Defining Mutual Funds, ETFs and REITs
A mutual fund is created by a company that pools funds from many investors and invests it in stocks, bonds or other assets across many industries and often countries. These are popular with banking and brokerage firms to offer clients diversification in their portfolio without requiring a large portfolio.
An ETF (Exchange Traded Fund) is a type of security that tracks an index, sector, commodity or other asset but can be purchased or sold on a stock exchange the same as a regular stock. Because there are multiple assets within an ETF, they can be a popular choice for diversification.
REITs (Real Estate Investment Trusts) are modelled after mutual funds and allow individuals to pool their capital in a company that owns, operates or finances income-producing properties, usually specializing in specific real estate sectors. These are usually traded on major exchanges offering liquidity to investors.
The downside to these investment types is that they create adverse tax effects and burdensome filing requirements for U.S. persons if the IRS views the mutual fund, ETF or REIT as a Passive Foreign Investment Corporation (PFIC).
Tests to Determine a PFIC
A company is considered a PFIC if it meets one of the following tests:
- Income Test – At least 75% of the foreign corporation’s gross income is passive income; or
- Asset Test – At least 50% of the assets are held to earn passive income.
For this reason, most Canadian mutual funds, Canadian ETFs and Canadian REITs are considered a PFIC. If you are a U.S. taxpayer with a PFIC, you may have to file IRS Form 8621-Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, to report the interest held in each PFIC. These will include PFIC funds held personally, in a Canadian holding company, in an RESP or in a TFSA. PFIC funds held in an RRSP do not have to be reported.
Information Required
For each PFIC, you will need to report on Form 8621:
- Name and address of the fund;
- Class of shares;
- Date of purchase;
- Number of shares held at year-end;
- Value of shares held at year-end;
- Current year distributions;
- Details of any gain or loss resulting from a sale of your holdings in the fund;
- Taxation of PFIC if No Election.
Provided you are over the threshold for filing Form 8621, a PFIC held without an election is taxed on excess distributions at the highest income tax rate for the applicable year. Your excess distributions is a formula which averages your distributions over the years owned and taxes you at the highest tax rate for that year. Excess distributions include income earned and capital gains on sale of the PFIC. The highest tax rate for 2021 is 37%, however, the Biden administration has currently proposed to increase this rate to 39.6%, which was where the top rate was in 2017. This could be significant for a long-term capital gain on sale of a PFIC which is normally taxed at a rate of 0%, 15% or 20%, depending on your income level. If in 2020, you sold a PFIC at a gain of $1,000 which you owned for four years, $800 is taxed at 37% (2018–2020) and $200 is taxed at 39.6% (2017). You would also be charged interest on distributions allocated to the 2017–2019 years.
Exemptions from PFIC Taxation
There are certain exemptions from the above reporting requirements. These include:
- De Minimis Exemption – If the value of all your PFIC stocks owned on the last date of the year does not exceed $25,000 ($50,000 if you file Married Filing Joint), the sale of a PFIC must still be reported on Form 8621;
- Note that stocks where you have made one of the two elections detailed below are not included in the threshold for the De Minimis calculation;
- Foreign pension plans – PFIC owned through a foreign pension plan where tax treaty between countries exempts (Ex. RRSP, RRIF in Canada-U.S. tax treaty);
- Short-term ownership – You owned the PFIC for 30 days or less;
- Start-up year – If it’s the first year of the company (where income is primarily passive), it’s not considered a PFIC in that year but would be the following year; or
- Limited number of other specific exemptions beyond the scope of this summary.
Elections to Avoid PFIC Taxation Treatment
The elections below help alleviate the negative tax consequence, however, for either election to work it must be made in the year you first purchased the fund.
Qualifying Election Fund or “QEF Election”
The QEF election allows you to report income on an annual basis and receive capital gains treatment when the investment is sold. Note however, that all dividend income earned in a PFIC is still taxed at ordinary income rates.
To make the election, the company must issue shareholders a PFIC statement indicating income earned per share in the year calculated under US income tax law. Some Canadian PFICs issue these statements, however many companies do not. You must file the Form 8621 for each PFIC you hold where you can make the QEF election so although the income tax consequence is lessened, the burden of filing the Form 8621 for every PFIC you hold remains. The election is valid for the year of the election and future years until the election is revoked or the fund is completely sold.
Mark to Market Election
The Mark to Market election (MTM) is only available with marketable stock (e.g. funds traded on the Toronto Stock Exchange). With MTM, you report the annual increase in the fair market value (FMV) of the stock, except it’s reported as ordinary income. A FMV decrease would be an ordinary loss up to your prior inclusions. Similarly, your capital gain on sale is also taxed as ordinary income and losses can offset previous inclusions. Just like the QEF election, the election is valid until revoked or your share of the PFIC is completely sold. A shareholder of a PFIC can switch from the QEF election to MTM but cannot switch from MTM to QEF.
Penalties and Statute Barred Years
If you hold at least one PFIC and do not meet one of the exemptions mentioned above, you must file the Form 8621 for each PFIC you own (unless you filed the QEF or MTM election). There is no specific penalty for failure to file Form 8621, but could be coordinated with Form 8938 (Statement of Specified Foreign Financial Assets) filing requirements, which if required and not filed properly, could lead to a $10,000 penalty. Also, failure to file the form leaves the statute of limitations open on all tax matters for that tax year indefinitely, not just the Form 8621. The statute of limitations is the time the IRS has to go back and review your tax filings. Standard Income Tax statute of limitations for the IRS is three years from the due date of the federal income tax return or filing of the return, so filing the Form 8621 is essential for U.S. owners of PFICs.
Complex Compliance Requirements
Determining the tax and filing obligations from a U.S. person owning Canadian mutual funds or ETFs can be very complex, especially when examining and executing the relief options. Mishandling of a PFIC could be costly in terms of penalties and future review of other areas in your U.S. tax return. When you are required to file tax returns in both countries, your investments should be reviewed carefully to ensure you understand the U.S. income tax and reporting obligations of your holdings.
If you have any questions or would like assistance, please feel free to reach out to one of our cross-border specialists.