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
cwattbickley@deloitte.ca

Canadian Tax Focus
Volume 4, Number 1, February 2014
©2014, Canadian Tax Foundation