U.S. citizens living in Canada, and Canadians who have moved to the U.S., are often advised not to invest in Canadian mutual funds because the Passive Foreign Investment Company (PFIC) regime may apply to them.
The IRS defines a PFIC as any foreign corporation for which:
- at least 75% of the gross income of a corporation for the taxable year is passive (investment) income, or
- the average percentage of assets held by a corporation during the taxable year that produce passive income, or which are held for the production of passive income, is at least 50%.
There are two main types of mutual funds in Canada: trusts and corporate class. Corporate class funds are likely PFICs because they’re automatically classified as foreign corporations under U.S. tax law, and they almost exclusively earn investment income. Mutual fund trusts may be different. A U.S. taxpayer who invests in them can take the position on their personal tax returns that these funds are not PFICs.
We have had informal discussions with IRS lawyers who agree that our arguments have merit. Here, we look at some of those arguments.
PFIC rules are onerous and complex. A U.S. taxpayer who sells shares of a PFIC pays U.S. tax at the highest marginal rate plus an interest charge in certain cases. For a long-term investor, the U.S. tax can easily exceed 70% of the gain on the sale of the investment.Depending on the rate of distributions from the fund, PFIC tax may also apply to annual distributions. Finally, U.S. taxpayers with more than $25,000 invested in PFIC stock must fill out Form 8621 annually for every PFIC. This is complex and expensive.
Source of the PFIC problem
The idea that Canadian mutual fund trusts are PFICs derives from a one-sentence declaration in an internal IRS memo. That memo states: “Based on the information provided, it appears that all the Canadian mutual funds held by Decedent’s RRSP would be classified as corporations for U.S. tax purposes.”
The memo does not explain which mutual funds it applies to. Further, the memo states that it “may not be used or cited as precedent.” So, there is no official IRS position or binding precedent establishing that Canadian mutual fund trusts are PFICs.
Considerations for clients with PFIC problems
To be a PFIC, a Canadian mutual fund trust must be classified as a corporation for U.S. tax purposes. Under U.S. tax law, if any investor in a Canadian mutual fund trust has any liability under Canadian law, the entity is not a corporation and, therefore, not a PFIC.
That means clients can make three different arguments:
- Older Canadian mutual fund trusts may not be PFICs.
Beginning in 2004, several provinces (see “Provincial statute changes,” this page) enacted legislation limiting the liability of investors in Canadian mutual fund trusts. This would seem to indicate that, prior to 2004, investors in Canadian mutual funds had some liability. Thus, the IRS’s “any liability” threshold would be satisfied and the Canadian mutual fund trust would not have been a PFIC at the time of its creation. Even though the legislation changed, the fund would retain its U.S. tax classification and remain a non-PFIC. In short, if a mutual fund was created in 1998, for instance, there is a good argument that the fund was not a PFIC when it was formed and remains a non-PFIC today.
- Privately sold Canadian mutual fund trusts may not be PFICs. The aforementioned provincial legislation only applies to certain mutual funds. Certain Canadian mutual funds are not “reporting issuers” in the language of securities legislation, and are thus not covered by the liability-limiting legislation. As a result, they may not be PFICs.
- All Canadian mutual fund trusts may not be PFICs. There is also an argument that no Canadian mutual funds are PFICs, regardless of their reporting-issuer status or formation date. Many Canadian mutual fund trusts disclose potential liabilities in their prospectuses. Additionally, Canadian mutual funds are organized as trusts, and individual beneficiaries may have some liability for the debts and obligations of the trust as principals of an agent (rather than as beneficiaries of a trust). This is a function of the liability-limitation legislation only applying to beneficiaries in their capacity as beneficiaries—not as principals liable for the actions of an agent. This argument is less strong, and so less likely to persuade the IRS than the other two arguments.
One caution: All three arguments only work if the mutual fund trust has not registered under the U.S. 1940 Investment Company Act. Most Canadian mutual funds do not register. For an individual U.S. taxpayer, taking the position that a mutual fund trust isn’t a PFIC not only eliminates the PFIC regime, but it also gets rid of the complex annual accounting paperwork.
Certain Canadian financial institutions have publicly stated their mutual funds are likely PFICs. But it isn’t so clear cut. A U.S. taxpayer is only required to take a “reasonable” position on his or her U.S. tax return. Other taxpayers, such as financial institutions, are also required to take “reasonable positions.” Nothing prevents two different taxpayers from making two different arguments regarding the classification of the same fund, especially when there is no official IRS position or binding precedent.
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