By Max Reed and Charmaine Ko, US Tax Lawyers Last May, the U.S. Department of Justice sued Jeffrey P. Pomerantz -- a Canadian resident, US citizen -- for over USD $860,300 in...
Canadians have invested over a trillion dollars in mutual funds, but the IRS has not issued guidance on how the estimated 1 million US persons in Canada should report mutual fund investments on their (mandatory) US tax returns. The general view is that a Canadian mutual fund is a corporation and may be classified as a passive foreign investment company (PFIC) for US tax purposes. A PFIC is defined under Code section 1297(a) as a foreign corporation for which 75 percent of its annual taxable income is passive income (dividend, royalty rent, capital gain, and annuity income) or at least 50 percent of its assets produce passive income. Owning an interest in a PFIC entails complex reporting requirements and exposes the US-person owner to punitive tax consequences, including: 1) the distribution or gain on sale may be required to be spread over the years the investor held the investment; 2) the amounts allocated to years before the current taxable year are taxed at the highest ordinary income rates in effect for those years (currently 39.6% plus any state and local taxes); and 3) the IRS collects interest as though these amounts had actually been taxed in the prior years and the taxpayer simply failed to pay the tax until the year in which the excess distribution or sale occurs. A mutual fund manager may be able to, and in light of the potential fiduciary duty owed by the fund to its investors probably should, elect to treat a Canadian mutual fund trust as a partnership for US tax purposes and thus eliminate the risk that it is a PFIC
Is a Canadian mutual fund a corporation for US tax purposes? A Canadian mutual fund is clearly a foreign (non-US) entity for US tax purposes. There are two different types of Canadian mutual funds: mutual fund corporations and mutual fund trusts. Under the Income Tax Act, a Canadian mutual fund corporation is incorporated as a Canadian public corporation. Under Treasury regulation section 301.7701-2(a)(8), a Canadian corporation is a per se corporation for US tax purposes. Although the PFIC determination is made fund by fund, a mutual fund generally earns a great deal of passive income from the securities that it holds and owns a high percentage of assets that produce passive income, and is thus likely to be a PFIC.
Most Canadian mutual funds are mutual fund trusts for Canadian tax purposes and their US tax classification is less straightforward than it is for a mutual fund corporation. The US entity classification regime is complex, but generally an entity may elect its classification if it is not a trust for US tax purposes, does not meet one of the seven definitions of a corporation, and is not specifically addressed elsewhere in the Code and regulations. A Canadian mutual fund trust is not a trust for US tax purposes because it has a profit motive, the trust interests are transferrable, and the trustee can vary the trust investments. Moreover, a Canadian mutual fund trust does not meet any of the seven definitions of a corporation and is not specifically addressed in the Code or regulations. Thus a Canadian mutual fund trust is probably a “foreign eligible entity” as defined in Treasury regulation section 301.7701-3(a) and can elect to be a partnership or a corporation for US tax purposes, commonly known as a check-the-box election. In the private letter ruling PLR 200752029, the IRS accepted that a mutual fund trust from an unnamed jurisdiction was classified as a “foreign eligible entity” that could elect to be treated as a partnership or corporation for US tax purposes. The PLR is not on all fours because it does not identify the mutual fund trust’s country of origin, but it does corroborate the conclusion that a mutual fund trust generally falls into the regulatory definition of “foreign eligible entity”. Electing to be treated as a partnership for US tax purposes eliminates the potential exposure to the PFIC rules for a US investor in a Canadian mutual fund trust.
In the absence of a check-the-box election, the default classification of a Canadian mutual fund trust is likely to be as a corporation for US tax purposes. In Chief Counsel Advice 201003013, the IRS concluded that a Canadian mutual fund trust was a corporation for US tax purposes. Under Treasury regulation section 301.7701-3(b)(2)(i), unless it elects otherwise a foreign entity that has two or more owners – all of which have limited liability – is classified as a corporation for US tax purposes. A Canadian mutual fund trust is a foreign entity that has more than two owners – it generally has many investors – all of which may have limited liability: many mutual fund trusts are organized in Ontario and under the Ontario Trust Beneficiaries’ Liability Act the beneficiaries of a trust that is a reporting issuer under the Securities Act (such as a Canadian mutual fund trust) is not liable for an obligation or debt of the trust. Thus unless the fund itself elects to treat the mutual fund trust as a partnership for US tax purposes, a Canadian mutual fund trust is most likely to be a PFIC and its US-person investors are exposed to negative US tax consequences.
Under the Income Tax Act a mutual fund trust must be an inter vivos trust resident in Canada. The mutual fund manager acts as a trustee and owes a fiduciary duty to the beneficiary investors of the trust that it administers, just like an ordinary trustee. (See Dobbie v. Arctic Glacier Income Fund et al 2011 ONSC 25 at para. 55 , and the Ontario Securities Act section 116; Mackenzie Financial Corporation (Re), 2008 CanLII 66161 (ON SEC); and Fischer v. IG Investment Management Ltd.  OJ No. 112, which was overturned but not on this point in Fischer v. IG Investment Management Ltd. 2011 ONSC 292.) Owing a fiduciary duty means that the manager must act in the trust beneficiaries’ best interests, which may encompass informing the US-person investor of the potential US tax risk associated with the investment and electing to treat the mutual fund trust as a partnership for US tax purposes to eliminate the risk of a PFIC classification.
Currently FATCA appears to enhance a mutual fund manager’s liability risks for breach of fiduciary duty and makes the risk-reduction issue even more urgent. A Canadian mutual fund is a Canadian financial institution under the Canada-US FATCA intergovernmental agreement and thus must report information on US account holders to the CRA, which in turn must pass the information on to the IRS. Legally and economically, a mutual fund manager has little choice but to comply with FATCA. By providing the IRS with information about US account holders, a mutual fund manager increases the risk of IRS enforcement against its investors because, for the first time, the IRS may have knowledge of an investor’s holdings. The increased chance of IRS enforcement due to FATCA disclosure may increase the investors’ US tax risk, and the Canadian mutual fund manager should be aware of the risks. Regardless of a legal obligation to do so, in the current environment a mutual fund trust may wish to elect to classify itself as a partnership for US tax purposes in order to relieve its existing US person investors of an expensive tax problem and make the fund more attractive to US investors. The PFIC problems for these US-person investors in Canadian mutual fund trusts can and should be solved with an election.