Written by Max Reed Canadian residents who aren’t U.S. citizens may be surprised to know that U.S. estate tax can apply to them. That’s because U.S. estate tax applies to...
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.
- 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.
- 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.
- 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.