To PFIC or not to PFIC: The Complex Reality of US Citizens Investing in Canada

For US citizens residing in Canada or maintaining cross border investment portfolios, few tax issues are as misunderstood, or as financially hazardous, as the Passive Foreign Investment Company (PFIC) regime. While Canadian mutual funds, ETFs, and real estate investment trusts (REITs) often serve as cost-effective and diversified investment vehicles for Canadian residents, they can trigger significant adverse tax consequences for US taxpayers under the Internal Revenue Code.

This blog post will provide an overview of the PFIC rules, the inherent risks and compliance burdens associated with holding Canadian funds as a US person, and considerations for cross border investors seeking to build a tax-efficient, globally diversified portfolio.

What is a PFIC?

A Passive Foreign Investment Company, or PFIC, is defined under US tax law in IRC §1297. Broadly, a foreign corporation is considered a PFIC if it meets either of the following tests:

1. Income Test: 75% or more of its gross income is passive (e.g. dividends, interest, capital gains); or
2. Asset Test: 50% or more of its assets produce or are held for the production of passive income

Under this definition, nearly all Canadian mutual funds, ETFs, and REITs qualify as PFICs in the eyes of the IRS, even if they are well-regarded, tax-efficient investment vehicles under Canadian law.

The Consequences of Holding a PFIC

The US tax treatment of PFICs is notoriously punitive and complex. Unless a qualifying election is made, a US taxpayer holding a PFIC is subject to the ‘excess distribution’ regime under IRC §1291, which involves the following:

• Punitive Tax Rates: Any distributions or gains from the sale of PFIC shares are taxed as ordinary income, regardless of how long the investment was held, and may be subject to the highest marginal US tax rate (currently 37%).
• Interest Charges: The IRS imposes a non-deductible interest charge on the portion of the gain that is allocated to prior years, treating the gain as though it had been earned ratably over the holding period.
• No Capital Gains Treatment: Unlike US mutual funds or ETFs, where long-term holdings are eligible for preferential capital gains rates, gains from PFICs do not enjoy such treatment unless a valid election is made.

In addition to harsh tax consequences, there is a significant compliance burden. Each PFIC must be reported annually on Form 8621, which is complex, time-consuming, and may need to be filed even if no income or gain was realized in the year.

Election Options: Mitigating the PFIC Nightmare

The IRS does allow US taxpayers to mitigate the punitive aspects of PFIC taxation through one of the following elections:

1. Qualified Electing Fund (QEF) Election: Under this option, the taxpayer includes their pro rata share of the fund’s ordinary income and capital gains annually. However, this requires that the fund provide detailed financial information according to US tax rules, information that many Canadian funds do not make available.
2. Mark-to-Market (MTM) Election: Available for PFICs that are ‘marketable stock’ (e.g. publicly traded ETFs), this election allows taxpayers to report annual unrealized gains as ordinary income. While it avoids the excess distribution regime, it results in taxation on phantom income, even when no actual distributions are received.

Neither election is simple, and both may result in taxation that exceeds the actual economic returns, a serious drawback for long-term investors.

The Practical Disadvantages of Canadian Funds for US Persons

From a portfolio construction standpoint, Canadian mutual funds and ETFs may be cost-effective, convenient, and well-diversified. However, for US persons, these benefits are often outweighed by the administrative complexity, risk of double taxation, and unfavourable US tax treatment. For example, even if a Canadian REIT is tax-efficient in Canada, it may trigger excess distribution rules and interest penalties in the US.

Exceptions and Strategic Workarounds

There are a few important exceptions and workarounds available to cross border investors:

• RRSPs and RRIFs: Thanks to the Canada-US Tax Treaty, these accounts are generally respected by the IRS, and PFIC reporting may be deferred as long as income remains in the account.
• US-Domiciled ETFs: US citizens residing in Canada may consider using US-listed ETFs that do not trigger PFIC rules. These are available for purchase in Canadian brokerage accounts but are denominated in US dollars.
• Individual Securities: Investing in individual stocks or bonds, either in Canada or the US, does not trigger PFIC rules and may offer more predictable tax treatment. This includes custom or direct indexing strategies that are beginning to gain momentum.
• Portfolio Managers: Given the high stakes involved, US citizens in Canada may want to consider consulting a professional with expertise in cross border portfolio management.

Conclusion: To PFIC or Not to PFIC?

For US citizens living in or investing through Canada, the decision to invest in Canadian mutual funds, ETFs, or REITs is fraught with complexity. While such funds may seem attractive on the surface, they come with considerable tax and compliance burdens under the US PFIC regime. Without careful planning and potentially burdensome elections, investors can find themselves subject to punitive tax rates, phantom income, and interest charges that far exceed the expected returns.

In this context, the prudent approach is to treat Canadian funds with extreme caution. When constructing a globally diversified portfolio, US persons are typically better served by US-domiciled ETFs or directly held securities, allowing them to maintain tax efficiency, reduce compliance costs, and avoid the traps of the PFIC regime altogether.

The bottom line: To PFIC, in most cases, is to invite complexity and unnecessary risk. Not to PFIC is often the wiser course.