Creating PFIC-free Canadian mutual fund trusts

    PFIC-free Canadian Mutual Funds

    Written by Max Reed

    The Canadian mutual fund trust is a very common Canadian investment structure.  It is used by retail mutual and exchange traded funds, REITs, income trusts, and other investment fund. A common view is that US taxpayers (whether they reside in the US or are US citizens in Canada) should not invest in these trusts because they may be Passive Foreign Investment Corporations (PFICs) for US tax purposes.  Owning an interest in a PFIC is expensive for the individual investor.

    Canadian mutual fund trusts can choose whether they wish to be classified as partnerships or corporations under US tax law. If they don’t make any choice, they are subject to the default rules.  There are two arguments that, by default, certain Canadian mutual fund trusts may not be PFICs.

    1. Older Canadian mutual fund trusts may not be PFICs

    While this argument is treated in a separate blog post, I’ll review it briefly here. The key factor in determining whether a Canadian mutual fund trust is a partnership or corporation under the default rules is whether all investors in the trust have limited liability. Put simply, if all investors do have limited liability, then the trust is classified as a corporation. If all investors do not have limited liability, then the trust is classified as a partnership. Responding to concerns from the investment community,  various provincial governments started enacting legislation beginning in 2004 that gave investors in certain Canadian mutual fund trusts limited liability. Prior to the creation of this legislation, investors had some liability exposure. Thus, mutual funds in existence prior to 2004 were arguably partnerships for US tax purposes at that point in time. The liability exposure of the investors may have changed in 2004. However, the US tax classification of the trust didn’t change as per the Treasury Regulations. So the trust was a partnership for US tax purposes prior to 2004 and remains that way today. Partnerships by definition can’t be PFICs.

    1. Funds that aren’t reporting issuers under securities legislation may not be PFICs

    The laws that grant limited liability to investors in Canadian mutual fund trusts are explicitly limited to “reporting issuers,” as is defined in securities legislation.  Funds that aren’t “reporting issuers” don’t benefit from the laws granting investors limited liability. Because investors still have some liability exposure, they may be classified as partnerships for US tax purposes and are thus may not be PFICs.

    1. Election to be classified as a partnership

    Regardless of their default classification, Canadian mutual fund trusts can choose whether they want to be classified as partnerships or corporations for US tax purposes. The reasons for this are outlined in another blog post.

    Choosing a partnership classification means that a fund will not be a PFIC. Making this election requires simply filing a couple of forms. This election is suitable for trusts wishing to cement the position that they have always been partnerships for US tax purposes. For instance, if a trust wants to take the position that they were a partnership for US tax purposes, either because it is not a “reporting issuer” or it is an older fund, the trust can make a "check-the-box" election to solidify this position. The election is also particularly well tailored for newly created trusts wishing to create an investment vehicle without US tax risks for US taxpayers whether they are in Canada or not. 

    Our initial, informal, discussions with the IRS suggest that they are interested in these positions and may be open to issuing private letter rulings to confirm them. 

    Foreign partnerships (such as a Canadian mutual fund trust that is a partnership under US tax law by default or by choice) do not have to file a US tax return if they don't have US source income. Nor are they obligated to provide their investors (partners) with the K-1 form if there is no US source income. 

    Operators of Canadian mutual fund trusts should pay attention to these issues. There are at least a million US Persons living in Canada. As US tax issues become more important, these investors will want to know about whether their investment is safe from a US tax perspective. The market will expect it. Trustees of Canadian mutual fund trusts owe a fiduciary duty to their investors. This duty may include informing them of US tax risks and taking appropriate steps to mitigate these risks.

    PFIC free Canadian mutual fund trusts are a real possibility. 

    It goes without saying that this is a very simplified version of what is a complex, technical argument. It certainly isn’t legal or tax advice.

    Certain Canadian mutual funds aren’t PFICs

      Mutual Funds as PFICs

      Written by Max Reed

      Of all the tax problems faced by a US citizen in Canada none are as potentially fraught as the ownership of Canadian mutual funds. A commonly held view is that these funds are Passive Foreign Investment Companies (PFICs) under US law. This view is based on an unsubstantiated, one sentence conclusion in a non-binding IRS memorandum pertaining to estate tax. The IRS has not taken any official position on the issue. Owning a PFIC outside an RRSP can be really expensive. In some cases, in particular for long-term investors, the sale price may equal the US tax owed.   

      Here is one strategy why certain Canadian mutual funds may not be PFICs. 

      A simple, non-technical way to understand PFIC is that in order to be a PFIC each word in the acronym must apply to the mutual fund –  PFIC =  Passive, Foreign Investment, Company.  Canadian mutual fund trusts earn only passive investment income so those two words easily apply to all mutual funds. Because they are located outside of the United States, all Canadian mutual funds are "foreign" under US law so that word applies to all of them also. The only thing is question is whether they are companies (a synonym of corporation). So, when viewed under a US lense, if a mutual fund is a corporation, it will be a PFIC. If it is not a corporation under US tax rules, it will be a partnership and so not a PFIC (because not all the words in the acronym apply to the mutual fund). 

      The chief determinant as to whether a Canadian mutual fund trust is classified as a corporation under US tax law is whether all the investors of the mutual fund trust have limited liability for the debts and obligations of the fund. There is no gradation of liability. It’s like pregnancy – you are either pregnant or not. Likewise, investors are either liable or not. If any investor is potentially liable for the debts of the fund, then the fund is likely not a PFIC. 

      Commencing in 2004, various provinces passed legislation guaranteeing limited liability to investors in mutual funds. Governments don’t pass laws without reason. So it stands to reason that before these laws were in place, investors in Canadian mutual fund trusts had some liability risk. Indeed, in 2003, the Bank of Canada issued a report concluding that the personal liability of investors in Canadian mutual fund trusts was possible. The Governments of Alberta and Saskatchewan identified the same risks as a reason why they enacted legislation to fix the issue.

      Professor Mark Gillen of the University of Victoria Law School has written a long, detailed paper examining what types of liability exist. Here is one example: put very simply, the investors in a Canadian mutual fund trust have some liability for the debts of the trust because they have some control over the trustees. In a case called Trident Holdings v. Danand Investments, Ontario’s highest court concluded that beneficiaries of a Canadian business trust were liable for the debts of the trust for this reason. Though there are other sources of liability perhaps none are as important as this one.  

      Prior to 2004, when the laws granting limited liability came into effect, there is a good argument that Canadian mutual fund trusts were partnerships for US tax purposes and thus not PFICs. Although the limited liability status of the investors may have changed with the new laws, because of Treasury Regulation 301.7701-3(a) the US tax classification of those funds does not change.

      In short, mutual funds created prior to 2004 may not have been PFICs because their investors had some liability for the debts and obligations of the fund. That liability status may have changed in 2004 when new laws went into effect, thereby dealing with that problem. But the US tax classification does not change. So the funds were likely partnerships for US tax purposes (and so not PFICs) prior to 2004 and as a result remain that way to this day.

      The best thing about this strategy: owning a small fraction of a foreign partnership doesn’t require filing any extra US tax forms. The taxpayer just reports the income as normal and that’s it – PFIC problem solved.

      Consider this example to illustrate this strategy. Let's say Mitchell is a US citizen who in Canada who owns a Royal Bank mutual fund. The Royal Bank mutual fund is subject to Ontario law. Ontario passed its law giving limited liability to investors in mutual fund trusts in 2004. Mitchell's mutual fund was created in 1998. So he can use this strategy. He would report the income he gets from his mutual fund on his yearly Form 1040 (annual US tax return). But he would not have to file Form 8621 or any other special form to report his ownership of the mutual fund. Nor would he have to pay any special tax on it. 

      It goes without saying that this is a very simplified version of what is a complex, technical argument. It certainly isn’t legal or tax advice.

      Holding Canadian mutual funds inside an RRSP doesn’t cause US tax problems

        RRSP Mutual Funds Canada

        Written by Max Reed

        Canadian mutual funds held inside of an RRSP should not cause US tax problems. Assuming that Canadian mutual funds are PFICs (a position that’s far from certain), holding them in an RRSP negates the bad tax consequences that would otherwise come with stock in a PFIC (high tax rate, nasty interest charge, complex paperwork). Here is the technical reason why this is the case. The Canada-US Tax Treaty applies to income taxes imposed by the US Internal Revenue Code. The PFIC tax regime is certainly an income tax regime and is thus covered by the Treaty. Paragraph XVIII(7) of the Canada-US Tax Treaty states that “taxation” may be deferred with respect to  “any income accrued in the plan but not distributed by the plan until such time as and to the extent that a distribution is made from the plan or any plan substituted therefor.” This obviously applies to RRSPs. If Canadian mutual funds are PFICs, and they are held inside of an RRSP, then the PFIC charge described above may be permanently avoided.  According to official IRS publications, when income comes out of an RRSP it is considered pension income and subject to tax as such. For instance, Rev. Proc. 2014-55 describes distributions from an RRSP as follows:

        Distributions received by any beneficiary or annuitant from a Canadian retirement plan, including the portion thereof that constitutes income that has accrued in the plan and has not previously been taxed in the United States, must be included in gross income by the beneficiary or annuitant in the manner provided under section 72, subject to any applicable provision of the Convention

        Note that Code Section 72 is the section that deems income from a pension plan to be taxable. As such, the IRS own view is that income taken out of an RRSP is pension income and the PFIC charges may not be applicable. Even if Canadian mutual funds are PFICs, there is no reporting required if the funds are held inside of an RRSP. Combined with the IRS’ understanding of RRSP income as pension income, this lack of reporting further suggests that a US court would not subject Canadian mutual funds held inside of an RRSP to the PFIC charge. Based on this, there is a very good argument that owning Canadian mutual funds inside of an RRSP shouldn’t cause US tax problems. 

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


          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


                      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.