Although this topic has been extensively covered in the Canadian media lately, a lot of U.S. taxpayers do not fully understand the tax issues involved when they invest in Canadian mutual fund trusts, Canadian mutual fund corporations, Canadian exchange traded funds, or Canadian corporate class investments.
In IRS Chief Counsel Advice (CCA) document number 201003013 the IRS determined, though in an estate tax context, the classification of Canadian mutual funds. The document states “The first determination that must be made is whether the Canadian mutual funds…are treated for U.S. tax purposes as corporations or trusts. This depends upon the U.S. tax classification of each particular Canadian mutual fund under the entity classification rules of Treas. Reg. §§ 301.7701-1 through 301.7701-4.” It further states “However, a mutual fund may have been formed as a “trust” under Canadian law, but be properly classified as a corporation under U.S. law. Based on the information provided, it appears that all the Canadian mutual funds…would be classified as corporations for U.S. tax purposes.”
Once the determination has been made that the particular Canadian mutual fund is a corporation for U.S. tax purposes, it must then be determined as to whether the fund is a Passive Foreign Investment Company (PFIC) for U.S. tax purposes.
A PFIC is defined in IRC §1297(a) to mean any foreign (i.e., Canadian) corporation if
- 75% or more of the gross income from such corporation for the taxable year is passive income, or
- The average percentage of assets…held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50%.
Given that in most cases the vast majority of a Canadian mutual fund’s gross income is from passive sources, the fund would be considered to be a PFIC for U.S. tax purposes.
It is the classification of the mutual fund as a PFIC that causes problems for U.S. taxpayers. The PFIC rules are an anti-deferral regime aimed to prevent U.S. taxpayers from earning investment income, through foreign corporations, and deferring any potential U.S. tax on the income. Though, in reality, most Canadian mutual funds distribute 100% of their income to the unit holders such that there is no deferral of income, the funds will still fall within the classification of a PFIC.
The PFIC rules are not new. They were enacted as part of the Tax Reform Act of 1986 (P.L. 99-514), under President Reagan, and were effective as of January 1, 1987. What is relatively new, however, is that the IRS is starting to enforce these provisions. The PFIC rules are extremely complicated and a complete dissertation on these rules is far beyond the scope of this document. Taxpayers need to be aware, however, that owning Canadian mutual funds may result in an increased U.S. compliance burden (i.e., the need to file FinCEN Form 114 (aka “FBAR”), Form 8621 and Form 8938) and additional tax costs. Individuals should seek professional U.S. tax advice before they purchase these investments to ensure that they fully understand the risks and benefits.
The above information is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of section 10.37(a)(2) of U.S. Treasury Department Circular 230. The contents of this document are intended for general information purposes only.