US Persons Holding Non-U.S. Mutual Funds

November 20, 2012

U.S. citizens and lawful permanent residents (green card holders) who hold certain investments may unknowingly be subject to adverse US tax implications where the investments are characterized as investments in Passive Foreign Investment Companies (“PFICs”). PFICs include non-U.S. mutual funds and exchange traded funds (ETFs) which are typically organized as corporations or trusts in Canada. The PFIC rules may also apply to other non-U.S. entities, treated as corporations under US tax law, that earn significant amounts of investment income or whose assets are substantially passive in nature. For purposes of this test, cash and cash equivalents are considered passive because they have the potential of producing passive income (interest).

Generally, capital assets held for longer than a year and most distributions from Canadian corporations are eligible for preferential US tax rates with a maximum applicable rate of 15 percent. Gains from dispositions of non-U.S. mutual funds and certain distributions are subject to ordinary income tax rates of up to 35 percent in 2012. In addition, gains and distributions from mutual funds may be pro-rated over the U.S. person’s holding period and taxed at the highest marginal rate applicable in each of the previous years. An interest charge is computed on the U.S. tax notionally deferred in those years. Finally, the ability to use Canadian taxes paid as a credit against a U.S. tax liability resulting from a disposition or distribution from a non-U.S. mutual fund may be significantly limited or inapplicable altogether.

If these adverse US tax consequences were not enough, in 2010 the US Congress passed legislation requiring U.S. persons with investments in PFICs to begin disclosing their ownership interests annually on IRS Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company even where no disposition or distribution has occurred during the year. These new reporting requirements are expected to become effective for the 2013 tax year.

We generally advise our clients who are U.S. persons to think twice about holding non-U.S. mutual funds (or other interests that might be characterized as PFICs) outside of an RRSP to avoid the adverse US tax consequences and disclosure requirements associated with them.