How far-reaching is the IRS’ power to collect taxes from Canada?

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    Written by Max Reed

    If you’re a U.S. citizen living in Canada, you might be frantic about the IRS tax crackdown and hefty fines if you haven’t been tax compliant. How fast can the IRS come after you? What are its enforcement powers in Canada, anyway?

    Turns out, Canadian law has a trick up its sleeve: a firewall to help U.S. citizens in Canada.  

    Here’s how it works. Say George is a dual Canadian and U.S. citizen who lives in Calgary.  He’s not up to date on his U.S. taxes. In 2014, George sold his Canadian house for a large gain. Thanks to FATCA, George’s bank reported his financial information to the IRS. The IRS analyzed George’s financial information and saw a spike in his account, so they decided to investigate. After an audit, the IRS determined that he owed US$100,000 in U.S. taxes for tax year 2014 as a result of the house sale.  

    Under the Canada-U.S. Tax Treaty, the Canada Revenue Agency will not help the IRS collect taxes owed by a person who was a Canadian citizen at the time that the tax debt arose. This is half of the firewall that protects George: The IRS says he owes U.S. taxes from tax year 2014, at which time he was a Canadian citizen. So the CRA will not help the IRS collect the tax he owes. 

    So, with Canada out of the picture, the IRS would have to act on its own to collect taxes. It can get a judgment from a U.S. court stating that George owes the U.S. government US$100,000, which can be easily enforced against any assets he has in the United States. But the IRS may have a hard time enforcing this tax debt against George’s Canadian assets. This is because of the other half of the firewall that protects George.

    Overly simplified, a foreign creditor such as the IRS has to get the permission of a Canadian court before it can enforce a foreign judgment against assets in Canada. In a 1967 case called United States v. Harden, the Supreme Court of Canada ruled that Canadian courts will not enforce judgements for U.S. taxes owed. This precedent still applies. 

    A couple of caveats are in order. Laws can and do change. Simply relying on the firewall might be risky and stressful for our U.S. citizen north of the 49th. Further, intentionally refusing to pay a U.S. tax debt is a criminal offense in the United States. So it is possible, although perhaps unlikely, that the U.S. government would eventually pursue criminal charges.  A more prudent approach for George might be to catch up on his U.S. taxes using the Streamlined Procedure (the IRS’ amnesty program) before the IRS finds him through FATCA, if only to ultimately renounce his U.S. citizenship.

    The Basics of U.S. Tax for Canadians

      istock taxes

      Written by Max Reed

      The US Foreign Account Tax Compliance Act (FATCA) has generated a lot of attention in Canada. It recently became Canadian law,  as a part of the 2014 federal budget. FATCA requires Canadian financial institutions to send information about their US account holders to the Canada Revenue Agency, which will, in turn, send the information to the IRS.

      FATCA did not create the obligation for US citizens and certain US Greencard holders anywhere in the world to file tax returns – those have existed for over 100 years. FATCA does make these obligations more pressing, because the IRS will soon have information on US citizens in Canada.

      FATCA, very understandably, frightens people.

      This is the first in a series of columns which will try to help US citizens living in Canada understand their tax obligations in this post-FATCA world.  

      For now, there is no need for panic. The IRS is not coming to seize your house. In a future column, I will explain exactly what enforcement powers the IRS has over US citizens in Canada. Panic may not be warranted, but the cautious route is to become compliant – if only to later give up your US citizenship (a topic for a future column). Even if you choose not to comply — not recommended — you should be aware of the risks you are taking.

      To get on the IRS’s good side, you can take advantage of an amnesty program called the streamlined process, which helps US citizens in Canada (and elsewhere) catch up on overdue tax returns without fear of penalties.  

      To take advantage of the streamlined process, you must:

      1. Have been outside of the United States for at least 330 days during at least one of the last three years and during that time have not lived in the country;  
      2. File complete US tax returns for the three most recent tax years;
      3. File 6 years of the FBAR form electronically. The FBAR form is required if at any point during the tax year you had more than USD $10,000 in foreign bank accounts;
      4. Certify that your failure to file the required US tax forms was not intentional.

      US citizens in Canada are only subject to US federal tax. Canadian federal and provincial tax rates are generally higher than the US federal rate, and the Canadian taxes you pay are credited against your US taxes. Unless you have US source income, most US citizens in Canada will not owe anything. As such, for most people getting caught up just means filing some paperwork.

      However, the paperwork can be daunting. Currently, there isn’t any specialized tax software designed to help you. But some American tax software, such as Turbo Tax, can be adapted to suit your needs. For those with simple financial circumstances, there are self-help books available. For those with more complicated financial situations, there are many accountants at many different price levels who specialize in US tax returns. As with everything, those with more expertise and experience tend to charge more. A prospective accountant should be able to give you a quote, so shop around. Living in a post-FATCA world complicates life for dual citizens, but with some early attention, these problems can be solved before they cause more headaches.  

      FBAR: Reporting Your Canadian Financial Accounts

        istock cda taxes

        Written by Max Reed

        The United States has two tools to get information on accounts held by its citizens: FATCA and FBAR.

        Lots of attention has been paid to FATCA — less to FBAR (Foreign Bank Account Reporting). Its rules have been around since the 1970s. FBAR targets accounts that US citizens own, as well as accounts over which US citizens have signing authority. The ownership piece is pretty straightforward. US citizens in Canada are obliged to file an FBAR form if they have an ownership interest in “foreign” (i.e. outside the United States) bank accounts that have a cumulative value of USD $10,000 or more. All accounts should be listed on this form.

        The signatory authority provisions are more complicated. All US citizens must report all foreign accounts worth USD $10,000 or more (even those owned by non-Americans) over which they have signing authority (i.e.  the ability to move money in and out of the account), even if they don’t have a financial interest in the account.  Many different types of accounts have to be reported, including bank accounts, accounts that hold securities, certain insurance accounts that have a cash value, accounts with a mutual fund, and commodity brokerage accounts. The few exceptions to the FBAR rules are unlikely to apply to any Canadian institutions.

        The implications of these rules are maddening. Take this example. Fred is a US citizen who is a Toronto-based broker who manages money for hundreds of Canadian clients. Because he has the power to move money in and out of different accounts, he may be considered to have signing authority over them. Thus he would have to report all of these accounts to the IRS on his annual FBAR form.

        Take another example. Jill is a US citizen who serves on the board of a non-profit organization. Because she has the power to sign cheques on behalf of the organization, Jill would have to report the account on her FBAR form.

        Or consider Jenny, a lawyer and a US citizen who has signing authority over the trust accounts which hold client funds. Jenny may have to list all these accounts on her FBAR form.

        All three of these individuals are in a tight spot. US law requires them to report this information, but Canadian privacy law may prevent them from doing so.  The problem is exacerbated by the FBAR fines, which range from USD $10,000 per account to USD $100,000, or 50% of the total value of the account if the failure to file is willful. FBAR fines can be excused if there were good reasons why the form could not be filed. Importantly, the CRA has indicated that it will not help the IRS collect the FBAR fines. And, to date, the IRS has not been enforcing the FBAR requirements rigorously. But even if the risk is remote, the potential fines are large.

        There are some solutions. The most obvious is to check to see if the signing authority you have over bank accounts is sufficient to necessitate their reporting on an FBAR form. There is an amnesty program for delinquent FBAR forms. A riskier option is to include a letter with your FBAR form indicating why, under Canadian law, you cannot report certain accounts. US citizens with signing authority over many accounts should likely talk to a US tax professional to figure out how to deal with the FBAR rules.

        Estate Planning for U.S. Citizens in Canada

          istock last will

          Written by Max Reed

          Ben Franklin famously said that nothing in life is certain except death and taxes. One wonders, then, what Franklin would say about taxes due on death? US citizens living in Canada are subject to two different tax regimes on their death. For them, it would seem that Ben Franklin was doubly right.

          Consider Rajit, an elderly single US citizen who lives in Montreal. His estate is made up of his principal residence worth USD $2 million, an RRIF worth USD $2 million, and a Canadian stock portfolio worth USD $2 million. When he dies his estate will be subject to a Canadian deemed disposition and the US estate tax.

          The US estate tax is imposed on US citizens in Canada. The total value of Rajit’s estate will be used to calculate his estate tax liability. There is, however, a lifetime USD $5.43 million (the 2015 amount) estate and gift tax exemption. At death, the first USD $5.43 million of his estate is exempt from tax. The remaining USD $570,000 will be subject to the US estate tax.

          Assuming a 40% tax rate Rajit’s estate will have to pay USD $ 264,000 of estate tax. Any taxable gifts Rajit made before his death would reduce the value of his exemption and may result in more estate tax. Let’s say Rajit gave USD $430,000 worth of stock to his son a few years ago.  He would have used up USD $430,000 of his lifetime estate and gift tax exemption and only $5 million would remain.

          Rajit’s estate will also be subject to the Canadian deemed disposition, meaning it will have to pay tax on the capital gains on all assets. To calculate the capital gain Rajit will have to subtract his basis in the assets (overly simplified — what he paid for them) from their current fair market value. Let’s say that Rajit paid USD $1 million for his stock portfolio which has doubled in value. The estate will have to pay Canadian tax on USD $1 million. Because it is his principal residence, Rajit’s house is exempt from the Canadian deemed disposition.

          Death taxes in Canada and the US are different. Rajit may be able to use the Canada-US Tax Treaty to offset some of the tax in both countries. For dual citizens, strategies to reduce the tax payable at death have to work in both countries. Some common Canadian strategies don’t work in the US and vice-versa. If Rajit gives up his US citizenship before his death, he may not be subject to the estate tax. Rajit must be careful, however, to follow the proper process to avoid the exit tax imposed when Americans give up their citizenship, and to avoid being considered a “covered expatriate” (this is discussed in another column in this series). He should get professional tax help.

          Taxes on death, to paraphrase Franklin, may be certain, but some planning may reduce the double taxation.

          Real Estate Ownership for U.S. Citizens in Canada

            istock real estate

            Written by Max Reed

            Owning real property on both sides of the border can create a confusing tax situation.

            Consider this example. Stefan and Jane are married and live in Vancouver. Jane is a Canadian citizen while Stefan holds both US and Canadian citizenships.  In 1994,  shortly after getting married they bought a house for $250,000 (all figures Canadian for simplicity’s sake) which they own jointly. Thanks to the Vancouver housing market the house is worth $2.25 million. Their increased net worth prompted Jane to buy a condo (in her own name) in Arizona, next to Stefan’s favorite golf course.   

            Now Stefan and Jane might owe some US tax if they want to sell the house or the condo. Under Canadian tax rules, the sale of their principal residence — their house — is free of capital gains tax (the tax due when an asset you own has appreciated in value).

            American rules are different, and as a dual citizen, Stefan is subject to both US and Canadian tax rules. In this case, the gain on the house would be $2 million (the purchase price of $250,000 is subtracted from the sale price of $2.25 million to arrive at the capital gain).  Stefan’s half of that is $1 million. Under US tax rules, Stefan is allowed to exclude $250,000 worth of capital gain income from tax. But that leaves $750,000 of capital gain income that is still subject to tax at a rate of 23.8% (approximately $178,500 of tax due). This might come as a surprise to Stefan and Jane. Like other couples, they may have thought — correctly under Canadian rules — that the sale of their principal residence was tax free. To avoid the American taxes, Stefan may be able to give his share of the house to Jane prior to the sale (and preferably years before the sale), but he should consult with a tax advisor before doing so as this will have US gift tax implications.

            Stefan’s ownership of the house isn’t the only US tax issue the couple has to grapple with. Jane owns a condo in the US. If she sells this condo, she will have to pay both US and Canadian capital gains tax on the sale. However, she can use the US tax paid as a credit to offset the Canadian tax on the sale.

            American estate taxes are another potential problem. Jane is Canadian, but because the property is located in the US, her estate may be subject to American estate taxes if she still owns the condo when she dies. US rules exempt the first USD $60,000 of property that Jane owns in the US from US estate tax. The Canada-US Tax Treaty offers further relief that should prevent Jane from owing US estate tax. If she does have some exposure, there are strategies (including owning the US property through a trust) that Jane can use to reduce her exposure to US estate tax. The tax issues surrounding the ownership of US real estate are complex, so the couple should seek professional tax help before purchasing property.  

            Jane and Stefan need to pay careful attention to the tax rules so that their real property doesn’t become a real tax problem.

            U.S. Tax Implications of Canadian Registered Plans

              istock rrsp

              Written by Max Reed

              Canada has a raft of registered plans. They all have different US tax consequences.

              Consider the following example. Julia is a US citizen living in Canada. She has an RRSP to save for retirement. She uses her Tax Free Savings Account to invest in some individual stocks. She has an RESP and an RDSP for her disabled son, Julio. When doing her annual US tax return, Julia can’t figure out what to do with all of these different accounts.

              There are two pieces to the puzzle: reporting the income and reporting the existence of the account. The RRSP is the easiest, because for tax purposes, retirement savings plans function the same way in the US as in Canada. The tax on income that builds up inside the plan is deferred until the money is taken out. Under a recent IRS ruling, if Julia is filing US taxes through the amnesty program (the streamlined program) then she will need to file Form 8891 each year in order to defer the tax and report the account. If Julia is all caught up on her US taxes, however, she no longer needs to file that form every year.  

              Julia’s other plans create more complications. For US tax purposes, income that builds up inside TFSA, RESP, and RDSP accounts is taxable. Let’s say that in one year, Julia earned $1000 in dividends in her TFSA. In Canada, she would not have to pay tax on this $1000. But in the US, this income is not protected and she has to pay tax on it. The same would be true if the $1000 was earned in an RESP or RDSP.  If Julia were married to someone who is not an American, she could put the RESP or RDSP in her spouse’s name. However, depending on its value, transferring an existing plan might constitute a gift under the US tax rules so Julia should consult a tax advisor first.

              Figuring out how to report these plans is a bit tricky. The IRS hasn’t clarified its position. In Canada, many of these plans are organized as trusts, and therefore the conventional wisdom is that they are also trusts under US law.  This means a US citizen in Canada has to file the complicated 3520 and/or 3520A forms every year. However, a detailed technical analysis suggests that TFSA, RDSP, or RESP plans are not trusts under US law, thus sparing US citizens in Canada the pain of filing the 3520 and/or 3520-A annually.

              So how should Julia report her various plans on her annual US tax return? Julia can attach a letter to her annual US tax return which describes the plans, states that the income earned has been reported on US Form 1040, recognizes that the IRS hasn’t been clear on how they want these plans reported, and asks the IRS how to report these plans in the future. If audited, Julia would simply tell the IRS she didn’t know how to report the accounts and has written a letter telling them the plans exist. Such an approach may protect her from any IRS penalties, as she has made an effort in good faith to report accounts for which the IRS has not provided an official form.

              In Canada, registered plans shelter income. With the exception of the RRSP, under US tax law they do not — but they don’t necessarily need to be avoided just because of the hassle of reporting them.

              Canadian Mutual Funds Cause U.S. Tax Problems

                headaches

                Written by Max Reed

                Common Canadian investments can inadvertently cause American tax problems for US citizens living in Canada.

                Let’s take a really common example. Jack is a 50-something US citizen married to Jill (a Canadian citizen) for 30 years. They have lived in Canada for 25 years. Jack was vaguely aware that he was supposed to be filing US taxes every year, but he didn’t.

                When Jack started reading about the new US FATCA law, he learned that his bank would soon be sending his financial information to the IRS by way of the CRA.

                Jack started to comply with his US tax obligations and in the process, discovered that his retirement portfolio, which comprises of Canadian mutual funds and ETFs held outside of an RRSP, might cause him problems.

                There are strategies that can be used to help someone in Jack’s situation. For instance, Jack might also be able to gift some of these problematic investments to his wife, who is not a US citizen.  

                Jack’s situation is avoidable with some foresight and planning. Canadian mutual funds and Canadian listed ETFs are likely classified as a passive foreign investment company (PFIC) under US tax law. The IRS has not taken a clear position on this, and there may be some exceptions to the rule for older funds. If the investments are classified as PFICs and are held outside of an RRSP/RRIF, they must be reported. The form for doing so is complicated.
                Furthermore, there are punitive tax consequences for owning such an investment. For instance, when the investment is sold, the capital gain is taxed at up to 35% or 39.6% (depending on the year).  Compound interest is charged on the tax owing stretching back to the date of purchase. There are strategies available to manage this headache are complicated and likely require the services of a tax professional. The simplest solution is to not own Canadian mutual funds and Canadian listed ETFs outside of an RRSP if you are US citizen.

                If owned inside of an RRSP, these investments are much less problematic. Recent IRS rule changes have eliminated the annual reporting requirement for such investments. The Canada-US Tax Treaty (an agreement between Canada and the United States that helps sort out some of the thorny cross-border tax issues) allows US citizens in Canada to defer any tax owed on income accrued inside the RRSP until the time of withdrawal. Many advisors agree that this deferral provision likely negates any of the punitive taxes that result from the classification of Canadian mutual funds and ETFs as PFICs — but only if the investments are sold before they are taken out of the RRSP. Importantly, this is not true for other Canadian registered plans such as TFSAs, RESPs, or RDSPs.  These plans generally do not work as designed for US tax purposes.

                To avoid Jack’s situation, US citizens in Canada should exercise care in making their investment choices. Tax advice should be obtained as necessary.

                Getting Rid of Your U.S. Citizenship

                  istock americaflag

                  Written by Max Reed

                  Many US citizens in Canada want to be rid of their citizenship to avoid being subject to American tax rules.

                  Let’s use an example. John is a Canadian citizen who lives in Ottawa. His mother was American, so John is a US citizen too. He keeps reading in the paper that as a US citizen living in Canada, he’s subject to US tax rules. Having lived in Canada all of his life, he’s annoyed that he has to file extra tax returns. So he marches down to the American Embassy, pays the $2350 (the current fee) and renounces his US citizenship.  

                  Before deciding to wave goodbye to the USA, John should know that Uncle Sam will want to try and collect one last income tax before letting John leave. This “exit tax” is levied on the difference between John’s basis in all of his assets (essentially what he paid for them) and their current value. The precise way that the exit tax is calculated is quite complicated, but the bottom line is that John might find it very expensive to renounce his American citizenship.

                  John has to pay the exit tax if a) the average US tax he owes exceeded USD $160,000 a year over the past 5 years, or b) his total assets on the date he gave up his citizenship exceed USD $ 2 million, or c) he hasn’t been tax compliant for five years.

                  If John was a dual US/Canadian citizen at birth, he could avoid the exit tax, regardless of his total assets, if he files US tax returns for the last five years. In short, John has to come clean with the IRS to get out of the US tax system. John can file three years of past US tax returns under the streamlined program that was discussed in an earlier column. He would then file tax returns for two future years. With this, John would be tax compliant for five years and may be able to avoid the exit tax.

                  For John, the advantages of giving up his citizenship are obvious — no more tax problems. But there are also downsides. John can no longer vote in US elections, rely on US consular services abroad, or live and work freely in the US. John might also be subject to future problems at the border. The 1996 Reed amendment gives the US Attorney General the power to deny entry to former US citizens who have renounced their citizenship for tax reasons. This law has rarely been applied, but it remains on the books. Some US lawmakers have tried, without success, to pass harsher versions of it. It’s hard to say what future laws will look like.

                  Some Americans who have renounced their citizenship tell stories of being hassled at the US-Canada border, but the vast majority report no problems. They simply enter on their Canadian passport like the millions of other Canadians who enter the US every year.

                  FATCA’s Impact on Canadians

                    istock fatca

                    Written by Max Reed

                    The US Foreign Account Tax Compliance Act (FATCA) has made waves in Canada since the 2014 federal budget made it Canadian law. It obliges financial institutions to report the accounts of US citizens to the Canada Revenue Agency, which passes the information on to the IRS.

                    Consider this example. Vangie is an American citizen born in Denver who moved to Calgary when she was young. She’s not compliant with her US taxes. Her consulting business has clients on both sides of the border. Vangie has personal and business bank accounts with RBC. FATCA affects both.  
                    Under FATCA, RBC is obliged to report Vangie’s personal accounts to the IRS. Because Vangie was born in the US, RBC will likely ask Vangie to complete a Form W-9, to certify that she’s a US citizen. Simply filling out this form shouldn’t cause Vangie to panic — even if she is behind on her US taxes.  This is just the first step in a long, winding road by which Vangie’s information will make its way to the IRS. While determining what exactly gets reported is complicated, accounts worth less than $50,000 and Canadian RRSPs, TFSAs, RESPs, and RDSPs should not be reported.

                    It’s not entirely clear what the IRS will do with the information it receives from the thousands of financial institutions all over the world required to report to it. That’s a lot of information to sort through. Processing it will take time. Theoretically, the IRS could easily cross-reference the detailed information it receives through FATCA against the list of people who file US taxes and send out letters to those who are not filing. Postage is cheap. Flying an IRS agent to Canada to conduct an examination is the opposite of cheap. Most US citizens in Canada won’t owe US tax. So even if the IRS did start aggressive enforcement, which they currently do not do, it’s not clear how much money they would collect. For someone like Vangie, the cautious course of action is to get caught up on her US taxes before the IRS gets her information through FATCA.  

                    FATCA will affect Vangie’s business as well. Since she does business in the US, she may receive Form W-8-BEN-E which looks, and is, pretty complicated. It may require Vangie to determine the FACTA classification of her business. Businesses filing this form for the first time should consult a professional tax advisor. After the initial determination has been made, the information can simply be replicated on all future W-8-BEN-E forms.

                    As a US citizen and person doing business in the US, Vangie to have more paperwork as a result of FACTA.  But she doesn’t have to fear FATCA — like all other new laws it can be dealt with.

                    Canadian Mutual Fund: US PFIC?

                      istock bank

                      Written by Max Reed

                      Canadians have invested over a trillion dollars in mutual funds, but the IRS has not issued guidance on how the estimated 1 million US persons in Canada should report mutual fund investments on their (mandatory) US tax returns. The general view is that a Canadian mutual fund is a corporation and may be classified as a passive foreign investment company (PFIC) for US tax purposes. A PFIC is defined under Code section 1297(a) as a foreign corporation for which 75 percent of its annual taxable income is passive income (dividend, royalty rent, capital gain, and annuity income) or at least 50 percent of its assets produce passive income. Owning an interest in a PFIC entails complex reporting requirements and exposes the US-person owner to punitive tax consequences, including: 1) the distribution or gain on sale may be required to be spread over the years the investor held  the investment; 2) the amounts allocated to years before the current taxable year are taxed at the highest ordinary income rates in effect for those years (currently 39.6% plus any state and local taxes); and 3) the IRS collects interest as though these amounts had actually been taxed in the prior years and the taxpayer simply failed to pay the tax until the year in which the excess distribution or sale occurs. A mutual fund manager may be able to, and in light of the potential fiduciary duty owed by the fund to its investors probably should, elect to treat a Canadian mutual fund trust as a partnership for US tax purposes and thus eliminate the risk that it is a PFIC

                      Is a Canadian mutual fund a corporation for US tax purposes? A Canadian mutual fund is clearly a foreign (non-US) entity for US tax purposes. There are two different types of Canadian mutual funds:  mutual fund corporations and mutual fund trusts. Under the Income Tax Act, a Canadian mutual fund corporation is incorporated as a Canadian public corporation. Under Treasury regulation section 301.7701-2(a)(8), a Canadian corporation is a per se corporation for US tax purposes. Although the PFIC determination is made fund by fund, a mutual fund generally earns a great deal of passive income from the securities that it holds and owns a high percentage of assets that produce passive income, and is thus likely to be a PFIC.

                      Most Canadian mutual funds are mutual fund trusts for Canadian tax purposes and their US tax classification is less straightforward than it is for a mutual fund corporation. The US entity classification regime is complex, but generally an entity may elect its classification if it is not a trust for US tax purposes, does not meet one of the seven definitions of a corporation, and is not specifically addressed elsewhere in the Code and regulations. A Canadian mutual fund trust is not a trust for US tax purposes because it has a profit motive, the trust interests are transferrable, and the trustee can vary the trust investments. Moreover, a Canadian mutual fund trust does not meet any of the seven definitions of a corporation and is not specifically addressed in the Code or regulations. Thus a Canadian mutual fund trust is probably a “foreign eligible entity” as defined in Treasury regulation section 301.7701-3(a) and can elect to be a partnership or a corporation for US tax purposes, commonly known as a check-the-box election. In the private letter ruling PLR 200752029, the IRS accepted that a mutual fund trust from an unnamed jurisdiction was classified as a “foreign eligible entity” that could elect to be treated as a partnership or corporation for US tax purposes. The PLR is not on all fours because it does not identify the mutual fund trust’s country of origin, but it does corroborate the conclusion that a mutual fund trust generally falls into the regulatory definition of “foreign eligible entity”. Electing to be treated as a partnership for US tax purposes eliminates the potential exposure to the PFIC rules for a US investor in a Canadian mutual fund trust. 

                      In the absence of a check-the-box election, the default classification of a Canadian mutual fund trust is likely to be as a corporation for US tax purposes. In Chief Counsel Advice 201003013, the IRS concluded that a Canadian mutual fund trust was a corporation for US tax purposes. Under Treasury regulation section 301.7701-3(b)(2)(i), unless it elects otherwise a foreign entity that has two or more owners – all of which have limited liability – is classified as a corporation for US tax purposes. A Canadian mutual fund trust is a foreign entity that has more than two owners – it generally has many investors – all of which may have limited liability:  many mutual fund trusts are organized in Ontario and under the Ontario Trust Beneficiaries’ Liability Act the beneficiaries of a trust that is a reporting issuer under the Securities Act (such as a Canadian mutual fund trust) is not liable for an obligation or debt of the trust. Thus unless the fund itself elects to treat the mutual fund trust as a partnership for US tax purposes, a Canadian mutual fund trust is most likely to be a PFIC and its US-person investors are exposed to negative US tax consequences.

                      Under the Income Tax Act a mutual fund trust must be an inter vivos trust resident in Canada. The mutual fund manager acts as a trustee and owes a fiduciary duty to the beneficiary investors of the trust that it administers, just like an ordinary trustee. (See Dobbie v. Arctic Glacier Income Fund et al  2011 ONSC 25 at para. 55 , and the Ontario Securities Act section 116; Mackenzie Financial Corporation (Re), 2008 CanLII 66161 (ON SEC); and Fischer v. IG Investment Management Ltd. [2010] OJ No. 112, which was overturned but not on this point in Fischer v. IG Investment Management Ltd. 2011 ONSC 292.) Owing a fiduciary duty means that the manager must act in the trust beneficiaries’ best interests, which may encompass informing the US-person investor of the potential US tax risk associated with the investment and electing to treat the mutual fund trust as a partnership for US tax purposes to eliminate the risk of a PFIC classification.

                      Currently FATCA appears to enhance a mutual fund manager’s liability risks for breach of fiduciary duty and makes the risk-reduction issue even more urgent. A Canadian mutual fund is a Canadian financial institution under the Canada-US FATCA intergovernmental agreement and thus must report information on US account holders to the CRA, which in turn must pass the information on to the IRS. Legally and economically, a mutual fund manager has little choice but to comply with FATCA. By providing the IRS with information about US account holders, a mutual fund manager increases the risk of IRS enforcement against its investors because, for the first time, the IRS may have knowledge of an investor’s holdings. The increased chance of IRS enforcement due to FATCA disclosure may increase the investors’ US tax risk, and the Canadian mutual fund manager should be aware of the risks. Regardless of a legal obligation to do so, in the current environment a mutual fund trust may wish to elect to classify itself as a partnership for US tax purposes in order to relieve its existing US person investors of an expensive tax problem and make the fund more attractive to US investors. The PFIC problems for these US-person investors in Canadian mutual fund trusts can and should be solved with an election.