Common Canadian investments can inadvertently cause American tax problems for US citizens living in Canada.
Let’s take a really common example. Jack is a 50-something US citizen married to Jill (a Canadian citizen) for 30 years. They have lived in Canada for 25 years. Jack was vaguely aware that he was supposed to be filing US taxes every year, but he didn’t.
When Jack started reading about the new US FATCA law, he learned that his bank would soon be sending his financial information to the IRS by way of the CRA.
Jack started to comply with his US tax obligations and in the process, discovered that his retirement portfolio, which comprises of Canadian mutual funds and ETFs held outside of an RRSP, might cause him problems.
There are strategies that can be used to help someone in Jack’s situation. For instance, Jack might also be able to gift some of these problematic investments to his wife, who is not a US citizen.
Jack’s situation is avoidable with some foresight and planning. Canadian mutual funds and Canadian listed ETFs are likely classified as a passive foreign investment company (PFIC) under US tax law. The IRS has not taken a clear position on this, and there may be some exceptions to the rule for older funds. If the investments are classified as PFICs and are held outside of an RRSP/RRIF, they must be reported. The form for doing so is complicated.
Furthermore, there are punitive tax consequences for owning such an investment. For instance, when the investment is sold, the capital gain is taxed at up to 35% or 39.6% (depending on the year). Compound interest is charged on the tax owing stretching back to the date of purchase. There are strategies available to manage this headache are complicated and likely require the services of a tax professional. The simplest solution is to not own Canadian mutual funds and Canadian listed ETFs outside of an RRSP if you are US citizen.
If owned inside of an RRSP, these investments are much less problematic. Recent IRS rule changes have eliminated the annual reporting requirement for such investments. The Canada-US Tax Treaty (an agreement between Canada and the United States that helps sort out some of the thorny cross-border tax issues) allows US citizens in Canada to defer any tax owed on income accrued inside the RRSP until the time of withdrawal. Many advisors agree that this deferral provision likely negates any of the punitive taxes that result from the classification of Canadian mutual funds and ETFs as PFICs — but only if the investments are sold before they are taken out of the RRSP. Importantly, this is not true for other Canadian registered plans such as TFSAs, RESPs, or RDSPs. These plans generally do not work as designed for US tax purposes.
To avoid Jack’s situation, US citizens in Canada should exercise care in making their investment choices. Tax advice should be obtained as necessary.