As a U.S. citizen or permanent resident (green card holder), you may not be aware that the purchase of Canadian mutual funds and/or exchange-traded funds (ETFs) can trigger onerous tax reporting requirements as well as costs. Certain strategies exist to minimize the tax implications of these investments for U.S. individuals.
Canadian mutual funds and ETFs may be viewed as ‘passive’ foreign investment companies (PFICs) under U.S. tax rules. As such, they may require substantial reporting requirements on the Internal Revenue Service (IRS) Form 8621. Each individual mutual fund and/or ETF generally requires a separate Form 8621.
In the eyes of the IRS, a PFIC is a corporation based in a foreign country when:
- 75 percent of the corporation’s gross income comes from passive income (royalties, earned interest, capital gains and the like) as opposed to regular business activities; or
- 50 percent of the corporation’s assets produce passive income (i.e., investments).
A notable exemption to the above is PFICs held in registered plans such as Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs). These types of investments do not require Form 8621 as these are arguably retirement plans or trust arrangements.
U.S. tax regulations may view Registered Education Saving Plans (RESPs) as foreign trusts. While they do not require disclosure on Form 8621, they do require Forms 3520 and 3502-A, which are even weightier documents. U.S. owners of RESPs will also face U.S. tax on income, gains, and grants received from the Canadian government.
One way to avoid these regulations is to place the RESP in the name of a non-U.S. citizen, such as a Canadian spouse.
Where tax-free savings accounts (TFSAs) are concerned, the IRS may view these as similar to RESPs, although Forms 3520 and 3502-A will likely not be required. Each mutual fund or ETF held in a TFSA, however, will require a separate filing of Form 8621. Also, while savings accrue tax free in Canada, those earnings will be subject to U.S. taxation.
In the case of a PFIC that has no distributions during a tax year and whose owner has not made the qualified electing fund (QEF) or mark-to-market elections, no Form 8621 will be required. The PFIC’s income will be calculated under Section 1291.
Where there is no election, the PFIC’s owner is subject to tax under Section 1291. When the annual distribution exceeds 125 per cent of the average of the last three years of distributions, that amount will be taxed as ordinary income andwill be subject to an interest charge. In addition, any capital gains made on fund unit sales may also be taxed in a similar fashion.
If an owner applies the QEF election, their share of the PFIC’s earnings – minus any income or gains already disclosed on their U.S. tax return – will be taxed.
If the PFIC constitutes ‘marketable stock’ – traded on a national or foreign exchange – then the market-to-market election becomes available. The owner must revalue the PFIC every year-end and disclose any gain in value as regular income. Owners may deduct losses, as long as they offset any gains reported earlier.
No penalty exists per se for not filing Form 8621. Yet, if the PFIC is not reported on Form 8938 Report of Specified Foreign Financial Assets, the IRS may levy a fine of $10,000 USD for each failure to report.
If you are currently recognized as U.S. person for tax purposes and hold Canadian mutual funds or ETFs, and you have not yet complied with reporting obligations for the U.S., we recommend you consult with your tax advisor.