Mutual funds tricky for U.S. filers

If you’re one of the estimated one million U.S. citizens living in Canada, you may have been warned by your U.S. tax advisor not to buy Canadian mutual funds. Of course, this assumes you are filing a U.S. tax return each year.

The U.S. is the only country that requires its citizens to file a tax return and report their worldwide income, no matter where in the world they might live or how many other citizenships they might hold. This differs from most other countries, like Canada, which bases its taxation system primarily on residency.

The problem with Canadian mutual funds for U.S. tax filers is that under U.S. tax law, they are considered to be Passive Foreign Investment Companies (PFICs) and as such, are governed by draconian U.S. tax rules and convoluted and complex annual reporting.

For example, under the PFIC rules, investors who dispose of Canadian mutual funds or who receive certain types of distributions from these funds are taxed on their U.S. returns at the rates that apply to earned income as opposed to the preferential tax rates that apply to capital gains. In addition, depending on the timing of the distributions and/or dispositions, punitive interest charges can also be imposed.

The PFIC rules themselves are extremely complex and require specialized U.S. tax reporting, including the filing of Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company,” for each PFIC owned. The form is three pages long and has six parts. According to the form’s instructions, the estimated time to properly comply with the PFIC rules is over 31 hours, which includes: 11 hours to learn about the law or form, 15 hours of recordkeeping and just over 20 hours to prepare and send in the form. And that’s just for one PFIC.

It’s therefore no wonder U.S tax preparers are discouraging their clients from owning Canadian mutual fund in the first place, since it’s challenging for them to recoup the fees they would have to charge their clients for the professional time involved to do the record keeping and fill out the forms necessary to comply with the U.S. laws.

This past week, the Investment Funds Institute of Canada (IFIC) which represents a large segment of Canada’s investment funds industry, called on the U.S. government to exclude Canadian mutual funds from the PFIC Rules.

Its submission was made to two congressional committees: the financial services working group committee on ways and means and the international tax reform working group.

In its submission, the IFIC suggested that an administrative solution could be negotiated to exclude Canadian mutual funds from the PFIC rules through “exchanging letters of understanding” between the Canada Revenue Agency and the Internal Revenue Service.