US PFIC rules for Americans holding Canadian mutual funds

Compliance costs for Canadian-resident American investors

Mutual funds are a familiar investment structure for Canadian and American investors alike. But for Americans living north of the border, holding a Canadian mutual fund is very different from holding its US counterpart. (In this article we use the term “Americans” refers to US persons, being US citizens and US resident aliens, who are resident in Canada in a relevant year.)

Americans must navigate the tax rules of both their country of citizenship and country of residence. This does not forbid Americans from holding Canadian mutual funds, but it does mean more tax compliance and potentially more tax.

Background to the passive foreign investment corporation (PFIC) rules

Like Canadians, Americans are taxed on their worldwide income in a year. While there are reliable ways to monitor foreign employment and business income, it is a challenge for any tax authority to oversee foreign passive investments.

Depending on the rules of the jurisdiction where an investment originates, there could be significant tax deferral on passive income, and the potential for conversion of ordinary income into preferably-taxed capital gains. Whether it’s by design or happenstance, such deferral and conversion may be contrary to the tax policies and practices of a foreign investor’s home jurisdiction.

Applicability to mutual funds generally

In 1986, the US introduced the PFIC rules. The main concern was the use of tax havens by wealthy individuals. Though the rules have a wide application to offshore entities of many sorts, their impact on average investors is most commonly felt when non-US mutual funds are held.

Applicability to Canadian mutual funds

For decades after the PFIC rules were introduced, it was unclear whether they extended to Canadian investments. Americans in Canada may not have been aware of the potential application of the rules to them, let alone organizing their investment choices to comply with the rules.

However, in 2010 the US Internal Revenue Service (IRS) was asked to rule on whether a deceased Canadian’s RRSP was US-situs property for calculating the US estate tax. The RRSP held Canadian mutual funds that held shares in US corporations. The US treats an RRSP as a trust, looking through it to what it owns. The IRS acknowledged that mutual funds may also be trusts under Canadian law, but stated that they would be classified as corporations for US tax purposes. Accordingly, the deceased did not directly own US shares, so no additional estate tax was due.

Though favourable in limiting the estate tax liability in that case, the implication since then has been that the IRS considers Canadian mutual funds to be corporations for all US tax purposes, including the PFIC rules.

Technical tests to be a PFIC

The PFIC rules do not list off every possible legal structure an investment may come in. Rather, they focus on what a structure does. The IRS considers a foreign corporation to be a PFIC if it meets either of the following tests:

Income test — 75% or more of the corporation’s gross income for its tax year is passive income.

Asset test — At least 50% of the average percentage of assets held by the foreign corporation during the tax year are assets that produce passive income, or are held for the production of passive income.

Three possible tax treatments

An American holding a Canadian mutual fund must report this as a PFIC with their annual income tax return. Each mutual fund requires a separate IRS Form 8621 Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. If the mutual fund itself owns other mutual funds then a separate Form 8621 is required for each mutual fund in the chain. There are three income treatments for a PFIC:

1. Qualifying Electing Fund (QEF) regime

The QEF regime was created as a way for investors in foreign mutual funds to receive similar tax treatment to US mutual funds. It will not be identical, as the investor is taxed on undistributed PFIC income as it is earned each year, making for timing differences of income recognition. Using Form 8621, the investor elects to annually include in income his or her pro rata share of ordinary income and long-term capital gains. Actual distributions in a later year are not taxable to the extent that they have already been taxed in a previous year.

To make the QEF election, the investor must obtain an Annual Information Statement (AIS) from the mutual fund provider. US tax regulations prescribe the content of the AIS, including the investor’s proportionate share of regular income and net capital gains, or sufficient information to perform that calculation.

The QEF election is the most favourable US tax treatment for a PFIC. However, as the year of income recognition will often differ for Canadian purposes, there will be limited opportunity to use foreign tax credits to protect against double taxation. Neither country allows such credits on personal passive income to be carried over to other years.

2. Mark-to-Market election

A second option on Form 8621 is to elect to mark-to-market the PFIC. This treats it as being disposed at fair market value (FMV) at the close of markets for the tax year (with no option to choose a more advantageous date), resetting the adjusted cost base (ACB) to that FMV. The investor realizes either a gain or loss from its previous ACB. Any gain is fully taxable (ie., not a capital gain) and any loss is deductible from US gross income.

The PFIC must be a “marketable stock” in order to make this election. Generally, this requires that the stock is listed on a foreign stock exchange recognized under US regulations. In the case of a mutual fund, the stocks within it would have to meet this requirement.

As with the QEF election, coordination with Canadian tax obligations presents a challenge. The US disposition is by way of election, so there is no corresponding disposition under Canadian rules. Even if it was a Canadian disposition, the result would presumably be a capital gain or capital loss, which would not align with the US treatment. Again, there would be little to no ability to use foreign tax credits.

3. Excess distribution method

If an investor does not make either of the preceding elections, the PFIC will be subject to the excess distribution method. It is the least favourable tax treatment:

- An “excess distribution” is a distribution from the PFIC that is greater than 125% of the average annual distributions received in the preceding three years.
- The excess distribution is allocated pro rata across all days the PFIC has been held.
- The amount allocated to the current year is subject to regular US income tax rules.
- Amounts allocated to previous years are generally taxed at the highest individual tax rate for that year.
- An interest charged is imposed on each of those previous years’ amounts based on underpayment of tax.
- When there is a disposition, any gain is usually treated as an excess distribution.

Application to retirement savings

Mutual funds held within a registered pension plan (RPP) are exempt from PFIC reporting rules. RRSPs and RRIFs are likely to be similarly exempt but there is some debate. Consult a qualified Canada-US tax advisor.

US persons holding Canadian registered plans

The challenge of two-fold tax compliance

Both Canada and the United States levy income tax on their residents. The US also taxes its citizens and ‘green card’ permanent residents (collectively “US persons”) wherever they are in the world.

Though our two systems are generally coordinated to avoid double-taxation, the US treatment of Canadian registered plans varies. The US taxes some income that is tax-sheltered in Canada, and has reporting rules that can make it more costly and complicated for US persons to hold such plans.

Retirement savings – RRSP, RRIF

Contributions

A Canadian Registered Retirement Savings Plan (RRSP) is like a US 401(K), the main US workplace retirement plan. The number refers to the relevant section of the US tax code. Despite the similarity, US domestic rules don’t allow a deduction for RRSP contributions, though the later withdrawal of those amounts are not taxable.

However, a deduction may be possible through an exception in the Canada-US Treaty (the “Treaty”) for qualifying retirement plans (QRPs). This is directed at plans that are primarily employer-sponsored, so not all RRSPs qualify as QRPs, though group RRSPs likely do. The deduction is limited to the current year’s maximum 401(K) limit, which is $US23,000 for 2024, and may be higher for those over age 50.

Note that 401(K) room is a per-year allotment, unlike Canadian RRSP rules that allow unused room to be carried forward to future years. Bear this in mind when considering a large single year RRSP catch-up contribution. It may be necessary to spread that contribution over multiple years to assure deductibility in both countries.

Growth

Income in an RRSP or Registered Retirement Income Fund (RRIF) is taxable in the year earned under US domestic law. Fortunately the Treaty has an exception that allows a deferral of that taxation until withdrawal. Prior to 2014, the RRSP/RRIF holder had to file Form 8891 to obtain the deferral, but it is now automatic.

Withdrawals

As noted above, undeducted RRSP contributions may be withdrawn tax-free for US purposes. Otherwise, both Canada and the US tax RRSP and RRIF withdrawals in the year taken. When filing the US tax return, a foreign tax credit can be claimed for the Canadian tax paid. Be aware that the Canadian pension income splitting rules (allowing a portion of certain RRIF payments to be allocated and taxed to a recipient’s spouse) have no effect on US reporting, where each person reports the income he or she actually received.

Non-retirement savings – TFSA

The Canadian tax-free savings account (TFSA) was legislated in 2008. Contributions are not tax-deductible, growth is tax-sheltered, and withdrawals are not taxable.

There is no special status for TFSAs under US domestic law, nor is there any relief under the Treaty, which was amended by the Fifth Protocol in 2007, just prior to the TFSA’s introduction. While the US makes no reference to TFSAs, the tax community consensus is that they are likely to be treated as foreign trusts, requiring an annual report of transactions and ownership information, using Forms 3520 and 3520-A respectively.

Details will also have to be reported at the same time as the US person’s income tax return using Form 8938 “Statement of Specified Foreign Financial Assets”, and for banking secrecy disclosure to the US Treasury on FinCEN Form 114, known as the “Report of Foreign Bank and Financial Accounts (FBAR)”.

Education savings – RESP

The Canadian Registered Education Savings Plan (RESP) provides tax assistance for education savings. Most commonly, parents or grandparents are the plan subscribers, saving for a child’s education. Contributions are made from after-tax money, with potential assistance from government sources. Income is tax-deferred when in the plan, and generally taxed to the student when withdrawn for education purposes.

A Canadian RESP is not tax-exempt under US domestic rules, and instead is likely to be treated as a foreign trust. Until recently, this required the annual filing of Forms 3520 and 3520-A as outlined above under TFSAs; but in March 2020, the US announced an exception for non-US plans for “medical, disability, or educational benefits”. There is however no relief from Form 8938 and FBAR filing, and the tax treatment remains unchanged.

That being so, a U.S person subscriber will be taxed on income generated in the plan. In addition, government grant money is likely to be treated as income for that subscriber in the year it is paid into the plan. Double-taxation can arise later when a student-beneficiary is taxed in Canada on education assistance payments.

If the student-beneficiary is a US person, RESP distributions will be taxed each year paid, unless proof is shown that the amounts are not taxable (for example, if they are partly or fully return of capital). Historically, a US person beneficiary would have to file Form 3520 in the year of any distributions. A US tax professional can advise whether the March 2020 exception relieves this requirement.

Disability needs – RDSPs

The Canadian Registered Disability Savings Plan (RDSP) provides tax assistance for those with a qualifying disability. Parents or other close family members may open a plan for a minor-age child beneficiary with a disability. The child may become the holder at age of majority if he or she is contractually competent.

Contributions are made from after-tax money, with significant assistance from government sources. Income is
tax-deferred when in the plan, and taxed to the beneficiary when withdrawn later in life.

Like RESPs, US tax concerns arise with RDSPs if the beneficiary (or a holder on behalf of the beneficiary) is a US person. These include the treatment as a foreign trust (along with the relief from Form 3520 and 3520-A filing), continuing Form 8938 and FBAR filing obligations, and similar concerns about double-taxation. Once again, a US tax professional can advise on these matters.

Summary

This article provides an overview to help financial advisors alert their US person clients resident in Canada when they may need to seek advice from a qualified US tax professional. The key points are:

- While there are constraints, RRSPs and RRIFs can provide effective tax sheltering of retirement savings.
- TFSAs are not tax-exempt, and they carry stringent information reporting requirements.
- RESPs and RDSPs are not tax-exempt, on top of which government grant money is taxable when paid into them. They are also subject to stringent information reporting, but some relief was announced in 2020.

US pension transfer to a Canadian RRSP?

The if, when, what & how of repatriating retirement savings

We Canadians share much with our southern neighbour, well beyond the world’s longest undefended border. Many of us have stints or entire careers in the United States, then return home to Canada.

However, pension savings don’t automatically come back with us. While that money could remain tax-sheltered there, then drawn and taxed in our later years, it could simplify things if those savings could come back home too.

The process to make this happen is a bit complicated, but manageable with good preparation. Mechanics aside, the most important issue to understand is the taxation – and potential double-taxation – that may result if you’re not careful .

What plans qualify?

Generally, the kind of US plans we’re talking about are:

- 401(K) plans – The contributing employer-sponsor is a private sector for-profit enterprise
- 403(B) plans – For government employees, and those in religious, education and non-profit sectors
- IRAs – Individual retirement accounts, which are self-contributory plans similar to our RRSP

Plans from other countries may also qualify, but US plans are seen most frequently, again given the close proximity and economic ties between our two countries. Notably, if the foreign pension benefit is exempt from Canadian tax then these rules can’t be used.

You can’t transfer directly to your RRSP

From your personal view, you expect it all to remain tax-sheltered, so why shouldn’t you be able to make a direct transfer to your RRSP? Well, apart from maintaining the sovereignty and privacy of our tax system, there could be conflicting definitions, timing mismatches, and of course currency/exchange rates.

Instead, our system makes an allowance within our domestic tax rules once the foreign pension has been cashed-out. As this collapse of the foreign pension is almost certainly irreversible, you will want to be sure that the particular plan and transactions qualify under these rules; what gross and net-of-tax amounts are involved; and whether the actions can be completed in the available time frame.

Foreign withholding tax on cashing-out

The pension administrator will be required to withhold taxes, which is normally your final tax duty to the United States as the source jurisdiction. The general US withholding rate on a lump sum distribution from a retirement plan to a non-resident is 30%.

Comparatively, the Canada-US tax treaty allows for a reduced withholding rate of 15% on periodic payments from a retirement plan. In some cases, a pension plan administrator may take the position that the particular transaction qualifies for the reduced rate. This should be confirmed with the administrator, as well as with a US tax advisor whether you may nonetheless be responsible to the US for the higher rate, despite that a lesser amount may have been withheld at source.

Some pension administrators may (incorrectly) use the 20% withholding rate that applies on some domestic US transfers.

If you are under age 59.5, an additional 10% penalty tax applies to the withdrawal. Some administrators withhold this amount, but if not then you may need to file a US return to pay it yourself. In the past, the Canada Revenue Agency had not allowed a credit for that age-related penalty (more below on claiming credits), however it reversed its position a few years ago. It would be advisable to verify with the CRA on its current practice before proceeding.

Whether it’s 15%, 20%, 25%, 30% or 40%, the net amount to you will be in US dollars. Be sure to confirm with the plan administrator and a US tax advisor as to which of these apply and how they are handled. Apart from clarifying your US reporting obligations, this will help you determine how much cash you will need to come up with to meet your Canadian tax obligations, as we turn to that part of the process.

Canadian income tax inclusion

As a Canadian resident, you are taxable on your worldwide income. The gross amount received from the US pension – converted into Canadian dollars – must therefore be added to your other income in the year of de-registration and reported on your Canadian tax return.

Special RRSP contribution and deduction

A special RRSP deduction is available if the plan meets the Canadian definition of superannuation, pension benefit or foreign retirement arrangement. This is generally true for a 401(K), 403(B) or a regular IRA. (Different rules apply to a Roth IRA, which is similar to our tax-free savings account.)

Key to this special deduction is that the withdrawal must be a lump sum and specifically not be part of a series of periodic payments. Note that if the US plan administrator applied the reduced 15% withholding rate (that normally is used for periodic payments), the withdrawal should still qualify for the special deduction if it meets the lump sum definition under Canadian rules. Ask your Canadian tax advisor.

This special deduction does not require or affect existing RRSP contribution room. But unlike regular RRSP room, the special deduction can only be used in the same taxation year as the income inclusion or within the first 60 days of the following year. Any unused room cannot be carried forward.

Bear in mind that the plan administrator withheld tax before paying the net amount to you. To take advantage of the full deduction, you will have to top-up the contribution from another money source. On the other hand, if the amount is not topped-up then Canadian tax will still be due, based on the difference between the gross payout and the lesser amount of your contribution, in which case you will still need to come up cash to cover that tax.

Claiming the foreign tax credit

Once your preliminary Canadian tax for the year is calculated, the next step is to determine whether a foreign tax credit may be claimed for the amount withheld in the US. A key consideration is that if you have a large pension withdrawal but have relatively little income in the year, you may not be able to use the full credit, which cannot be carried forward. This opens up the possibility of double taxation on some part of the withdrawn pension: first in the year of withdrawal from the foreign pension, and then a second time on drawdown of the RRSP/RRIF.

Once more, it is critical to obtain advance tax advice on issues and estimates on both sides of the border.

Your retirement plans

Obviously, your decision will be affected by where you expect to retire, especially if you may end up back in the United States. And if you are a US citizen, there are additional considerations, even if you remain here in Canada. Be aware that the special contribution can only go to your RRSP, not to a RRIF, so this procedure must be completed no later than the end of the year you turn 71. As you can’t be certain how long it may take for that foreign plan administrator to process things, it would be prudent not to push it too close to that deadline.