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 standard solution to the PFIC problem offered by certain banks and investment funds is that a US investor in a PFIC should rely on the QEF election.
This is an election on behalf of the taxpayer that the products in which they have invested and to which the election applies are not to be treated as Passive Foreign Investment Companies (PFICs). Effectively, this will eliminate the PFIC tax moving forward for the investor, provided the correct paperwork is filed for each fund every year. Though often touted as a simple way out of the PFIC problem, QEF election is anything but.
The QEF election on behalf of investors is suboptimal for a number of reasons, not least of which being that, from a nuts and bolts point of view, it’s expensive to prepare. It can cost anywhere from $100 to $500 dollars to prepare Form 8621 properly: and this is per mutual fund, per year. This is a drop in the bucket when compared to the actual tax consequences of the QEF election, however. Though a far superior outcome to PFIC-status, QEF election is not as painless as many think.
The first major issue with QEF election is that a taxpayer must “clear the slate,” so to speak. This means that one must realize all unrealized capital gains for the years between when the individual bought the investment and when the individual first uses the QEF election. The taxpayer is then assessed the PFIC tax on all of this with the tradeoff of never again having to deal with it as a PFIC — provided the appropriate yearly filing obligations are observed, per mutual fund.
This of course assumes that the QEF election is done properly in the first place. In addition to the compliance costs already noted, Form 8621 is rather complicated, and there is much room for error. The problem with this is twofold: first, if done improperly an individual is still exposed to the PFIC problem and second, it now alerts the IRS to an individual’s holdings in possible PFICs and encourages the assessment of the PFIC tax as well as applicable penalties for incorrect filing.
Finally, the QEF election on behalf of an investor can change the character of an individual’s earnings. This can actually wind up including income otherwise taxed at preferential rates (notably, dividends) as ordinary income, taxable at an individual’s existing marginal rate.
All of this assumes that the funds in question make available all of the relevant material to make the QEF election in the first place. This is not always the case. Though many larger Canadian Mutual Funds do furnish the required information for QEF election, it is most certainly not the case for all funds. Where it is not the case, individuals still face exposure to the onerous PFIC regime and are unable to make a QEF election.
Ultimately, though the QEF election is preferable to PFIC status, it is not without its own problems. The problems noted here assume that Canadian mutual funds are PFICs. Our view is that this is not always the case.