Many US citizens or US residents living or working in Canada and many Canadians living in the US have invested in Canadian Mutual Funds. A significant number of these investors may not realize that foreign mutual funds are classified as Passive Foreign Investment Companies. If they were not aware that they unwittingly held an interest in a PFIC they probably were not aware that the IRS has established a strict tax and reporting regime governing taxation of their Canadian (or other foreign) mutual funds. As a consequence many US taxpayers holding Canadian have failed to meet the required US tax and reporting obligations.
US taxpayers holding an interest in a PFIC must file a Schedule B with their US income tax returns and a Form 8621 to report certain elections and transactions within their Canadian or other foreign mutual funds. If the total value of foreign accounts, including mutual funds, held and controlled by a US taxpayer exceeds $10,000 at any time during a taxation year, a Form 90-22-1 (FBAR) must be separately filed with the US Treasury Department.
Definition of a Passive Foreign Investment Company (PFIC)
Under the United States Internal Revenue Code a foreign company that meets either of the following tests is considered to be a Passive Foreign Investment Company:
- 75% or more of its gross income for a taxable year is passive income (the income test); or
- 50% or more of assets held during the taxable year produce passive income, or are held for the production of passive income (the asset test).
Passive income includes interest, dividends, royalties, annuities, rents, income equivalent to interest, net gains from commodity transactions, net foreign currency gains, payments in lieu of dividends, income from notional contracts, and income earned from certain personal service contracts. Generally the fair market value of a foreign company’s assets (based on the value of the corporation’s assets at the end of each quarter) is used to apply the Asset Test.
In applying these tests to a foreign corporation it is necessary to look-through subsidiary corporations that the tested corporation holds an interest in. If a foreign corporation owns, directly or indirectly, 25% or more of a subsidiary, the corporation’s share of the earnings and assets of the subsidiary must be included when determining if the corporation is a Passive Foreign Investment Company.
The IRS does not classify as Passive Foreign Investment Companies foreign corporations such as bona fide banks, financial institutions, insurance companies, and security traders that can establish that passive income was earned in the conduct of an active business by the corporation. PFIC status applies separately for each US person owning shares, and also separately with respect to shares acquired at different times. PFIC status does not, in and of itself, have any impact on the foreign corporation or foreign shareholders.
A Passive Foreign Investment Company is a corporation by definition and in most cases a trust or partnership would not be a Passive Foreign Investment Company (notwithstanding that the IRS might argue that a foreign trust or foreign partnership had the characteristics of a corporation). A partnership that does not own shares in a PFIC is not a Passive Foreign Investment Company even if all of its income is from passive investments. The same is true with respect to any trust or estate that does not own any shares of a Passive Foreign Investment Company. Partnerships and trusts, however, are taxed under other sections of the Internal Revenue Code that require earned income to flow through to individual taxpayers regardless of whether or not such earnings are distributed.
What Happens if a Corporation is Classified as a Passive Foreign Investment Company
In 1986 Congress added PFIC rules to the Internal Revenue Code due to concerns that U.S. taxpayers investing in passive assets indirectly through a foreign investment company had an inappropriate tax advantages when compared to direct investments in those same assets. The purpose of the PFIC rules was to eliminate this advantage. PFICs include foreign-based mutual funds and pooled investment vehicles that have at least one U.S. shareholder. Most US investors in PFICs must pay income tax on all distributions and appreciated share values, regardless of whether capital gains tax rates would normally apply. PFICs are subject to the complicated and strict tax guidelines set out in Sections 1291 through 1297 of the Internal Revenue Code. These strict guidelines are set up to discourage ownership of PFICs and particularly foreign mutual funds by U.S. investors. In fact, the rules are clearly intended to deter US investors from using a foreign corporation as an investment fund.
When assessing the severity of the tax regime established by Congress for PFIC holdings it is important to compare the tax treatment of for shareholders of ordinary corporations. Corporate shareholders are normally taxed on the corporation’s income when dividends are declared and only taxed at the taxpayer’s ordinary rate. Furthermore, shareholders are normally only taxed on accumulated value gains when the shares are sold or otherwise deemed disposed by the IRS. It is important to note that gains in the value of shares in an ordinary corporation are generally taxed at significantly reduced capital gains rates. It is also important to note that Congress has addressed other areas where US taxpayers have obtained inappropriate tax advantages through the utilization of foreign corporations in offshore tax havens. Two specific areas are Controlled Foreign Corporation and Foreign Personal Holding Company legislation. In essence Congress has re-characterized the income from such corporations as flow-through income to the individual shareholders subject to US taxes in the current year.
The Tax and Interest Regime (Excess Revenue Regime) for Taxing PFICs
A US taxpayer holding an interest in a PFIC is subject to taxation under tax and interest regime set out in Section 1291 of the Internal Revenue Code. This tax and interest regime includes a look-back procedure to allocate distributed income by a PFIC in excess of 125% of the three year moving average to the taxpayer’s entire holding period. Income allocated to the current year is reported on the taxpayer’s tax return as other income and taxed at the taxpayer’s ordinary rate. The portion of the distribution that is allocated to each prior year, however, is taxed at the taxpayer’s highest possible rate and the amount calculated is deemed to have been payable in the year of allocation. The statutory interest rate for unpaid taxes is then applied to the to each prior year that the taxpayer has held the PFIC.
The sum of the tax and interest payable for each year that the taxpayer has held the PFIC is added to the taxpayer’s current tax liability without setoff for an otherwise reported loss or loss carry forward. If the taxpayer has held the PFIC for an extended period of time it is possible for the PFIC tax liability to exceed the amount distributed. The legislation passed by Congress, however, limits the tax payable to 100% of the distribution received. For more detailed information on this subject please refer to our article entitled “Excess Distribution Tax Regime for Taxing Passive Foreign Investment Companies”.
AG TAX LLP Can Help
If you have any other tax-related queries, and/or need assistance with tax planning/filing please contact AG Tax. Our tax professionals are highly-experienced with U.S. and Canadian tax laws and can provide you the right guidance to handle your tax situation.
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