AMERICAN TAXPAYERS IN CANADA who own units in Canadian mutual funds continue to pose a vexing problem for the Canadian financial services industry: the way the U. S. taxes income from Canadian mutual funds can result in tax liability that is significantly higher than what Americans resident in Canada who own units in Canadian funds would otherwise pay under Canadian tax rules alone.

“Obviously, this is a concern for our industry,” says James Carman, senior policy advisor for taxation with the Toronto-based Investment Funds Institute of Canada (IFIC), “and also for our advisors, who value the relationships they have with their investors.”

A change in 2010 in the way the U. S. government views foreign mutual funds means that Canadian mutual funds and exchange-traded funds now are considered “passive foreign investment corporations” (PFICs) under U. S. tax law. A PFIC is an investment in which either 75% of the income it produces is derived from passive investments or more than 50% of its assets produce passive income.

The U. S. taxes its citizens, holders of U. S. green cards and U. S. residents for tax purposes on their worldwide income, regardless of their country of residence. That means that American taxpayers living in Canada – there are an estimated one million such people – must file a U. S. tax return and fulfil all other U. S. tax obligations annually in addition to their Canadian tax obligations. A tax treaty between Canada and the U. S. means that double taxation usually can be avoided.

An American taxpayer either receiving income from a PFIC or realizing a gain from the sale of a PFIC is subject to specific taxes and interest under PFIC rules. This could mean that distributions from PFICs that would be treated as dividends under Canadian tax law – or increases in the value of a PFIC, which would be treated as capital gains – would have to be included as ordinary income on the American taxpayer’s tax return. Under the PFIC regime, therefore, American investors would lose out on the tax advantages of owning units in Canadian mutual funds.

There are two possible elections that may be taken to avoid these results: the “qualified electing fund” (QEF) election and the “markto-market” election. But neither is a complete solution. In order for a QEF to apply, the PFIC must issue an annual information statement based on U. S. requirements. Most Canadian mutual fund companies are not set up to provide QEF statements.

@page_break@ “A fund may find itself in the difficult position of having too many American clients to make it feasible to provide individual manual reporting,” Carman says, “and yet not enough volume that it makes sense to build the systems to support the QEF.”

And in order to meet U. S. Treasury regulation on making a mark-to-market election on a PFIC, the PFIC must be traded on a qualifying securities exchange, as defined by the regulation – a condition most Canadian mutual funds don’t meet.

If the taxpayer chooses to make no election on the PFIC, then he or she will lose the tax advantages of dividend and capital gain treatment; essentially, all the income and gain coming from the PFIC will be treated as ordinary income, taxed at the investor’s highest marginal rate. There also is an interest penalty, which is based on the length of time the investor held the PFIC.

“It depends on how much income, after [American clients] do their Canadian taxes, could be owed in the U. S.,” Carman says. “It also depends on the composition of their investments, and the amount of their holdings. Each individual client really needs to look at their own circumstances with their investment advisor or tax advisor.”

Terry Ritchie, a registered financial planner and partner with Transition Financial Advisors Group Inc. who works in both Phoenix and Calgary, says he’s recommending that his American clients either invest in Canadian mutual funds that do provide QEF statements or avoid Canadian funds altogether. Says Ritchie: “You have to change the nature and makeup of your American client’s portfolio.”

IFIC is working with the Canadian government to ask the U. S. authorities to make policy changes on the issue of PFICs. Says Carman: “To make it really simple, we’ve basically asked that the [Internal Revenue Service] not consider Canadian mutual funds to be foreign corporations for purposes of PFIC rules, or to provide Canadian mutual funds with the option of providing the annual [QEF] information statement using [existing] Canadian tax information forms. That would allow American investors to calculate PFIC earnings that way, and not lose out on the tax advantage of owning [units in] Canadian mutual funds.”

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