Why PFIC Classification Matters for Holders of Canadian Mutual Funds

Sep 15, 2017

Today, the FBAR Wiz examines the importance of the IRS' classification of the 'passive foreign investment company' ("PFIC"), and why such classification matters for holders of Canadian mutual funds. Canadian expats should also be tuning in, as they are likely to have Canadian mutual funds. 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. The IRS has not issued guidance on how the estimated 1 million U.S. persons residing in Canada should report mutual fund investments on their (required) United States tax returns. The general view is that a Canadian mutual fund is a corporation and may be classified as a PFIC for United States tax purposes. A PFIC is defined under Internal Revenue Code § 1297(a) as a foreign corporation for which 75% of its annual taxable income is passive income (dividend, royalty rent, capital gain, and annuity income) or at least 50% of its assets produce passive income. Owning an interest in a PFIC entails complex reporting requirements and exposes the US-person owner to punitive tax consequences, including: (1) the distribution or gain on sale may be required to be spread over the years the investor held the investment; (2) the amounts allocated to years before the current taxable year are taxed at the highest ordinary income rates in effect for those years (currently 39.6% plus any state/local taxes); and (3) the IRS collects interest as though these amounts had actually been taxed in the prior years and the taxpayer simply failed to pay the tax until the year in which the excess distribution or sale occurs. A mutual fund manager may be able to, and in light of the potential fiduciary duty owed by the fund to its investors probably should, elect to treat a Canadian mutual fund trust as a partnership for US tax purposes and thus eliminate the risk that it is a PFIC. American taxpayers who have an interest in a PFIC must file Form 8621 (unless the maximum value is less than $ 25,000 and no sale has occurred) 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. You can quickly determine if you have an FBAR filing obligation (along with other filing obligations) by using the free FBAR Wiz app. A December 30, 2013 Internal 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. The penalty for failure to file a Form 8621 is $10,000 (starting with tax year 2013) pursuant to IRM § 6038D(d). Also, the statute of limitations on the whole return would not expire until three years after the Form 8621 is filed (so the statute of limitation will not run if no informational return/Form 8621 is filed) pursuant to IRM § 6501(c)(8). The remaining of this article is written under the assumption that Canadian mutual funds (treated as trusts under Canadian law) are PFICs. It is important to note that while Canadian mutual funds definitively meet the “passive” part of the PFIC definition (i.e., the income test and asset test discussed below), it is debatable whether such investment vehicle may be considered a "corporation." The IRS classified something as a “business entity” if it is not a trust (26 CFR § 301.7701-2(a)). 26 CFR § 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 26 CFR § 301.7701-4 or otherwise subject to special treatment under the Code. A Canadian mutual fund may or may not be an investment trust as described in 26 CFR § 301.7701-4 (c)(1) – in which case the mutual fund would not be classified as a PFIC. The IRS has issued a Private Letter Ruling (PLR 200752029) in the context of PFIC in which it ruled that the mutual fund was an "eligible entity" (i.e., the 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 200024024 "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). Private Letter Ruling 200752029 "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." Memo (UILC: 2103.00-00) "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 – 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).

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). So now you understand the importance of carefully analyzing the IRS' various definitions and classifications, as it makes a world of difference if an account as treated as a PFIC or not. Remember that you can quickly determine your offshore reporting obligations by trying out the free FBAR Wiz app.