US spouse
could then invest in mutual funds or ETFs in his or her own name without
raising a PFIC concern.
The taxpayer could also take the filing position (not entirely
without risk) that investments held in an RRSP for which a treaty
election has been filed are not subject to the PFIC rules.
Finally, the careful choice of a fund can help to limit a taxpayer’s
exposure to US taxes under the default (absent the elections) PFIC
regime, though the reporting requirements still remain. Investing in
funds that have a stable distribution history helps to reduce the risk
that a portion of the distribution will be considered an excess
distribution. Also, investing in funds that maintain a high payout ratio
helps to limit the risk that the taxpayer will realize a large capital
gain when the fund is sold. Finally, maintaining a short holding period
will effectively limit the interest charge if there is an excess
distribution or capital gain.
Chris Watt Bickley
Deloitte LLP, Ottawa