The Tax Consequences of Inheriting Money from the U.S.

The Tax Consequences of Inheriting Money from the U.S.

    Written by Max Reed

    Many Canadians inherit money from relatives in the United States. There are generally no issues on either side of the border if a Canadian inherits property or money through a will. That being said, many U.S. residents plan their estates by using a trust rather than a will for the purpose of avoiding probate. U.S. tax law pretends this trust does not exist. As such, there is a bump in cost basis when the person who set up the trust dies so there is no capital gains tax when the assets are later liquidated.  

    Canada takes a different view, however, and this can cause tax problems for Canadian residents who inherit from U.S. trusts.

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    Protecting Canadians from the U.S. Estate Tax

      Written by Max Reed

      Canadian residents who aren’t U.S. citizens may be surprised to know that U.S. estate tax can apply to them.

      That’s because U.S. estate tax applies to any assets that are considered to be located in the United States. This includes U.S. real estate, stocks in U.S. corporations (such as Apple, Exxon or Walmart), and personal property located in the country.

      The 2016 top U.S. estate tax rate is 40% of the value of the property. This could create a sizable tax bill when any Canadian resident who owns U.S. real estate or a large U.S. stock portfolio dies. Under domestic U.S. law, only US$60,000 of U.S. property is protected from estate tax. Note that RRSPs offer no protection from the U.S. estate tax. Canadians get an increased estate tax credit thanks to the Canada-U.S. Tax Treaty, which is more complicated than meets the eye.


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      The QEF Election is a Suboptimal Remedy to PFIC Pain

        QEF Elections and PFICs

        Written by Max Reed

        The standard solution to the PFIC problem offered by certain banks and investment funds is that a US investor in a PFIC should rely on the QEF election.

        This is an election on behalf of the taxpayer that the products in which they have invested and to which the election applies are not to be treated as Passive Foreign Investment Companies (PFICs). Effectively, this will eliminate the PFIC tax moving forward for the investor, provided the correct paperwork is filed for each fund every year. Though often touted as a simple way out of the PFIC problem, QEF election is anything but.

        The QEF election on behalf of investors is suboptimal for a number of reasons, not least of which being that, from a nuts and bolts point of view, it’s expensive to prepare. It can cost anywhere from $100 to $500 dollars to prepare Form 8621 properly: and this is per mutual fund, per year. This is a drop in the bucket when compared to the actual tax consequences of the QEF election, however. Though a far superior outcome to PFIC-status, QEF election is not as painless as many think.

        The first major issue with QEF election is that a taxpayer must “clear the slate,” so to speak. This means that one must realize all unrealized capital gains for the years between when the individual bought the investment and when the individual first uses the QEF election. The taxpayer is then assessed the PFIC tax on all of this with the tradeoff of never again having to deal with it as a PFIC — provided the appropriate yearly filing obligations are observed, per mutual fund.

        This of course assumes that the QEF election is done properly in the first place. In addition to the compliance costs already noted, Form 8621 is rather complicated, and there is much room for error. The problem with this is twofold: first, if done improperly an individual is still exposed to the PFIC problem and second, it now alerts the IRS to an individual’s holdings in possible PFICs and encourages the assessment of the PFIC tax as well as applicable penalties for incorrect filing.

        Finally, the QEF election on behalf of an investor can change the character of an individual’s earnings. This can actually wind up including income otherwise taxed at preferential rates (notably, dividends) as ordinary income, taxable at an individual’s existing marginal rate.

        All of this assumes that the funds in question make available all of the relevant material to make the QEF election in the first place. This is not always the case. Though many larger Canadian Mutual Funds do furnish the required information for QEF election, it is most certainly not the case for all funds. Where it is not the case, individuals still face exposure to the onerous PFIC regime and are unable to make a QEF election.

        Ultimately, though the QEF election is preferable to PFIC status, it is not without its own problems. The problems noted here assume that Canadian mutual funds are PFICs. Our view is that this is not always the case.

        Creating PFIC-free Canadian mutual fund trusts

          PFIC-free Canadian Mutual Funds

          Written by Max Reed

          The Canadian mutual fund trust is a very common Canadian investment structure.  It is used by retail mutual and exchange traded funds, REITs, income trusts, and other investment fund. A common view is that US taxpayers (whether they reside in the US or are US citizens in Canada) should not invest in these trusts because they may be Passive Foreign Investment Corporations (PFICs) for US tax purposes.  Owning an interest in a PFIC is expensive for the individual investor.

          Canadian mutual fund trusts can choose whether they wish to be classified as partnerships or corporations under US tax law. If they don’t make any choice, they are subject to the default rules.  There are two arguments that, by default, certain Canadian mutual fund trusts may not be PFICs.

          1. Older Canadian mutual fund trusts may not be PFICs

          While this argument is treated in a separate blog post, I’ll review it briefly here. The key factor in determining whether a Canadian mutual fund trust is a partnership or corporation under the default rules is whether all investors in the trust have limited liability. Put simply, if all investors do have limited liability, then the trust is classified as a corporation. If all investors do not have limited liability, then the trust is classified as a partnership. Responding to concerns from the investment community,  various provincial governments started enacting legislation beginning in 2004 that gave investors in certain Canadian mutual fund trusts limited liability. Prior to the creation of this legislation, investors had some liability exposure. Thus, mutual funds in existence prior to 2004 were arguably partnerships for US tax purposes at that point in time. The liability exposure of the investors may have changed in 2004. However, the US tax classification of the trust didn’t change as per the Treasury Regulations. So the trust was a partnership for US tax purposes prior to 2004 and remains that way today. Partnerships by definition can’t be PFICs.

          1. Funds that aren’t reporting issuers under securities legislation may not be PFICs

          The laws that grant limited liability to investors in Canadian mutual fund trusts are explicitly limited to “reporting issuers,” as is defined in securities legislation.  Funds that aren’t “reporting issuers” don’t benefit from the laws granting investors limited liability. Because investors still have some liability exposure, they may be classified as partnerships for US tax purposes and are thus may not be PFICs.

          1. Election to be classified as a partnership

          Regardless of their default classification, Canadian mutual fund trusts can choose whether they want to be classified as partnerships or corporations for US tax purposes. The reasons for this are outlined in another blog post.

          Choosing a partnership classification means that a fund will not be a PFIC. Making this election requires simply filing a couple of forms. This election is suitable for trusts wishing to cement the position that they have always been partnerships for US tax purposes. For instance, if a trust wants to take the position that they were a partnership for US tax purposes, either because it is not a “reporting issuer” or it is an older fund, the trust can make a "check-the-box" election to solidify this position. The election is also particularly well tailored for newly created trusts wishing to create an investment vehicle without US tax risks for US taxpayers whether they are in Canada or not. 

          Our initial, informal, discussions with the IRS suggest that they are interested in these positions and may be open to issuing private letter rulings to confirm them. 

          Foreign partnerships (such as a Canadian mutual fund trust that is a partnership under US tax law by default or by choice) do not have to file a US tax return if they don't have US source income. Nor are they obligated to provide their investors (partners) with the K-1 form if there is no US source income. 

          Operators of Canadian mutual fund trusts should pay attention to these issues. There are at least a million US Persons living in Canada. As US tax issues become more important, these investors will want to know about whether their investment is safe from a US tax perspective. The market will expect it. Trustees of Canadian mutual fund trusts owe a fiduciary duty to their investors. This duty may include informing them of US tax risks and taking appropriate steps to mitigate these risks.

          PFIC free Canadian mutual fund trusts are a real possibility. 

          It goes without saying that this is a very simplified version of what is a complex, technical argument. It certainly isn’t legal or tax advice.

          Certain Canadian mutual funds aren’t PFICs

            Mutual Funds as PFICs

            Written by Max Reed

            Of all the tax problems faced by a US citizen in Canada none are as potentially fraught as the ownership of Canadian mutual funds. A commonly held view is that these funds are Passive Foreign Investment Companies (PFICs) under US law. This view is based on an unsubstantiated, one sentence conclusion in a non-binding IRS memorandum pertaining to estate tax. The IRS has not taken any official position on the issue. Owning a PFIC outside an RRSP can be really expensive. In some cases, in particular for long-term investors, the sale price may equal the US tax owed.   

            Here is one strategy why certain Canadian mutual funds may not be PFICs. 

            A simple, non-technical way to understand PFIC is that in order to be a PFIC each word in the acronym must apply to the mutual fund –  PFIC =  Passive, Foreign Investment, Company.  Canadian mutual fund trusts earn only passive investment income so those two words easily apply to all mutual funds. Because they are located outside of the United States, all Canadian mutual funds are "foreign" under US law so that word applies to all of them also. The only thing is question is whether they are companies (a synonym of corporation). So, when viewed under a US lense, if a mutual fund is a corporation, it will be a PFIC. If it is not a corporation under US tax rules, it will be a partnership and so not a PFIC (because not all the words in the acronym apply to the mutual fund). 

            The chief determinant as to whether a Canadian mutual fund trust is classified as a corporation under US tax law is whether all the investors of the mutual fund trust have limited liability for the debts and obligations of the fund. There is no gradation of liability. It’s like pregnancy – you are either pregnant or not. Likewise, investors are either liable or not. If any investor is potentially liable for the debts of the fund, then the fund is likely not a PFIC. 

            Commencing in 2004, various provinces passed legislation guaranteeing limited liability to investors in mutual funds. Governments don’t pass laws without reason. So it stands to reason that before these laws were in place, investors in Canadian mutual fund trusts had some liability risk. Indeed, in 2003, the Bank of Canada issued a report concluding that the personal liability of investors in Canadian mutual fund trusts was possible. The Governments of Alberta and Saskatchewan identified the same risks as a reason why they enacted legislation to fix the issue.

            Professor Mark Gillen of the University of Victoria Law School has written a long, detailed paper examining what types of liability exist. Here is one example: put very simply, the investors in a Canadian mutual fund trust have some liability for the debts of the trust because they have some control over the trustees. In a case called Trident Holdings v. Danand Investments, Ontario’s highest court concluded that beneficiaries of a Canadian business trust were liable for the debts of the trust for this reason. Though there are other sources of liability perhaps none are as important as this one.  

            Prior to 2004, when the laws granting limited liability came into effect, there is a good argument that Canadian mutual fund trusts were partnerships for US tax purposes and thus not PFICs. Although the limited liability status of the investors may have changed with the new laws, because of Treasury Regulation 301.7701-3(a) the US tax classification of those funds does not change.

            In short, mutual funds created prior to 2004 may not have been PFICs because their investors had some liability for the debts and obligations of the fund. That liability status may have changed in 2004 when new laws went into effect, thereby dealing with that problem. But the US tax classification does not change. So the funds were likely partnerships for US tax purposes (and so not PFICs) prior to 2004 and as a result remain that way to this day.

            The best thing about this strategy: owning a small fraction of a foreign partnership doesn’t require filing any extra US tax forms. The taxpayer just reports the income as normal and that’s it – PFIC problem solved.

            Consider this example to illustrate this strategy. Let's say Mitchell is a US citizen who in Canada who owns a Royal Bank mutual fund. The Royal Bank mutual fund is subject to Ontario law. Ontario passed its law giving limited liability to investors in mutual fund trusts in 2004. Mitchell's mutual fund was created in 1998. So he can use this strategy. He would report the income he gets from his mutual fund on his yearly Form 1040 (annual US tax return). But he would not have to file Form 8621 or any other special form to report his ownership of the mutual fund. Nor would he have to pay any special tax on it. 

            It goes without saying that this is a very simplified version of what is a complex, technical argument. It certainly isn’t legal or tax advice.

            Holding Canadian mutual funds inside an RRSP doesn’t cause US tax problems

              RRSP Mutual Funds Canada

              Written by Max Reed

              Canadian mutual funds held inside of an RRSP should not cause US tax problems. Assuming that Canadian mutual funds are PFICs (a position that’s far from certain), holding them in an RRSP negates the bad tax consequences that would otherwise come with stock in a PFIC (high tax rate, nasty interest charge, complex paperwork). Here is the technical reason why this is the case. The Canada-US Tax Treaty applies to income taxes imposed by the US Internal Revenue Code. The PFIC tax regime is certainly an income tax regime and is thus covered by the Treaty. Paragraph XVIII(7) of the Canada-US Tax Treaty states that “taxation” may be deferred with respect to  “any income accrued in the plan but not distributed by the plan until such time as and to the extent that a distribution is made from the plan or any plan substituted therefor.” This obviously applies to RRSPs. If Canadian mutual funds are PFICs, and they are held inside of an RRSP, then the PFIC charge described above may be permanently avoided.  According to official IRS publications, when income comes out of an RRSP it is considered pension income and subject to tax as such. For instance, Rev. Proc. 2014-55 describes distributions from an RRSP as follows:

              Distributions received by any beneficiary or annuitant from a Canadian retirement plan, including the portion thereof that constitutes income that has accrued in the plan and has not previously been taxed in the United States, must be included in gross income by the beneficiary or annuitant in the manner provided under section 72, subject to any applicable provision of the Convention

              Note that Code Section 72 is the section that deems income from a pension plan to be taxable. As such, the IRS own view is that income taken out of an RRSP is pension income and the PFIC charges may not be applicable. Even if Canadian mutual funds are PFICs, there is no reporting required if the funds are held inside of an RRSP. Combined with the IRS’ understanding of RRSP income as pension income, this lack of reporting further suggests that a US court would not subject Canadian mutual funds held inside of an RRSP to the PFIC charge. Based on this, there is a very good argument that owning Canadian mutual funds inside of an RRSP shouldn’t cause US tax problems. 

              How far-reaching is the IRS’ power to collect taxes from Canada?


                Written by Max Reed

                If you’re a U.S. citizen living in Canada, you might be frantic about the IRS tax crackdown and hefty fines if you haven’t been tax compliant. How fast can the IRS come after you? What are its enforcement powers in Canada, anyway?

                Turns out, Canadian law has a trick up its sleeve: a firewall to help U.S. citizens in Canada.  

                Here’s how it works. Say George is a dual Canadian and U.S. citizen who lives in Calgary.  He’s not up to date on his U.S. taxes. In 2014, George sold his Canadian house for a large gain. Thanks to FATCA, George’s bank reported his financial information to the IRS. The IRS analyzed George’s financial information and saw a spike in his account, so they decided to investigate. After an audit, the IRS determined that he owed US$100,000 in U.S. taxes for tax year 2014 as a result of the house sale.  

                Under the Canada-U.S. Tax Treaty, the Canada Revenue Agency will not help the IRS collect taxes owed by a person who was a Canadian citizen at the time that the tax debt arose. This is half of the firewall that protects George: The IRS says he owes U.S. taxes from tax year 2014, at which time he was a Canadian citizen. So the CRA will not help the IRS collect the tax he owes. 

                So, with Canada out of the picture, the IRS would have to act on its own to collect taxes. It can get a judgment from a U.S. court stating that George owes the U.S. government US$100,000, which can be easily enforced against any assets he has in the United States. But the IRS may have a hard time enforcing this tax debt against George’s Canadian assets. This is because of the other half of the firewall that protects George.

                Overly simplified, a foreign creditor such as the IRS has to get the permission of a Canadian court before it can enforce a foreign judgment against assets in Canada. In a 1967 case called United States v. Harden, the Supreme Court of Canada ruled that Canadian courts will not enforce judgements for U.S. taxes owed. This precedent still applies. 

                A couple of caveats are in order. Laws can and do change. Simply relying on the firewall might be risky and stressful for our U.S. citizen north of the 49th. Further, intentionally refusing to pay a U.S. tax debt is a criminal offense in the United States. So it is possible, although perhaps unlikely, that the U.S. government would eventually pursue criminal charges.  A more prudent approach for George might be to catch up on his U.S. taxes using the Streamlined Procedure (the IRS’ amnesty program) before the IRS finds him through FATCA, if only to ultimately renounce his U.S. citizenship.

                The Basics of U.S. Tax for Canadians

                  istock taxes

                  Written by Max Reed

                  The US Foreign Account Tax Compliance Act (FATCA) has generated a lot of attention in Canada. It recently became Canadian law,  as a part of the 2014 federal budget. FATCA requires Canadian financial institutions to send information about their US account holders to the Canada Revenue Agency, which will, in turn, send the information to the IRS.

                  FATCA did not create the obligation for US citizens and certain US Greencard holders anywhere in the world to file tax returns – those have existed for over 100 years. FATCA does make these obligations more pressing, because the IRS will soon have information on US citizens in Canada.

                  FATCA, very understandably, frightens people.

                  This is the first in a series of columns which will try to help US citizens living in Canada understand their tax obligations in this post-FATCA world.  

                  For now, there is no need for panic. The IRS is not coming to seize your house. In a future column, I will explain exactly what enforcement powers the IRS has over US citizens in Canada. Panic may not be warranted, but the cautious route is to become compliant – if only to later give up your US citizenship (a topic for a future column). Even if you choose not to comply — not recommended — you should be aware of the risks you are taking.

                  To get on the IRS’s good side, you can take advantage of an amnesty program called the streamlined process, which helps US citizens in Canada (and elsewhere) catch up on overdue tax returns without fear of penalties.  

                  To take advantage of the streamlined process, you must:

                  1. Have been outside of the United States for at least 330 days during at least one of the last three years and during that time have not lived in the country;  
                  2. File complete US tax returns for the three most recent tax years;
                  3. File 6 years of the FBAR form electronically. The FBAR form is required if at any point during the tax year you had more than USD $10,000 in foreign bank accounts;
                  4. Certify that your failure to file the required US tax forms was not intentional.

                  US citizens in Canada are only subject to US federal tax. Canadian federal and provincial tax rates are generally higher than the US federal rate, and the Canadian taxes you pay are credited against your US taxes. Unless you have US source income, most US citizens in Canada will not owe anything. As such, for most people getting caught up just means filing some paperwork.

                  However, the paperwork can be daunting. Currently, there isn’t any specialized tax software designed to help you. But some American tax software, such as Turbo Tax, can be adapted to suit your needs. For those with simple financial circumstances, there are self-help books available. For those with more complicated financial situations, there are many accountants at many different price levels who specialize in US tax returns. As with everything, those with more expertise and experience tend to charge more. A prospective accountant should be able to give you a quote, so shop around. Living in a post-FATCA world complicates life for dual citizens, but with some early attention, these problems can be solved before they cause more headaches.  

                  FBAR: Reporting Your Canadian Financial Accounts

                    istock cda taxes

                    Written by Max Reed

                    The United States has two tools to get information on accounts held by its citizens: FATCA and FBAR.

                    Lots of attention has been paid to FATCA — less to FBAR (Foreign Bank Account Reporting). Its rules have been around since the 1970s. FBAR targets accounts that US citizens own, as well as accounts over which US citizens have signing authority. The ownership piece is pretty straightforward. US citizens in Canada are obliged to file an FBAR form if they have an ownership interest in “foreign” (i.e. outside the United States) bank accounts that have a cumulative value of USD $10,000 or more. All accounts should be listed on this form.

                    The signatory authority provisions are more complicated. All US citizens must report all foreign accounts worth USD $10,000 or more (even those owned by non-Americans) over which they have signing authority (i.e.  the ability to move money in and out of the account), even if they don’t have a financial interest in the account.  Many different types of accounts have to be reported, including bank accounts, accounts that hold securities, certain insurance accounts that have a cash value, accounts with a mutual fund, and commodity brokerage accounts. The few exceptions to the FBAR rules are unlikely to apply to any Canadian institutions.

                    The implications of these rules are maddening. Take this example. Fred is a US citizen who is a Toronto-based broker who manages money for hundreds of Canadian clients. Because he has the power to move money in and out of different accounts, he may be considered to have signing authority over them. Thus he would have to report all of these accounts to the IRS on his annual FBAR form.

                    Take another example. Jill is a US citizen who serves on the board of a non-profit organization. Because she has the power to sign cheques on behalf of the organization, Jill would have to report the account on her FBAR form.

                    Or consider Jenny, a lawyer and a US citizen who has signing authority over the trust accounts which hold client funds. Jenny may have to list all these accounts on her FBAR form.

                    All three of these individuals are in a tight spot. US law requires them to report this information, but Canadian privacy law may prevent them from doing so.  The problem is exacerbated by the FBAR fines, which range from USD $10,000 per account to USD $100,000, or 50% of the total value of the account if the failure to file is willful. FBAR fines can be excused if there were good reasons why the form could not be filed. Importantly, the CRA has indicated that it will not help the IRS collect the FBAR fines. And, to date, the IRS has not been enforcing the FBAR requirements rigorously. But even if the risk is remote, the potential fines are large.

                    There are some solutions. The most obvious is to check to see if the signing authority you have over bank accounts is sufficient to necessitate their reporting on an FBAR form. There is an amnesty program for delinquent FBAR forms. A riskier option is to include a letter with your FBAR form indicating why, under Canadian law, you cannot report certain accounts. US citizens with signing authority over many accounts should likely talk to a US tax professional to figure out how to deal with the FBAR rules.