Why are PFIC rules important for holders of Canadian mutual fund?
Many American citizens living or working in Canada have invested in Canadian mutual funds – likewise, many Canadians who subsequently moved to the United States retained their Canadian mutual funds holdings. They likely are unaware of the PFIC rules. Consequently, many American taxpayers holding Canadian PFIC have not met their reporting obligations. Not only that, but PFIC investments are to be avoided since its taxation (with the exception of the QEF regime) designed to be punitive.
American taxpayers who have an interest in a PFIC must file Form 8621 (unless maximum value is less than $ 25,000 and no sale) with their tax returns.
In all likelihood, these investments are held within a foreign bank (securities) account – in that case, if the total value of foreign accounts, including mutual funds, owned and controlled by an American taxpayer exceeds $ 10,000 at any time during a taxation year, a FinCEN 114 form (FBAR) must be filed separately with the Treasury Department. Regardless of the account balance, the existence of the foreign bank accounts is to be reported on Schedule B to the tax return.
The Dec 30, 2013 revenue ruling somewhat reduced the paperwork/reporting requirement since a form 8621 is no longer required if there is no disposition, no election made and PFIC holdings are less than $25,000 http://www.irs.gov/irb/2014-3_IRB/ar05.html
Penalty for failure to file a form 8621 : $10,000 (starting with tax year 2013) Section 6038D(d). Also, the statute of limitation on the whole return would not expire until 3 years after the form 8621 is filed (so no statute of limitation if no informational return/form 8621 is filed) Section 6501(c)(8)1
The remaining of this article is written under the assumption that Canadian mutual funds (treated as trusts under Canadian law) are PFICs. It is however noteworthy to note that while Canadian mutual funds definitively meet the “passive” part of the PFIC definition (income test & asset test discussed below), it is debatable that it is a corporation.
The IRS says that it is a “business entity” if it is not a trust (Section 301.7701-2(a)) 2
A Canadian mutual fund might or might not be an investment trust as described in 26 CFR 301.7701-4 (c)(1) – in which case the mutual fund will not be a PFIC 3
The IRS has issued a private ruling letter (200752029) in the context of PFIC in which it ruled that the mutual fund was an eligible entity (for check the box classification – in this case, the fund elected to be treated as a corporation on form 8832). Absent such an election, the eligible entity (with several members) would be treated as a partnership, hence it would be a pass-through entity and the PFIC rules wouldn’t apply.
Outside the PFIC context, the IRS issued a private ruling letter (200024024) also indicating that a mutual fund is an eligible entity.
– Private Letter Ruling 200752029: http://www.irs.gov/pub/irs-wd/0752029.pdf :
“The Fund is not a trust under Treas. Reg. § 301.7701-4(a) because it is not simply an arrangement to protect or conserve property for the beneficiaries. The Fund is a device to carry on a profit-making business.
Because the Fund is a business entity that is not classified as a corporation under Treas. Reg. § 301.7701-2(b)(1), (3), (4), (5), (6), (7), or (8), it is an eligible entity. As an eligible entity, the Fund can elect its classification for federal tax purposes under Treas. Reg. § 301.7701-3.
On Date 1, the Fund filed a Form 8832, Entity Classification Election, indicating that is was a foreign eligible entity electing to be classified as an association taxable as a corporation for U.S. income tax purposes.”
– Private Letter Ruling 200024024: http://www.irs.gov/pub/irs-wd/0024024.pdf :
”Based solely on the facts submitted and representations made, we conclude that the Fund is a “business entity” within the meaning of § 301.7701-2(a). The Fund represents that it is not classified as a corporation under § 301.7701-2(b)(1), (3), (4), (5), (6), (7) or (8). Accordingly, we further conclude that the Fund is an eligible entity and can elect its classification for federal tax purposes as provided in § 301.7701-3T and § 301.7701-3.”
Finally, the following might have been seen as indicating that mutual funds are corporations (this memo was not written in the context of PFIC rules)
– Memo (UILC: 2103.00-00): http://www.irs.gov/pub/irs-wd/1003013.pdf
”Assuming the Canadian mutual funds held by Decedent’s RRSP are classified as corporations for U.S. tax purposes, which appears to be the case, no portion of the RRSP would be includible in Decedent’s gross estate for federal estate tax purposes.”
The IRS has not issued a revenue ruling on the subject so in theory it would still be possible to roll the dice.
Also, if unsure if you have a PFIC, you can make a protective statement (described under “Protective statement regime” on page 5 of the instructions http://www.irs.gov/pub/irs-pdf/i8621.pdf – if it later turn out to be a PFIC, the protective statement allows the taxpayer to make a late election)
Definition of a PFIC (Passive Foreign Investment Company)
Under the Internal Revenue Code, a foreign corporation that meets one of the following criteria is considered a Passive Foreign Investment Company:
- 75% or more of its gross income for a tax year is passive income (the income test); or
- 50% or more of assets during the tax year produce passive income or are held for the production of passive income (the asset test). 4
Passive income includes interest, dividends, royalties, annuities, rents, equivalent to interest income, net gains on foreign commodities, the net foreign exchange earnings, payments in lieu of dividends, income from derivatives contracts, and income from certain personal service contracts. In general, the fair market value of the assets of a foreign company (based on the value of the assets of the company at the end of each quarter) is used to apply the asset test.
If a foreign corporation owns, directly or indirectly, 25% or more of a subsidiary, the part of the company’s earnings and assets of the subsidiary must be included in determining whether the company is a passive foreign investment company.
The IRS does not classify as a PFIC an active business (for which there truly is an activity) companies such as banks, financial institutions and insurance companies. The PFIC rules are applied separately for each person while holding shares, and also separately with respect to shares acquired at different times. The PFIC does not in itself affect the foreign corporation or foreign shareholders (non-US persons).
Ok, it is PFIC. So what?
In 1986, Congress added the PFIC rules to the Internal Revenue Code because of concerns that American taxpayers investing in passive assets indirectly through a foreign investment company have an inappropriate tax benefit compared to direct investments in these assets. The purpose of the PFIC rules was to eliminate this advantage. PFIC include mutual funds based abroad. Most American investors in PFICs must pay taxes on distributions and the value of appreciated stock, regardless of whether the tax rate on capital gains would normally apply. PFIC are subject to complex and strict fiscal guidelines set forth in sections 1291 through 1297 of the Internal Revenue Code. These strict guidelines are in place to discourage the ownership of PFIC and mutual funds in particular foreigners by American investors. In fact, the rules are clearly intended to deter investors from the United States to use a foreign company as an investment fund.
The different regime for the taxation of PFICs
- Excess distribution (section 1291 of the Internal Revenue Code): This is the default regime – this is the one which will be applied to those taxpayers who do not make an election to be taxed under another regime. It also happens to be the most punitive in most cases.
- Losses disallowed – “Buy low, sell high!” How hard can that be?
- Default if no election made
- Any excess distribution (over 125% of the prior 3 years, but in the case of a capital gain of a security which didn’t previously pay dividend/interest, it would be the whole capital gain) will be taxed at top marginal tax rates (39.6%)
- If holding period covers several years, the excess distribution would be allocated over several years and interest and failure to pay penalties would be added to the tax liability
- This is reported as another tax on the 1040 meaning that the personal exemption/ itemized deduction or any other mechanism to reduce tax usually available is not available here. Only relief: one can claim a foreign tax credit on the form 8621 BUT this credit can only be applied on the tax itself, not on the interest/failure to pay penalty
- Information needed: Purchase date, cost, cash flows occurring since purchase date (including disposition price). A typical T3 only shows income for the year.
Under the excess distribution regime, distributions in excess of 125% of the average distributions of the past three years will be taxed. So, if you have a security which does not pay a dividend or interest, the 125% will be zero, hence the total capital gain will be taxed. How will it be taxed? 1) At the maximum marginal rate (currently 39.6%) 2) Allocated to prior periods with interest applied.
An excess distribution is treated as if it has been realized pro rata over the holding period for the PFIC’s stock.
With that in mind, the effect of a pro rata realization of an excess distribution becomes painfully obvious: the tax due on such a distribution is the sum of deferred yearly tax amounts plus interest. But the worst is yet to come. And that is that the sum of the deferred yearly tax amounts is calculated using the highest tax rate in effect in the years that the income was accumulated.
Very simply, this method unilaterally eviscerates the benefits of deferral by assessing an interest charge on the deferred yearly tax amounts. While there is no silver-lining, taxpayers can take some comfort in the fact that they can claim a direct foreign tax credit with respect to any withholding taxes imposed on PFIC distributions.
- Mark-to-Market: Taxpayer would simply record as capital gain/loss the unrealized portion of capital gains/loss due to fluctuation of value of the PFIC. This is the alternative that makes the most sense. While one can not record a capital loss (below basis), it is possible to reverse prior year capital gains.
- Requires an election to be made on first year of holding the PFIC. And only available for securities traded on an exchange.
- Change in FMV is taxed as other income on 1040. Lower tax rate for LT capital gain/ qualified dividend not available but personal exemption/ itemized deduction can offset the tax.
- Losses disallowed, except to offset earlier/later years mark-to-market gains
- Information needed: FMV at the beginning and end of the year but again only available for securities traded on an exchange.
- A QEF election – most advantageous: Direct U.S. investors can make a QEF election and report the realized income attributable to PFIC shares, which most U.S. investors do. The fund must provide an annual statement to shareholders, reporting their share of income (in U.S. dollars) based up on their ownership of shares of stock.
- Income from a QEF is classified as ordinary or long-term capital gain. While losses may not be deducted currently, short-term gains are included in ordinary income. QEF election is made on Form 8621 and is binding for subsequent tax years.
- Requires an election to be made on first year of holding the PFIC – and enough info to actually report it.
- A shareholder of a QEF must annually include in gross income as ordinary income its pro rata share of the ordinary earnings and as long-term capital gain its pro rata share of the net capital gain of the QEF.
- Doesn’t sound like much, but it means that the amounts will be on the 1040, taxed at regular rates (including lower rate for LT capital gains). The idea being that taxation would be similar to the one of a US mutual fund.
- Only 2 firms in Canada provide the info to compute it (Mackenzie http://www.mackenzieinvestments.com/en/pub/media_centre/press/search_details.jsp?file=/mf/english/PressRelease/pressrelease_e_us-tax-filers-20131213 & Fidelity http://www.fidelity.ca/cs/Satellite/en/public/products/regulatory_documents/pfic )
- Information needed: Prorata share of earnings using US concepts
1 The 2013 temporary regulations increase the importance of properly identifying PFIC investments and determining whether a taxpayer is a PFIC ‘shareholder.’ Previously, there was no specific penalty for failing to file a Form 8621, other than missing the opportunity to make a timely election. Failing to meet these new requirements may now result also in extensions of the statute of limitations, and potential penalties under Section 6038D
2 Section 301.7701-2(a) defines a “business entity” […] as any entity recognized for federal tax purposes […] that is not properly classified as a trust under § 301.7701-4 or otherwise subject to special treatment under the Code.
3 An investment trust with a single class of ownership interests, representing undivided beneficial interests in the assets of the trust, will be classified as a trust if there is no power under the trust agreement to vary the investment of the certificate holders.
Ability to buy additional shares of mutual funds does not make it a corporation: From http://www.irs.gov/irb/2009-40_IRB/ar10.html : A power to vary does not exist as a result of reinvestments that occur outside of the original investment trust.
4 From IRC Section 1297, a ““passive foreign investment company” means any foreign corporation if—
(1) 75 percent or more of the gross income of such corporation for the taxable year is passive income, or
(2) the average percentage of assets (as determined in accordance with subsection (e)) held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50 percent.”
IRC Section 1297(1) makes the link to section 954(c), where passive income is described to include A) Dividends, interests, rent, annuities, B) Certain property transactions C) Commodities transactions