United States citizens, Green Card holders, and residents (particularly those with Canadian ties) have likely heard the term ‘Passive Foreign Investment Company’ (PFIC) in recent years. For those of you who are unfamiliar with the term, a PFIC is (in the eyes of the IRS) any foreign (non-U.S.) corporation that meets a passive asset or a passive income test. Specifically, a foreign corporation is deemed to be a PFIC if 75% or more of its gross income is from passive sources; or if 50% or more of its assets could be used to produce passive income.
What does this mean for the average investor? Well, it is of particular concern to taxpayers with U.S. reporting obligations such as U.S. citizens living in Canada, U.S. Green Card holders living in Canada, and/or foreign nationals temporarily residing in the United States. Such individuals should be aware of PFICs and their potential tax consequences.
Obviously, Holdco’s and dormant corporations are potential PFIC candidates, but more commonly, and as you’ve likely heard, the majority of non-U.S. mutual funds are structured in such a way that they meet the IRS’s definition of a PFIC. What does that mean? Well, PFICs, including Canadian mutual funds, fall squarely into an anti-deferral regime governed by the U.S. tax authorities.
Simply put, the IRS does not like the idea of U.S. taxpayers holding investments in non-U.S. corporations, and as such, absent proper reporting and proper elections, they seek to punitively tax any income earned therein.
I’ll try to explain how income earned within a PFIC is taxed (and remember: the vast majority of Canadian mutual funds meet the income and asset tests noted above). By default, absent any elections, any distributions paid by a PFIC are compared to distributions paid across the past three years. If this year’s distribution is in excess of 125% of the prior three-year average, the distribution is taxed at the top U.S. tax rate, plus a deferred interest charge is levied.
That might not seem all that bad, especially if a PFIC pays consistent distributions, but what typical investors often don’t realize is that a sale, and the associated gain on sale, is treated the same way as a distribution.
So, imagine buying a mutual fund for $4,000, then selling it six years later for $10,000. The $6,000 gain would certainly be over and above the average distribution received over the prior three years. Accordingly, if earned by a U.S. taxpayer (i.e., a U.S. citizen living in Canada), the $6,000 gain, absent any elections, would be subject to tax at the top U.S. tax rate plus six years worth of deferred interest. Over long periods of time, that deferred interest, coupled with the top rate of U.S. tax, could be larger than the gain!
Now, the treatment of PFICs is not without relief. There are two elections available to taxpayers that can alleviate the punitive treatment discussed above. One is a mark-to-market (MTM) election, where a taxpayer effectively chooses to have the PFIC experience a ‘deemed sale’ each and every year. Hardly perfect, but at least the MTM election gets you out of the punitive excess distribution tax and deferred interest charge noted above! That said, and as you may have guessed, triggering an annual disposition could mean triggering a tax bill each and every year.
A second available election is open to qualifying funds, which allows taxpayers to have only their share of a PFIC’s annual income taxed in their hands, and at regular rates. This election is commonly referred to as the ‘QEF Election’.
Again, this is a sound alternative; however, not all PFICs qualify. To qualify, each PFIC (i.e., each mutual fund) must fashion every owner with an annual information statement showing the owner’s pro-rata share of the fund’s earnings. Most Canadian mutual fund providers do not offer such a statement, and as such, most Canadian mutual funds do not qualify for the QEF election.
Remember, the IRS’s goal here is to prevent U.S. taxpayers from deferring U.S. income tax by moving their investments abroad. Unfortunately, U.S. citizens who reside in Canada are caught in the net of this regime.
There are solutions available. In addition to the above-noted strategies, several investment managers have come up with U.S.-friendly investment solutions aimed at servicing their U.S. citizen and U.S. Green Card holder clients. T.E. Wealth’s Investment Counsel group certainly provides that service – it is our responsibility to design portfolios that achieve one’s investment goals, and maintain tax efficiency.
If you have U.S. reporting obligations and are in need of a U.S. and IRS-friendly portfolio, there are solutions available to meet your specific needs. Let’s get started.
Personable and professional, Brent Soucie specializes in cross-border tax and financial planning for U.S. citizens and/or Green Card holders residing in Canada, as well as Canadian residents with U.S. employment and/or property. His clients include professional athletes, entrepreneurs, and corporate executives.
These articles are for general informational purposes only. Please obtain professional advice before taking any action based on this information. No endorsement or approval of any third parties or their advice, information, products or services should be implied by any references to third parties contained in any article. Trademarks cited in these articles are the respective properties of their owners.