How citizenship-based taxation steals from the treasury of other countries: PFIC Edition

The following comment was on the ACA Facebook page:

I say with every ounce of facetiousness I can muster up: Every government of the world should stop letting Americans come to reside in their country. Eventually the ones that have slipped in before the draw bridge was raised will die off, leaving each country sanitized of these toxic elements. No more punishment for leaving the homeland, no more drain on anyone’s resources trying to hunt us down. Citizenship based taxation, the sacred cow of stupidity.

The author is correct. U.S. citizens should be banned from immigrating to any other country. U.S. citizens are a threat to the fiscal stability and sovereignty of any country. There are a number of reasons: including the inability of U.S. citizens to participate in normal financial planning and other vehicles of self reliance. I intend to do a series of posts exploring this theme. Today (as we get to the June 15 tax filing deadline) I offer you the “PFIC Edition”.

Lately I have been reading about the shortage of labor in Alberta. The suggestion is that this shortage could be helped by bringing U.S. citizens to Alberta. U.S.  workers can come to Canada pursuant to NAFTA or by seeking  to become permanent residents of Canada. Some of them will eventually become Canadian citizens and some may not. U.S. citizenship-based taxation means that the U.S. citizen in  Canada will be subject to all tax reporting and information return requirements. Most countries use their tax laws as a way to encourage people to save for retirement, save for home, etc. You will see that the opportunities for U.S. citizens to do this are far more limited.

Financial Planning in Canada – The hallmark of smart financial planning in Canada is tax deferral

In Canada the public policy objective of encouraging responsible financial planing and savings is accomplished through a variety of vehicles that allow for the deferral of tax. This is accomplished in one of two ways:

1. Allowing an investment to accrue “tax free” until it is distributed. Examples include: RRSP, TFSA, RESP, etc. (in the case of an RRSP the contributor is even allowed a tax deduction in the year of contribution).

2. Allowing the use of a Canadian Controlled Private Corporation which allows for a threshold amount of income to be taxed a lower rate. The result is that one can accumulate a pool of investment capital more quickly. ( I think the “long run” value of this is dubious.)

In other words, the hallmark of smart financial planning in Canada is to invest and save in a way that defers tax.

The U.S. Tax System is designed to attack investments that are designed to defer tax – it is the opposite of Canada’s tax system

The U.S. Canada tax treaty seems to have carved out an “exception” for RRSPs making it possible for U.S. citizens in Canada to have an RRSP. That is the only “tax deferral” investment that the U.S. allows. For example, although a TFSA is a smart vehicle for retirement planning in Canada, it is not tax deferred in the U.S. In other words, income in the TFSA is reportable every year in the U.S. This means that a U.S. citizen in Canada who owns a TFSA is required to pay tax on income (assuming it stays in the TFSA) that was never received. This destroys the whole point of the TFSA. Now the question becomes: from a practical point of view how much tax is actually payable. It appears that all of it is taxable. Why? Investment income is NOT covered by the earned income exclusion. My primary point is that TFSAs provide an opportunity for a U.S. tax to be payable on income that was never been received. This is a major problem.

Note also that I am concentrating only on the tax implications of investments. As you know, the penalties for failing to report these investments are “life altering”. For those who are dying to read more: I offer you “Looking for Mr. FBAR“.

Investments that are particularly problematic for U.S. citizens in Canada

Mutual Funds = Tax Cancer: U.S. citizens should invest only in mutual funds that are in the United States!

Now for the record, my experience is that most mutual funds are bad investments. Although one cannot predict the future, my guess is that we are going to be in an long investment environment that has a “low rate of return”. The return on GICs is very low. Yet the management fees on Canadian mutual funds are very high. Although this post is not about evaluating the quality of investments, it is hard to make a case for investing in mutual funds. Furthermore, I want you to feel better with what I am about to tell you.

Canadian Mutual Funds = PFICs for U.S. Tax Purposes = The most punitive tax ever

The bottom line is that when it comes to PFICs you will be taxed:

– at the highest marginal tax rate (even as a capital gain)

– on money you actually receive

– on money that you did NOT receive but are deemed to have received

– and  will be subject to the endless mindlessness of the “Form Nation” forms

That’s all you need to know. But, for those who want to understand a bit about PFIC:

There are two issues:

1. What is a PFIC – Explained by taxplannercpa.com

While many portions of the U.S. tax code possess confusing and sometimes harsh rulings, the tax regime for Passive Foreign Investment Companies (PFIC) is almost unmatched in its complexity and almost draconian features. Countless times, our international clients have come to us to prepare what they thought would be straightforward tax returns- only to later learn that the small investment they had made in a non-US mutual fund was now subjecting them to all the concomitant filing requirements and tax obligations. While it is beyond the scope of this article to cover all the numerous details related to PFIC reporting requirements, my hope is to provide guidance and insight into the world of PFICs.

History
The PFIC tax regime was created via the Tax Reform Act of 1986 with the intent to level the playing field for US based investment funds (ie mutual funds). Prior to the legislation of 1986, U.S.-based mutual funds were forced to pass-through all investment income earned by the fund to its investors (resulting in taxable income). In contrast, foreign mutual funds were able to shelter the aforementioned taxable income as long as it was not distributed to its U.S. investors. After the passage of the Tax Reform Act of 1986, the main advantage of foreign mutual funds was effectively nullified by a tax regime that made the practice of delaying the distribution of income prohibitively expensive for most investors. To employ this punitive regime, the IRS requires shareholders of PFICs to effectively report undistributed earnings via choosing to be taxed through one of three possible methods- Section 1291 fund, Qualified Election Fund, and Mark to Market election.

Basics
Defined in the Internal Revenue Code (section 1297), a Passive Foreign Investment Company is any foreign corporation that has either:
1. 75% or more of its gross income classified as passive income (i.e. interest, dividends, capital gains, etc…), or
2. 50% or more of its assets are held for the production of passive income.

While there are a few exceptions to above rules, most foreign mutual funds, pension funds, and money market accounts would be good examples of PFICs. Furthermore, many foreign REITS also get trapped in the PFIC web. Finally, a foreign holding company that possesses passive investments (like rental real estate or government bonds) would be subject to PFIC regulations if the company was set up as a corporation.

PFIC related information is reported on Form 8621 .

2. Is a Canadian mutual fund a PFIC – Explained by Terry Ritchie

Notice that the assumption that a Canadian mutual fund is a PFIC is the result of a 2010 IRS policy review! Yet, the IRS will treat a mutual fund owned prior to 2010 as a PFIC compounding the unfairness!

What about U.S. citizens who own Canadian mutual funds? Last year, the IRS changed its view of the U.S. tax treatment of foreign mutual funds. Starting in 1986, many Americans used foreign mutual funds to gain tax deferral on income that wasn’t distributed to them. Thanks to the lobbying efforts of the mutual fund industry, the government enacted a new set of complex rules regarding Passive Foreign Investment Companies. A PFIC exists when 75% or more of its gross income for the taxable year consists of passive income or 50% or more of the average fair market value of its assets consists of assets that produce or are held for the production of passive income.

Passive income includes dividends, interest and its equivalents, passive rents and royalties, annuities, gains from the disposition of stocks and securities and other assets, certain gains from commodity trading, and certain foreign currency exchange gains.

As a result of the 2010 IRS policy review, the IRS issued Chief Counsel Advice 201003013, stating Canadian mutual funds should be classified as corporations for U.S. tax purposes. Therefore, if an American citizen receives income from a PFIC or sells a Canadian mutual fund that is a PFIC, U.S. tax and interest penalties could apply.

U.S. citizens in Canada should not invest in Canadian  mutual funds! In the words of Bradly Kirschner:

“There has been a lingering question about the US tax treatment of Canadian Mutual Funds in taxable accounts.  This discussion does not apply to investments in RRSP accounts.  In early 2010, the Internal Revenue Service issued a determination that most Canadian Mutual Funds are corporations for US tax purposes, even though they are organized as trusts under Canadian law.  Because they are corporations, most Canadian Mutual Funds are Passive Foreign Investment Companies (PFIC).

A PFIC investor has burdensome US tax reporting as well as potentially confiscatory taxation.  If a PFIC provides certain required information, the tax burden can be lessened, but this is not practical for must Canadian Mutual Funds.

There are two solutions—one short-term and one permanent.  On a short-term basis you can report income on a “marked to market” basis in your US income tax return.  This means that the change in value during the year will be reported as ordinary income.  This, of course will, require additional valuation information each year, but it will avoid potential tax and interest charges that have the potential to exceed 100% of the income from the investment.

The second solution, and the one I recommend is divest your portfolio of all foreign mutual funds and invest in individual security issues.  While this may not sound like a sensible solution for the Canadian investor, but it is the price of being a U.S. taxpayer.”

Bradley Kirschner – Seattle Based CPA

Conclusion: U.S. citizens cannot benefit from the same financial planning rules as other Canadians. U.S. Citizenship-based taxation does violence to the policy of the Government of Canada that its citizens/residents save for retirement and participate in responsible financial planning. This increases the likelihood that U.S. citizens in Canada will be dependent on the government for support. Canadian immigration policy discourages immigrants who are likely to impose undue costs on other taxpayers. For example, applicants who are believed to impose high costs on the health care system may not be given “permanent residence” status. The fact that U.S. citizens in Canada are disabled from effective financial planning is a strong reason why the Government of Canada should not allow U.S. citizens to immigrate to Canada!

This is another example of how citizenship-based taxation imposes a cost on the governments where U.S. citizens may reside!

Stupid is stupid does

I know that the U.S. does not care about its citizens abroad. But, the fact is that U.S. citizenship-based taxation is very harmful to the U.S. economy. Some advice for the U.S.:

Stop citizenship-based taxation – Repeal FATCA