Why Canadian mutual funds can cause U.S. tax headaches
Written by: Max Reed
Common Canadian investments can inadvertently cause U.S. tax problems for U.S. citizens in Canada.
Let’s take a really common example that we see frequently. Jack is a U.S. citizen in his 50s who married Jill (a Canadian citizen) many years ago. They have both lived in Canada for a long time. Jack was vaguely aware that he was supposed to be filing U.S. taxes every year. But he didn’t. Then Jack started reading about a recent U.S. law, the Foreign Account Tax Compliance Act (FATCA) under which his financial institutions would soon be sending his financial information to the IRS by way of the Canada Revenue Agency.
Jack started to comply with his U.S. tax obligations and in the process discovered that his retirement portfolio, which is comprised of Canadian mutual funds and ETFs that are held outside of an RRSP, might cause him problems.
There are strategies that can be used to help someone in Jack’s situation. For instance, Jack can swap his Canadian mutual funds and Canadian-listed ETFs into his RRSP for other investments that may be less problematic. Jack may also be able to gift some of these problematic investments to his wife Jill who is not a U.S. citizen.
Jack’s situation is avoidable with some foresight and planning. Canadian mutual funds and Canadian listed ETFs held outside of an RRSP/RRIF may cause U.S. tax problems. They may (the IRS has not taken a clear position on this and there may be some exceptions to the rule for older funds) be classified as a passive foreign investment company (PFIC) under U.S. tax law. If the investments are classified as PFICs and are held outside of an RRSP/RRIF, they must be reported on a complicated form.
There are punitive tax consequences for owning such an investment. For instance, when the investment is sold, the gain on the investment is subject to tax at up to 35% or 39.6% (depending on the year) and compound interest is charged on the tax owed stretching back to when the investment was purchased. There are strategies available to manage, but not eliminate, this headache but the strategies themselves are quite complicated and likely require the services of a tax professional. The simplest way to avoid this headache is to not own Canadian mutual funds and Canadian listed ETFs outside of an RRSP if you are U.S. citizen.
If Canadian mutual funds and ETFs are owned inside of an RRSP, there is much less of a U.S. tax problem. Recent IRS rule changes have eliminated the annual reporting requirement for Canadian mutual funds and Canadian ETFs held inside of an RRSP. Similarly, the Canada-U.S. Tax Treaty (an agreement between Canada and the United States that helps sort out some of the thorny cross-border tax issues) allows U.S. citizens in Canada to defer any tax owed on income accrued inside the RRSP until the income is withdrawn from the RRSP. Many advisors agree that this tax deferral provision likely negates any of the punitive taxes related to the classification of Canadian mutual funds and Canadian ETFs as PFICs as long as the investments are sold before they are taken out of the RRSP. Importantly, the same is not true for other Canadian registered plans such as a TFSA, an RESP, or an RDSP (these plans generally do not work as designed for US tax purposes).
To avoid Jack’s situation, U.S. citizens in Canada should exercise care in making their investment choices. Tax advice should be obtained as necessary.