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....
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.