Complex and punitive tax rules for U.S. investors who hold Canadian mutual funds make it important for them to find ways to receive the most favourable U.S. tax treatment, experts say.

The U.S. Passive Foreign Investment Company (PFIC) rules are increasingly raising concerns for U.S. tax filers, who should choose their investments wisely and get good advice about reporting mutual fund income, says Peter Bowen, vice-president of tax and research solutions for Fidelity Investments Canada.

“People need to be aware of these rules and take the proper steps to ensure their investments are structured properly,” says Mr. Bowen, who specializes in tax issues that affect Fidelity’s mutual funds and their investors.

Anyone who is classified as a “U.S. person” under U.S. tax law is obliged to file a U.S. tax return to the Internal Revenue Service and comply with such rules, he says. Estimates suggest there are one million U.S. citizens and dual citizens in Canada.

The PFIC legislation has existed since the 1980s but was little-noticed until a clarification issued by the IRS in 2010 stating that Canadian mutual funds are corporations, and therefore PFICs, Mr. Bowen says. The issue is now “beginning to gather steam,” he says, noting that Fidelity offers annual information statements to ensure that its mutual fund holders who are U.S. persons are able to make a special “election” that gives them the most optimal U.S. tax treatment.

There are two rules, one of them income-based and the other asset-based, to determine whether a mutual fund is a PFIC, Mr. Bowen explains. If more than 75 per cent of a corporation’s gross income comes from interest, dividends or other passive sources, or if more than 50 per cent of the assets it holds during the year produce this type of income, then it is a PFIC. He says that investments such as exchange-traded funds, some REITs and other public companies can also be PFICs.

“These are very complicated rules,” he says, recommending that people get appropriate assistance from a U.S. tax advisor as well as a financial advisor, to ensure the investments they hold are properly structured.

The definition of “U.S. person” is broad, including U.S. citizens, U.S. green card holders and persons with a substantial connection to the United States. Mr. Bowen says that some Canadian residents may not even be aware that they have U.S. tax filing obligations or that their investments are PFICs.

“Ignorance is no excuse, unfortunately,” he says. “The penalties for non-compliance can be quite harsh, and we’re hearing more and more about those penalties being applied.”

Ray Kinoshita, a tax partner at Grant Thornton who focuses on Canada-U.S. border tax issues, says the PFIC rule and other requirements for information reporting are arising “big time” with the firm’s U.S. clients.

“Penalties can apply regardless of whether you owe income tax,” says Mr. Kinoshita, who leads Grant Thornton’s global mobility services practice. He says the PFIC rules are “ridiculously complicated,” and there isn’t complete guidance in terms of how to apply them. “There are lots of unanswered questions.”

U.S. investors with PFICs are taxed on one of three ways on an annual filing to the IRS, using Form 8621. The most beneficial to tax filers is a Qualified Electing Fund (QEF) election, which includes a breakdown of their pro-rata share of the mutual fund’s earned income and capital gains for U.S. tax purposes, measured in U.S. dollars.

Mr. Bowen says that Fidelity can provide an annual information statement that includes those key items on request. He warns that the T3 and T5 slips issued for Canadian tax purposes do not contain sufficient information to support a QEF election.

The second option is to make a Mark-to-Market election, but this is available only if the mutual fund units themselves are publicly traded, Mr. Kinoshita points out. The third method, referred to as the default method or a Section 1291 Fund, is “subject to all of the bad PFIC rules,” he says.

Under the default method, when a particular holding is sold, the gain is treated as ordinary income, rather than getting capital gains treatment. The gain will also be viewed as having been made pro-rata over the holding period and amortised back to the date it was purchased. It is taxed at higher tax rates in the earlier years, and an interest charge is added.

Mr. Kinoshita notes that a separate Form 8621 with one of these elections must be filed each year for each PFIC held, although the U.S. Treasury recently issued regulations indicating that if an individual’s total PFIC holdings are less than $25,000 (U.S.), then no Form 8621 is required.

On a Section 1291 Fund with excess distributions, filling out the form “can be a voluminous exercise,” he says, but even the simplest ones can be time-consuming and costly for professionals to complete. “I’ve seen many forms where the incremental tax plus interest on an excess distribution was less than $100, but it takes the same time to prepare the form as if the tax was $5,000 or more.”

Mr. Bowen points out that RRSPs and RRIFs are respected as tax-deferred savings vehicles by the United States, so mutual funds that are part of such plans are not subject to the PFIC rules. However, these rules are expected to affect investments in non-registered accounts, TFSAs and RESPs.

He says there are some nuances with PFICs, for example with fund-to-fund structures, where one PFIC owns other PFICs, the U.S. requires reporting on both the top-level PFIC and the lower-level PFICs, so additional Form 8621s have to be filed. “It’s a bit more of a headache, it’s not the end of the world, but all other things being equal, perhaps you want to hold funds that aren’t fund-to-fund structures.”

The number of expats choosing to renounce their U.S. citizenship to avoid the growing burden of U.S. taxation, rules and paperwork has been “growing dramatically,” Mr. Bowen adds. He notes that renouncing citizenship can come with steep administrative costs, and requires people to be up-to-date with their U.S. income tax and other filings.