There is a mistake that catches careful people, not careless ones.
You are a U.S. citizen or green card holder living in Canada. You do the responsible thing. You open a Canadian investment account and buy a broad, low cost Canadian mutual fund or ETF. Diversified. Cheap. Exactly what every sensible source tells you to do.
From where you are standing, you have made a good decision. From where the IRS is standing, you have bought a Passive Foreign Investment Company, and what follows is nothing like what you expected.
Nothing is wrong with the fund. The problem is who is holding it.
Table of Contents
What a PFIC actually is
The name sounds like it should describe something exotic. An offshore structure. A shell company with a palm tree in the logo.
It does not. A foreign corporation is generally treated as a PFIC if it meets either of two tests in a given year:
The income test. Seventy five percent or more of its gross income is passive income, meaning things like interest, dividends, rents, royalties and capital gains.
The asset test. Fifty percent or more of its assets, on average, produce passive income or are held to produce it.
A pooled investment fund exists precisely to hold assets that produce passive income. So most non U.S. mutual funds and a great many non U.S. listed ETFs meet the definition comfortably. Canadian ones included.
There is nothing improper about owning one. Millions of Canadians hold them and for a Canadian with no U.S. connection it is a complete non issue. The rules only bite when the holder is a U.S. taxpayer.
Who this applies to
More people than realise it.
U.S. citizens living in Canada, whether or not they have lived in the U.S. for decades.
Green card holders resident in Canada.
So called accidental Americans, people born in the U.S. who left as children, or who inherited citizenship through a parent, and who have never thought of themselves as American for tax purposes.
Canadians who meet the U.S. substantial presence test through time spent in the U.S.
If you file a U.S. return and you hold a Canadian fund, this applies to you.
Why the treatment is punitive
The regime was built in 1986 to remove the advantage of deferring income inside an offshore fund. It works by making that deferral expensive, and it does so in a way that has nothing to do with whether you personally were trying to defer anything.
Under the default treatment, an excess distribution or a gain on sale gets allocated back across your holding period. The amount allocated to earlier years is taxed at the highest ordinary rate that applied in each of those years, not your actual rate, and not the capital gains rate. Then an interest charge is added on top, as though the tax had been owed all along.
Three consequences follow, and they are worth stating plainly.
Long term gains lose their preferential rate. A gain that would have been taxed at capital gains rates in a U.S. fund is taxed at ordinary rates in a PFIC.
The interest charge grows with time. The longer you have held it, the worse the arithmetic gets. This is the opposite of how almost every other investment behaves.
Losses do not help you the way you would expect. The regime is asymmetric by design.
It is entirely possible for a modest, perfectly ordinary fund holding to produce a tax bill that is a large fraction of the gain.
The reporting burden, which is often the bigger problem
Each PFIC generally requires its own Form 8621 each year. Not one form for the account. One per fund.
Somebody has to prepare those, and the underlying calculations are genuinely intricate. Preparers who handle this well are specialists and they charge accordingly. It is common for the annual compliance cost on a small holding to exceed anything the fund earned that year.
The practical shape of this: an investor with six Canadian ETFs in a non registered account has six forms a year, forever, until those positions are gone.
And it compounds by accident. Every automatic contribution, every reinvested dividend, every rebalance inside the account can create a new PFIC position or add to an existing one. People frequently discover the issue several years in, having quietly built a much larger problem than they would have had on day one.
The elections, and why they are not a clean escape
There are two elections that can improve the default treatment. Both help. Neither is a free pass.
The QEF election, or Qualified Electing Fund. This lets you include your share of the fund’s ordinary earnings and net capital gain each year, which avoids the punitive allocation and the interest charge. The catch is that it requires the fund to provide a PFIC Annual Information Statement with specific figures. Some Canadian fund companies produce these. Many do not, and no rule requires them to. If the fund does not supply it, the election is simply unavailable to you.
The mark to market election. This is available for PFIC stock that is regularly traded on a qualified exchange, which brings many listed ETFs into scope. You include the annual increase in value as ordinary income each year, whether or not you sold anything. That removes the interest charge, but it means paying tax on paper gains from cash you have not received, and gains are ordinary rather than capital.
Both elections generally work best when made in the first year you hold the position. Making them late brings its own complications.
The elections are the accountant’s territory, not ours, and this is a place where good specialist advice pays for itself several times over.
What about registered accounts?
This is the question everybody asks next, and the answer is more reassuring than the rest of this article.
Under the Canada U.S. tax treaty, RRSPs and RRIFs generally receive deferral treatment for U.S. purposes, which means the PFIC problem does not arise on holdings inside them in the way it does in a taxable account. That is one of several reasons the asset location question, meaning what you hold in which account, is materially different for a U.S. person in Canada than for anybody else.
TFSAs are a different and less happy story. The U.S. does not recognise the TFSA the way it recognises an RRSP, so a TFSA holding Canadian funds can produce both PFIC exposure and additional reporting. For a U.S. person in Canada, a TFSA is frequently not the account it appears to be.
The general planning rule that falls out of this: if a U.S. person in Canada is going to hold pooled Canadian funds at all, an RRSP is usually the least bad place for them, and a taxable account or a TFSA is usually the worst.
How this is actually avoided
Almost always by holding the same exposure in a different wrapper.
A U.S. person living in Canada can generally get the market exposure they want through U.S. domiciled funds and individual securities, neither of which carries PFIC treatment. Canadian equity exposure is still available. Emerging market exposure is still available. The investment thesis does not have to change at all.
What changes is the vehicle, and that is a portfolio construction decision, not a tax filing decision.
Three practical notes.
Individual stocks are not PFICs. A portfolio of individual Canadian companies has no PFIC issue at all, which is one reason direct holdings appear more often in cross border portfolios than in domestic ones.
U.S. domiciled ETFs can generally give you the same underlying markets. There are currency and estate tax considerations that come with them, which is a separate conversation and one worth having properly.
Not every non U.S. pooled vehicle is a PFIC, and the analysis is fund by fund. Do not assume, and do not let anyone tell you a specific fund is fine without checking.
If you already own PFICs
Start by finding out what you actually hold. That sounds obvious and it is where most people are stuck, because a fund’s PFIC status is not printed on a statement.
Then get a specialist involved before you sell anything. Selling is a taxable event under a regime specifically designed to punish long holding periods, and the sequencing of a cleanup matters. There are situations where unwinding over several years is materially better than doing it in one.
And be aware that if the holdings sat unreported for years, there are established procedures for coming into compliance. That is a well trodden path, and it is very much better walked deliberately with advice than stumbled into.
None of this is a reason to panic. It is a reason to look.
Where we fit
Sartorial Wealth does not prepare tax returns and does not file Forms 8621. That belongs with a cross border accountant.
What we do is the decision that creates the form in the first place. By the time an accountant sees a PFIC, it is a compliance exercise with a limited set of unattractive options. At the moment the account is being built, it is a portfolio design question with several clean answers and no downside.
That gap is exactly what goes missing when the advisor is registered in one country and the accountant is in the other, and neither is looking at the whole picture. We are registered in both, and we work alongside your accountant rather than around them.
Common questions
Are all Canadian mutual funds PFICs?
Most are, and many Canadian listed ETFs are too, because pooled funds hold assets that generate passive income by design. The analysis is fund by fund, so verify rather than assume, but the safe working assumption for a U.S. person is that a Canadian pooled fund is a PFIC until shown otherwise.
Do I have to file Form 8621 for every fund?
Generally yes, one per PFIC per year, subject to some threshold exceptions. This is why the compliance cost scales with the number of holdings rather than the size of the account, and why six small positions can be worse than one large one.
Does the PFIC problem apply inside my RRSP?
Generally no. The Canada U.S. treaty provides deferral treatment for RRSPs and RRIFs, so the issue does not arise there in the same way. A TFSA does not get the same treatment, which surprises most people.
What is the difference between the QEF and mark to market elections?
QEF requires the fund to give you an annual information statement, which many Canadian funds simply do not produce. Mark to market is available for regularly traded stock and taxes the annual increase in value as ordinary income, whether or not you sold. Both avoid the punitive default, and both work best when elected in the first year.
Can I just avoid PFICs entirely?
Usually, yes. Individual securities and U.S. domiciled funds can deliver the same market exposure without PFIC treatment. For most U.S. persons living in Canada, that is the cleanest answer and it costs nothing to implement at the outset.
I have owned these for years and never filed. What now?
Do not sell first and ask later. Get a cross border accountant involved, establish what you hold, and look at the compliance options that exist for exactly this situation. The order of operations matters and the outcome is usually better than people fear.
Sources
Internal Revenue Service, Instructions for Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. https://www.irs.gov/forms-pubs/about-form-8621
Internal Revenue Service, Publication 550, Investment Income and Expenses. https://www.irs.gov/forms-pubs/about-publication-550
Convention Between Canada and the United States of America With Respect to Taxes on Income and on Capital, Article XVIII. Department of Finance Canada. https://www.canada.ca/en/department-finance/programs/tax-policy/tax-treaties/country/united-states-america-convention-consolidated-1980-1983-1984-1995-1997.html
Disclaimer
Sartorial Wealth Inc. is a registered Portfolio Manager in Canada (ON, QC, AB, BC, NT, NS, SK, NB, NL) and an SEC-registered investment adviser. Content is for informational purposes only and does not constitute investment, legal, tax, or insurance advice. Investing involves risk; past performance is not indicative of future results. Services are only offered where properly registered. See full disclosures at https://sartorialwealth.com.
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