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The US tax classification of Canadian mutual fund trusts – solving the PFIC Problem
Max Reed1
The mutual fund trust structure is commonly used in Canada for a wide range of investment
vehicles including consumer oriented financial products (mutual funds and ETFs) as well as
income trusts, and real estate investment trusts. The US tax classification of this structure is of
crucial importance to: US Persons resident in Canada, Canadian financial institutions seeking US
investors, and the US resident investors themselves. There is a risk that the Canadian mutual
fund trust might be classified as a corporation for US tax purposes. If so, those used as
investment vehicles will very likely be subject to the punitive Passive Foreign Investment
Corporation (“PFIC”) regime. For simplicity’s sake, I refer to these entities below as Canadian
mutual fund trusts even though there are many such trusts that would not be subject to the PFIC
regime because they are not used as investment vehicles. This paper explores the US tax
classification of these trusts and presents a number of options for navigating the adverse US tax
consequences that result from owning stock in a PFIC (the “PFIC Problem”). The IRS has not
taken a clear position on the issue. In a memorandum concerning the application of the US estate
tax, the IRS made a one sentence declaration that Canadian mutual fund trusts are likely
corporations for US tax purposes.2 This IRS memorandum is examined further below. Based on
this IRS memorandum, the conventional wisdom is that Canadian mutual fund trusts are likely
corporations for US tax purposes and thus almost certainly PFICs.3 Owning and disposing of
PFIC stock can cause adverse US tax consequences. These adverse US tax consequences are
reviewed in section 1.
1 Max Reed is a cross-border tax lawyer at SKL Tax a boutique US and Canadian tax advisory firm in Vancouver,
Canada ([email protected].) The author would like to thank Stephen Albers for his excellent research assistance and
Alan McBurney and Stephen Katz of SKL Tax for many of the ideas found in this paper and their exceptional
mentorship. 2 CCA 201003013 (Sept. 30, 2009).
3 Max Reed, “Classification of Canadian Mutual Funds for U.S. Tax Purposes,” (2014) 40:5 Int’l Tax JL 31 at 33.
2
Seven potential solutions to the PFIC Problem are presented:
1. Only holding Canadian mutual funds inside an RRSP;
2. Making the QEF election on an individual investor’s US tax return. The QEF election
requires information to be provided from the fund;
3. Making the mark-to-market election on an individual investor’s US tax return;
4. Taking the position that certain, older Canadian mutual trusts are partnerships for US tax
purposes and thus not PFICs;
5. Taking the position that certain Canadian mutual fund trusts not covered by the limitation
of liability statutes are not PFICs;
6. Making a check-the-box election at the fund level to classify a Canadian mutual fund
trust as a PFIC for US tax purposes; 4
7. Taking the position that all Canadian mutual fund trusts are partnerships for US tax
purposes and thus not PFICs.
The pros and cons of each option are discussed in the relevant section. Options 1-3 are only
available at the individual investor level. They are based on the assumption that a Canadian
mutual fund trust is a corporation for US tax purposes and thus likely a PFIC. Option 6 is only
available at the fund level. I conclude with a discussion of two other US tax aspects of Canadian
mutual fund trusts – the US estate tax and the publicly traded partnership rules.
1. Overview of the PFIC regime
To start out, examine the PFIC regime and why it is a problem. A “US Person Investor” in a
PFIC may be subject to certain adverse US federal income tax consequences with respect to the
sale, exchange or other disposition of the stock of a PFIC and with respect to certain distributions
4 Reed supra note 3 at 37.
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made by the PFIC. Here, “US Person Investor” is defined as a US Person (US citizen, US
resident, Green card holder, US partnership, US corporation, or US trust) holding shares of stock
of a Canadian mutual trust. In general, a non-US corporation will be treated as a PFIC for US
federal income tax purposes in any taxable year in which either (a) at least 75% of its gross
income is "passive income" or (b) on average, at least 50% of the value of its assets is
attributable to assets that produce passive income or are held for the production of passive
income.5 Passive income for this purpose generally includes, among other things, dividends,
interest, certain royalties, gains from commodities and securities transactions, and gains from the
sale of capital assets.6 Assuming that Canadian mutual fund trusts are corporations (discussed in
detail below), they readily meet the PFIC definition because:
a) they are organized under laws outside of the United States;
b) they realize passive income; and/or
c) they own a large percentage of assets which produce passive income.
If a non-US corporation is treated as a PFIC in any taxable year, such corporation will generally
be treated as a PFIC in each subsequent year, regardless of the level of passive income and
passive assets in such subsequent years (unless certain elections are made at the investor level).7
Section 1291(a) requires a US Person Investor to pay a special tax plus an interest charge on (a)
gain recognized from the disposition of stock of a PFIC (including a pledge of stock of a PFIC)
and (b) the receipt of an “excess distribution”. An excess distribution is generally defined as a
distribution in any one year to the extent that it exceeds 125% of the average distributions
5 26 USC § 1297(a).
6 Ibid at § 1297(b)(1).
7 Ibid.
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received in the prior three years.8 In general, (i) any gain realized or excess distribution received
would be allocated ratably to each taxable year (or portion of a taxable year) in the US Person
Investor’s holding period for the shares in the PFIC; (ii) the amount so allocated to the current
taxable year will be taxed as ordinary income (not capital gain) earned in the current taxable
year; (iii) the amount so allocated to earlier taxable years will be taxed at the highest marginal
rates applicable to ordinary income for those earlier taxable years; and (iv) an interest charge for
the deemed benefit of deferral of US federal income tax will be imposed with respect to the tax
deemed attributable to each such earlier taxable year. For example, if a PFIC makes no
distributions to shareholders for three years, but then pays a dividend in year four, the entire
amount of the dividend will be an excess distribution.
The gross amount of any distribution in respect of the stock of a PFIC that is not an
"excess distribution" will be taxable under the rules generally applicable to corporate
distributions.9 The dividend, however, will not be eligible for the preferential tax rate applicable
to certain "qualified dividend income" received by individuals.10
US Person Investors normally
have to file one Form 8621 annually for each fund that they own. 11
Form 8621 is unwieldy and
costly to have prepared by a professional tax advisor. US Persons who own fewer than US
$25,000 of PFIC stock do not have to file Form 8621 annually.12
2. Existing authority on the US tax treatment of Canadian mutual fund trusts
There is no official IRS guidance proclaiming that Canadian mutual funds not formed as
corporations under Canadian law are corporations for US tax purposes, let alone PFICs.
8 Ibid at § 1291(b).
9 Prop. Treas. Reg. § 1.1291-2(e).
10 Ibid at § 1(h)(11)(C)(iii).
11 Treas. Reg. § 1.1298-1T (b)(1).
12 Treas. Reg. § 1.1298-1T (c)(2)(i)(A)(1).
5
Nevertheless, this is the conventional wisdom which is based on Chief Counsel Advice
201003013. There, Canadian mutual funds held inside an RRSP were US situs property under
Code § 2104(a) and thus subject to the US estate tax. The decedent was a Canadian citizen,
resident and domiciliary. He was not nor had he ever been a U.S. citizen or domiciliary. The
decedent owned mutual funds in an RRSP and had not reported the US assets in his RRSP in his
gross estate for US estate tax purposes. US estate tax was only owed because the decedent had
contributed US real property to his RRSP. The Chief Counsel Advice concludes:
You indicated that the RRSP held shares in several mutual funds that are organized as
trusts. However, a mutual fund may have been formed as a “trust” under Canadian law,
but be properly classified as a corporation under U.S. law. Based on the information
provided, it appears that all the Canadian mutual funds held by Decedent’s RRSP would
be classified as corporations for U.S. tax purposes.13
This conclusion is not explained. It does not have the force of law. According to the IRS manual,
Chief Counsel Advice “does not set out official rulings or positions of the Service and may not
be attached or referred to in other advisory products or subsequent Chief Counsel Advice as
precedent.”14
The Chief Counsel Advice itself indicates that it “may not be used or cited as
precedent.” The legal value of this short, unsubstantiated, assertion that cannot be cited as
precedent is questionable.
3. Holding Canadian mutual funds inside an RRSP
Even assuming that Canadian mutual funds are corporations for US tax purposes (and thus
PFICs) holding them inside of an RRSP negates the negative PFIC consequences set out in
section 1 above. The Canada-US Tax Treaty15
applies to income taxes imposed by the US
Internal Revenue Code. The PFIC tax regime is certainly an income tax regime and is thus
13
Chief Counsel Advice 201003013 [“CCA”]. 14
Internal Revenue Service, “IRS Manual: Section 33.1.2.2.3.4”. 15
Convention between Canada and the United States of America with Respect to Taxes on Income and on Capital,
Canada and the United States, 26 September 1980 at art 2 s.2(b) [Canada-US Tax Treaty].
6
covered by the Treaty. Paragraph XVIII(7) of the Canada-US Tax Treaty states that “taxation”
may be deferred with respect to “any income accrued in the plan but not distributed by the plan
until such time as and to the extent that a distribution is made from the plan or any plan
substituted therefor.”16
This obviously applies to RRSPs. If Canadian mutual funds are PFICs,
and they are held inside of an RRSP, then the PFIC charge described above may be permanently
avoided. According to official IRS publications, when income comes out of an RRSP it is
considered pension income and subject to tax as such. For instance, Rev. Proc. 2014-55 describes
distributions from an RRSP as follows:
Distributions received by any beneficiary or annuitant from a Canadian retirement plan,
including the portion thereof that constitutes income that has accrued in the plan and has
not previously been taxed in the United States, must be included in gross income by the
beneficiary or annuitant in the manner provided under section 72, subject to any
applicable provision of the Convention
Note that Code Section 72 is the section that deems income from a pension plan to be taxable. As
such, the IRS own view is that income taken out of an RRSP is pension income and the PFIC
charges may not be applicable. Even if Canadian mutual funds are PFICs, there is no reporting
required if the funds are held inside of an RRSP.17
Combined with the IRS’ understanding of
RRSP income as pension income, this lack of reporting further suggests that a US court would
not subject Canadian mutual funds held inside of an RRSP to the PFIC charge.
4. The QEF election
Assuming that Canadian mutual funds are corporations for US tax purposes (and thus almost
certainly PFICs), a US Person Investor may be able to avoid the PFIC Problem by making a
16
Canada-US Tax Treaty supra note 15 at art 7. 17
Treas. Reg. §1.1298–1T(b)(3)(ii)
7
timely election to treat the company as a “qualified electing fund” (“QEF”).18
If a timely QEF
election is made, the electing US Person Investor will generally avoid the adverse consequences
of the company being classified as a PFIC described above, but will be required annually to
include in gross income the following:
(i) As ordinary income, a pro rata share of the PFIC’s ordinary earnings; and
(ii) As long-term capital gain, a pro rata share of the PFIC’s net capital gain; and
(iii) In either case, whether or not cash associated with such earnings is distributed by
the PFIC in each year in which it is so earned.19
The Canadian mutual fund trust would be required to would be required to provide each electing
shareholder with an Annual Information Statement, which is required to include the following
information: (i) dates of tax year to which statement applies; (ii) the unitholder’s pro rata share of
the trust’s ordinary earnings and net capital gain for the trust’s tax year, or sufficient information
to allow the unitholder to calculate these figures, or a statement that the trust has permitted the
unitholder to examine its books, records and other documents to calculate the trust’s ordinary
earnings and net capital gain and the unitholder’s pro rata share of such amounts; (iii) the amount
of cash and fair market value of property distributed or deemed distributed to the unitholder
during the trust’s tax year; and (iv) a statement that the trust will permit the unitholder to inspect
a copy of the PFIC’s books, records and other documents.20
The timeliness of this election is crucial. If the QEF election is made in the first year that a US
Person Investor owns the investment, then all PFIC Problems will be avoided. Taking the QEF
election in a year following the first-year that the investor owned the investment is a different
18
IRC § 1291(c)(2). 19
IRC § 1293(a). 20
Treas. Reg. § 1.1295-1(g).
8
story. In order for the QEF election to be effective (and thus avoid PFIC Problems going
forward) in a year following the first year in which the investor owned the investment the
investor must realize any gain from the date that the investor purchased the investment. This gain
will be subject to the excess distribution regime described above. 21
Put differently, making an
effective QEF election that actually solves the PFIC Problem in a year after the first year in
which the investor owns the investment requires the investor to pay the PFIC tax from the date
that the investment was purchased until the year in which the QEF election was made. Therefore,
taking a QEF election that would solve PFIC Problems going forward may have a high tax cost
for a US Person Investor who has owned the investment for a long period of time. A retroactive
QEF election is possible, but only with the permission of the IRS, and only if the QEF
information is available (this is not always the case). Even if the QEF election has been made,
Form 8621 must still be filed: meaning that, while the QEF election may reduce specific tax
exposure related to holding the investment, it will not reduce the annual compliance costs.
5. The mark-to-market election
Assuming that Canadian mutual funds are corporations for US tax purposes (and thus likely
PFICs) the mark-to-market election can be taken to solve the PFIC Problem. Under the mark-to-
market election, the US Person Investor reports the annual gain in value as ordinary income (and
not capital gain) - even if the gain was not realized - on his/her US tax return.22
This may result
in double taxation. Canada will not necessarily grant foreign tax credits for the US tax paid
because of the mark-to-market election. Further, when the funds are actually sold Canadian tax
will apply normally to the sale without regard to previously paid US tax resulting from the mark-
to-market election. The mark-to-market election has a further drawback that is similar to the
21
IRC § 1291(d)(2)(A). 22
IRC 1296(a)(1).
9
drawback of the QEF election. An effective mark-to-market election taken in a year following
the first year in which the investor owned the investment that solves PFIC problems going
forward requires the realization of gain built up to date. This gain is subject to the excess
distribution regime. In other words, in order for the mark-to-market election to be effective, the
US Person Investor will be pay PFIC tax on any gain that has built up since the time the investor
owned the investment. 23
Finally, the compliance costs for the mark to market election are
significant, given that a Form 8621 will have to be filed for each fund for each year.
6. Certain Canadian mutual fund trusts are not PFICs for US tax purposes
The first three strategies discussed above (funds held inside of an RRSP, the QEF election, and
the mark-to-market election) all assume that Canadian mutual fund trusts are corporations for US
tax purposes and thus very likely PFICs. There is an argument that certain funds are not
corporations for US tax purposes and thus not PFICs. This argument applies to funds formed
before 2004 in Ontario24
, 2005 in Manitoba25
, 2004 in Alberta26
, and 2006 in British Columbia27
and 1994 in Quebec28
and Saskatchewan in 200629
. The years indicated mark the time when the
particular province implemented a statute to grant beneficiaries of Canadian business trusts
limited liability. The determination of the default classification of a Canadian mutual fund trust
comes down to whether the beneficiaries of the trust have limited liability. If the trust was
organized prior to the enactment of the statutes, then it was and remains a partnership for US tax
purposes because the beneficiaries of the trust did not have limited liability at the time that the
trust was organized.
23
Ibid at 1296(j). 24
Trust Beneficiaries’ Liability Act, SO 2004, c 29, Schedule A. 25
Investment Trusts Unitholders’ Protection Act, CCSM 2005, c 105. 26
Income Trusts Liability Act, SA 2004, c I-1.5. 27
Income Trust Liability Act, SBC 2006, c 14. 28
art 1322 CCQ 29
Income Trust Liability Act, SS 2006, c I-2.02.
10
To fully understand this argument, it is necessary to go through all of the steps under the US
entity classification rules established under Treasury Regulation 7701 to classify a Canadian
mutual fund trust for US tax purposes. For clarity, the multiple steps required to arrive at this
conclusion are set out sequentially.30
i. Is the entity separate from its owners? 31
If not, the entity classification regime does not
apply. Canadian mutual fund trusts are separate from their owners because the trust has a
structure which is independent from the beneficiaries.
ii. Are there special classification rules that apply to the entity?32
If so, those rules determine its
classification and the general entity classification regime does not apply.33
Canadian mutual
fund trusts are not subject to a special entity classification regime. Certain types of entities,
such as Real Estate Mortgage Investment Conduits, are subject to special rules under the
Code.34
Mutual fund trusts do not fit into one of these special categories. One might think
that they would fit into the rules that govern US mutual funds. This, although intuitive, is
incorrect. US mutual funds are often treated as Regulated Investment Companies (“RIC”)
under sections 851-855 of the Code. Canadian mutual funds cannot be classified as RICs
because to do so they must be a “domestic corporation”, which they are not.35
Absent a
special classification, the general entity classification rules apply.36
30
See Reed, supra note 3 at 34-36. 31
Treas. Reg. § 301.7701-1(a) 32
Treas. Reg. § 301.7701-1(b) 33
Ibid. 34
Treas. Reg. § 301.7701-1(b) 35
IRC § 851(a). 36
Treas. Reg. § 301.7701-1(b).
11
iii. Is the entity a trust? If an entity is not a trust, then it is classified as a business entity and
subject to the rules classifying business entities. 37
Canadian mutual fund trusts are not trusts
for US tax purposes. Of the types of trusts set out in Treasury Regulation §301.7701-4, there
are only two that are possibly applicable: ordinary trusts, and investment trusts. 38
Consider
each one in turn.
a) Is a Canadian mutual fund trust an “ordinary trust”? An “ordinary trust” is an
arrangement in which the trustee “take[s] title to property for the purpose of
protecting or conserving it for the beneficiaries under the ordinary rules applied in
chancery or probate courts.” 39
While a Canadian mutual fund trust may take title to
the property, it does more than simply conserve and protect the beneficiary’s
property. Rather, the goal of a Canadian mutual fund trust is to make profit and
maximize the investment returns for its unit holders. A mutual fund that tried to
simply conserve an investor’s property at the same level would not be a viable
commercial enterprise for long. Case law and commentary offers insight into the
distinction between a business entity and an “ordinary trust”. The US Tax Court has
held that the characteristics to distinguish a business entity from an ordinary trust are
(i) whether the trust has associates and (ii) whether the trust has an objective to carry
37
Treas. Reg. § 301.7701-2(a). 38
There are others but they are clearly inapplicable to the question at hand. 39
The full definition is as follows: In general, the term “trust” as used in the Internal Revenue Code refers to an
arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the
purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate
courts. Usually the beneficiaries of such a trust do no more than accept the benefits thereof and are not the voluntary
planners or creators of the trust arrangement. However, the beneficiaries of such a trust may be the persons who
create it and it will be recognized as a trust under the Internal Revenue Code if it was created for the purpose of
protecting or conserving the trust property for beneficiaries who stand in the same relation to the trust as they would
if the trust had been created by others for them. Generally speaking, an arrangement will be treated as a trust under
the Internal Revenue Code if it can be shown that the purpose of the arrangement is to vest in trustees responsibility
for the protection and conservation of property for beneficiaries who cannot share in the discharge of this
responsibility and, therefore, are not associates in a joint enterprise for the conduct of business for profit.
12
on a business.40
Treasury Regulation § 301.7701-1(b) invokes the same distinction.41
So does the preamble to the regulations which reformed the entity classification
scheme (but left the regulations regarding trusts untouched).42
It is self-evident that a
Canadian mutual fund trust fulfills the second criteria as its entire purpose is to make
money for its investors. The presence of associates is determined by a number of
factors including whether the interests in the trust are transferrable.43
Because
interests in Canadian mutual fund trusts are transferrable, the trusts have associates
and do not meet the definition of “ordinary trust”.
b) Is a Canadian mutual fund trust an “investment trust”?44
An investment trust,
although imprecisely defined in the Regulations, can be thought of as “a trust created
to facilitate direct investment in the assets of the trust through a pooling arrangement
that creates the opportunity to diversify investments.”45
At first glance, it would
appear that a Canadian mutual fund trust could satisfy this definition. However, an
investment trust will be classified as a business entity if the trustee has the power to
vary the investments of the trust.46
It is the premise of the Canadian mutual fund trust
that the trustee be able to use its expertise to select the best investments. As such, a
40
Elm Street Realty Trust v. Commissioner, 76 TC 803 at 809 (1981) [Elm Street Trust]; Bedell Trust v.
Commissioner, 86 TC 1207 at 1218 (1986) [Bedell Trust]. 41
The full text of this regulation reads: “For the classification of organizations as trusts, see §301.7701-4. That
section provides that trusts generally do not have associates or an objective to carry on business for profit. Sections
301.7701-2 and 301.7701-3 provide rules for classifying organizations that are not classified as trusts.” 42
Preamble to Prop Treas. Reg. § 301: “The regulations provide that trusts generally do not have associates or an
objective to carry on business for profit. The distinctions between trusts and business entities, although restated, are
not changed by these regulations.”
43 Carter G. Bishop, “Forgotten Trust: A Check-the-Box Achilles’ Heel” (2010) 43:3 Suffolk Univ. L Rev 529 at
555; Bedell Trust supra note 39 at 1220-1221; Morrissey v. Commissioner 296 US 344 at 360 [Morrissey]. 44
Treas. Reg. § 301.7701-4(c)(1). 45
Supra note 40. 46
Treas. Reg. § 301.7701-4(c)(1).
13
Canadian mutual fund trust will likely be classified as a “business entity” rather than
a trust.
iv. How many members does the entity have? If an entity is not a trust under Treasury
Regulation § 301.7701-4 or subject to special classification under the Code, then its
classification is determined by reference to the number of members it has. If it has two or
more members, it is either a partnership or a corporation.47
If the entity has only one member,
then it is either an association or an entity that is disregarded from its owner.48
Although
“member” is not defined in the Regulations, it is generally used as synonymous with
beneficial owner. A Canadian mutual fund trust typically would have many beneficial
owners (members). Thus, it is either a corporation or a partnership for US tax purposes.
v. Does the entity meet one of the automatic definitions of a corporation? An entity is
automatically classified as a corporation if it meets one of seven different definitions. 49
If it
does not meet one of these seven different definitions, it must be examined under the default
entity classification rules. A Canadian mutual fund trust likely does not meet any of these
definitions of “corporation”. 50
47
Treas. Reg. § 301.7701-2(a). 48
Ibid. 49
Specifically, an entity that is not classified as a corporation under Treas. Reg. §§ 301.7701-2(b)(1), 301.7701-
2(b)(3), 301.7701-2(b)(4), 301.7701-2(b)(5), 301.7701-2(b)(6), 301.7701-2(b)(7), or 301.7701-2(b)(8) is an “eligible
entity that may select its classification.” 50
The Canadian mutual fund trust does not meet any of the following definitions: 1) Treasury Regulations §
301.7701-2(b)(1) - it is not a business entity organized under a federal or state statute that is referred to as
incorporated; 2) Treasury Regulations § §301.7701-2(b)(3) – it is not a business entity organized under a state
statute that refers to the entity as a “joint stock-company or joint-stock association”; 3) Treasury Regulations §
§301.7701-2(b)(4) – it is not an insurance company; 4) Treasury Regulations § 301.7701-2(b)(5) – it is not a State-
chartered entity that conducts banking activities; 5) Treasury Regulations § 301.7701-2(b)(6) – it is not wholly
owned by a foreign government; 6) Treasury Regulations § 301.7701-2(b)(7) – it is not taxable as a corporation
under a specific section of the IRC; and 7) Treasury Regulations § 301.7701-2(b)(8) – it is not on the per se
corporations list.
14
vi. Is the entity foreign or domestic? An entity that does not meet one of the seven automatic
definitions of corporation must be analyzed under the default entity classification rules. The
first step is to determine whether the entity is foreign or domestic. An entity is classified as
foreign if it is not domestic.51
Domestic entities are those organized under the laws of the
United States.52
Since a Canadian mutual fund trust is not organized under the laws of the
United States, it is a foreign entity.
vii. Is the entity an “eligible entity”? If an entity is not a per se corporation, then it generally
would be an “eligible entity” and may elect to be classified as a corporation or partnership for
US tax purposes. 53
Since a Canadian mutual fund trust likely does not meet any of the set
definitions of “corporation”, it is likely an eligible entity and may elect to be taxed as a
partnership or as a corporation.54
Private letter rulings issued by the IRS confirm this view. In PLR 200752029, a mutual fund
trust from an unnamed jurisdiction requested a ruling that it was a corporation for the
purposes of Code § 1(h)(11)(C). This section states that dividends paid by a “qualified
foreign corporation” to US persons are taxed at capital gains rates. The mutual fund trust was
not a US person. The purpose of the fund was to invest in securities and other instruments to
benefit the unit holders.
The IRS performed a similar type of analysis to the one conducted above. It concluded that
the fund was an entity separate from its owners. It was not an ordinary trust because it had a
profit making motive. It could not be classified as an investment trust because the trustee had
51
IRC § 7701(a)(5). 52
IRC § 7701(a)(4). 53
Treas. Reg. § 301.7701-3(a). 54
Ibid.
15
power to vary the fund’s investments. The fund did not meet one of the seven automatic
classifications as a corporation. Therefore, the fund was a foreign eligible entity that could
elect to make a classification under Treasury Regulation §301.7701-3(a) to be treated as a
corporation or a partnership for US tax purposes.
In this particular instance, the fund had filed a form 8832 and elected to be classified as an
association taxable as a corporation. The fund represented that it was not a PFIC. The IRS
accepted the desired classification as a “foreign corporation” for the purposes of Code §
1(h)(11)(C). The PLR does not address the classification of a mutual fund trust absent an
election. Further, because it does not identify the country of origin of the mutual fund trust, it
cannot be determined whether the PLR is applicable to Canadian mutual fund trusts.
Nevertheless, the PLR corroborates the above analysis that a mutual fund trust may be a
foreign eligible entity.
viii. What is the default classification of the entity? All foreign eligible entities with more than
one member may file a Form 8832 to elect to be classified as a partnership or a corporation
for US tax purposes. Absent this election, each “foreign eligible entity” has a default
classification as a partnership or a corporation for US tax purposes. Since 1997, the sole
criterion used to determine whether a foreign eligible entity is a partnership or a corporation
by default is whether the members of the entity have limited liability. Thus, a foreign eligible
entity with two or more members is, by default either: a) a partnership if at least one member
does not have limited liability; or b) a corporation if all members have limited liability.55
A
member is not considered to have limited liability if he/she is personally liable for any of the
55
Treas. Reg. § 301.7701-3(b)(2)(i).
16
debts of the organization even if he/she is indemnified for those debts.56
The question is
whether a member of a Canadian mutual fund trust has unlimited liability. Since the primary
members of a Canadian mutual fund trust are its beneficiaries57
, it makes sense to examine
their liability for the debts and obligations of the fund.
ix. Do the beneficiaries of Canadian mutual fund trusts have limited liability?
The question as to whether beneficiaries of a mutual fund trust have sufficient limited liability so
that those trusts are considered corporations under US law is an interplay between US tax law
and Canadian trust law. To start out, consider under US tax law what level of limited liability is
required in order for an entity to be classified as a corporation for US tax purposes. The
definition of “limited liability” under the Internal Revenue Code is whether “the creditors of the
entity may seek satisfaction of all or any portion of the debts or claims against the entity from the
member as such.” As there is no authority on this point, it is unclear precisely what level of
liability is required to meet this definition. However, the plain meaning of the word “any”
suggests that limited liability is a litmus paper test - meaning that if the members have even a
small risk of personal liability then the entity may not have limited liability as it is defined in the
Code. The rejoinder to this reading is foreseeable. On this logic, even a Canadian corporation
would not be classified as a corporation for US tax purposes because its shareholders have some
potential personal liability (i.e. the risk of piercing the corporate veil). But this rejoinder ignores
56
The full definition is here: For purposes of paragraph (b)(2)(i) of this section, a member of a foreign eligible entity
has limited liability if the member has no personal liability for the debts of or claims against the entity by reason of
being a member. This determination is based solely on the statute or law pursuant to which the entity is organized,
except that if the underlying statute or law allows the entity to specify in its organizational documents whether the
members will have limited liability, the organizational documents may also be relevant. For purposes of this section,
a member has personal liability if the creditors of the entity may seek satisfaction of all or any portion of the debts or
claims against the entity from the member as such. A member has personal liability for purposes of this paragraph
even if the member makes an agreement under which another person (whether or not a member of the entity)
assumes such liability or agrees to indemnify that member for any such liability. 57
In another paper, I examined, and rejected, the possibility that the trustee might be a member of a Canadian
mutual fund trust.
17
that entities (such as a Canadian corporation) that are akin to a US corporation are placed on the
per se corporations list discussed above. Further, entities subject to these default rules have the
option of electing their status. This means that for many entities it doesn’t matter what their
default status is – their owners will simply elect the desired status. Consequently, the objection
that the Code should not be read this way is meritorious but rebuttable.
A purposive reading of the definition of limited liability suggests that a Canadian mutual fund
trust should be classified as a partnership by default. The intent of the Code’s classification
mechanism is straightforward. Entities that resemble corporations should be taxed as such.
Entities that more closely resemble partnerships should be taxed as a partnership. Setting aside
the liability question the moment, from a tax perspective the Canadian mutual fund trust
functions much more like a partnership than it does a corporation. It is a flow through entity that
normally pays no entity level tax. Like a general partnership, most of the decisions made by the
trust are made by the trustee (akin to a general partner) on behalf of many other passive
participants.
Nevertheless, the analysis turns, in the Code’s words, “solely on local law”. Thus, if it can be
shown that, as a matter of Canadian law, the beneficiaries have even modest potential liability
then a Canadian mutual fund trust may, by default, be classified as a partnership for US tax
purposes. There is a good argument that the beneficiaries of certain funds organized in certain
provinces may not have limited liability. At different times, Ontario (2004)58
, Manitoba
(2005)59
, Alberta (2004)60
British Columbia (2006)61
, Saskatchewan (2006)62
and Quebec
58
Supra note 23. 59
Supra note 24. 60
Supra note 25. 61
Supra note 26. 62
Supra note 28.
18
(1994)63
passed legislation that granted limited liability to the beneficiaries of mutual fund trusts.
Prior to the enactment of legislation, there were concerns that the beneficiaries of Canadian
mutual fund trusts did not enjoy limited liability. The Bank of Canada issued a report in 2003
which concluded, “Although this [personal liability of unit holders] is legally feasible, a number
of Canadian securities firms have given legal opinions that there is little probability of this type
of event occurring."64
Similarly, the Government of Alberta issued a report referring to potential
personal liability of unit holders, concluding that, "Although the chances are thought to be
remote, such an occurrence could have a potentially devastating impact on the financial well-
being of unit holders.” 65
The Government of Saskatchewan, in justifying its statute, states, “in
situations where the trust property is insufficient to cover the liabilities, beneficiaries may be
called upon to indemnify the trustee for amounts in excess of the investor's initial investment.”66
The Bank of Canada, and the Governments of Alberta and Saskatchewan identified a remote, but
still real, risk that beneficiaries of Canadian mutual fund trusts did not have limited liability.
Statutes were, in many provinces, enacted as a result of these risks identified. Logic dictates that
governments don’t legislate without reason and would not have enacted such statutes had the risk
not been real. The next section explores the type of limited liability faced by Canadian mutual
fund trusts in more detail.
a) The Indemnification Risk
Professor Mark Gillen of the University of Victoria law school has written an excellent paper on
63
Supra note 27. 64
Bank of Canada, Working Paper 2003-25 (September 2003), at 19. 65
Government of Alberta (Alberta Revenue), "Income Trusts: Governance and Legal Status - a Discussion Paper"
(July 2004) [Alberta Discussion Paper] at 5. 66
http://www.justice.gov.sk.ca/Income-Trust-Liability-Act
19
the liability exposure of beneficiaries of Canadian mutual fund trusts. 67
His article was focused
on the issue from a Canadian business law perspective rather than a US tax perspective.
He identified three sources of potential liability for the beneficiaries of mutual fund trusts. Two
are applicable here. First, beneficiaries of mutual fund trusts could be liable for the debts of the
trustee because the trustee (and more importantly, its creditors) have the right to be indemnified
out of the asset of the fund. If there are insufficient assets in the fund, the beneficiaries might be
liable to the creditors. This is known as the “Indemnification Risk”. It functions as follows.
Under Canadian law, a trust cannot be liable in contract or tort because it is not a legal person.68
But the trustees (usually financial institutions in the case of retail mutual fund trusts) are legal
persons. In order to carry out their duties as trustees, they enter into contracts and they may
commit torts. As a matter of general Canadian trust law, if trustees incur liability while they are
performing their duties, they are entitled to indemnification out of the assets of the trust. 69
This right to indemnity is commonly found in the organizing documents that govern Canadian
mutual fund trusts. For instance, the trust documentation that RBC uses for its mutual funds
includes a clause under which the trustee can be indemnified for all liability it incurs, while
67
Mark R. Gillen, “Income Trust Unitholder Liability: Risks and Legislative Response” (2005) 42:3 Can. Bus. L.J.
325. [Gillen] This section is largely based on the ideas in Professor Gillen’s article. I am indebted to his work on this
issue (albeit in a different context). The particular sections of his paper are referenced below. I have reproduced
many of Professor Gillen’s footnotes verbatim and have indicated as such to aid the reader finding the primary
sources. 68
“See, e.g., Kingsdale Securities Co. v. M.N.R., [1974] 2 F.C. 760, 74 D.T.C. 6674 at p. 6681 (C.A.). See also Sir
Arthur Underhill and David J. Hayton, Law Relating to Trusts and Trustees, 15th ed. (London, Butterworths, 1995)
at 4.” As cited in Gillen supra note 67 at 332 footnote 21.
69 “See, e.g., Waters' Law of Trusts in Canada, at 1155: "The trustee is entitled to be indemnified for all the costs,
charges and expenses which he has reasonably incurred." See also s. 95 of the Trustee Act, R.S.B.C. 1996, c. 464,
which provides that “a trustee [...] is answerable and accountable only for the trustee's own acts, receipts, neglects or
defaults, and not for those of other trustees or a banker, broker or other person with whom trust money or securities
may be deposited, nor for the insufficiency or deficiency of securities or any other loss, unless it happens through
the trustee's own willful default, and may reimburse himself or herself, or pay or discharge out of the trust premises,
all expenses incurred in or about the execution of his or her trusts or powers.” “ as cited in Gillen supra note 67 at
332, note 23.
20
acting in good faith, out of the assets of the fund.70
If the trust assets and the trustee's assets were
insufficient to meet the liability, then the trustee's creditors might seek to enforce the right of
indemnification in their favour.71
As such, the beneficiaries may be liable for the debts of the
trustee and the fund in its entirety.72
This liability risk to the beneficiaries is offset by the fact
that the Trustee often contractually releases the beneficiaries from liability. For instance, the
RBC Trust Agreement releases the unitholders from any liability. Nevertheless, it is not clear if,
in bankruptcy for example, a third party creditor would be required to respect this agreement. In
sum, the Indemnification Risk creates a theoretical, if perhaps unlikely to actually occur, risk that
the beneficiaries of a mutual fund trust do not have limited liability.
b) The Control Risk
The second potential source of liability is referred to as the Control Risk.73
The Control Risk
arises because of the trust-beneficiary relationship can be classified as a principal-agent
relationship. A principal-agent relationship arises “when the principals control the agent’s
action, both the principal and agent consent to the relationship, and the agent has legal authority
to affect the principal’s legal position.”74
An agency relationship is a question of fact. It does not
require a legal agreement between the parties.75
It can be implied from the circumstances. If a
trustee is found to be an agent on behalf of one or more beneficiaries, then the beneficiaries may
be held directly liable as principals. A trustee might be found to be an agent of the beneficiaries
where the beneficiaries have a significant degree of control over the acts done in respect of the
70
RBC Funds, Amended and Restated Master Declaration of Trust, clause 15.2 71
Gillen supra note 67 at 332. 72
Ibid at 333. 73
Gillen supra note 67 at 342. 74
Grosvenor Canada Limited v. South Coast British Columbia Transportation Authority 2015 BCSC 177 at para 58
[Grosvenor]. 75
Grosvenor supra note 74 at para. 58.
21
trust. Beneficiaries of Canadian business trusts have been found liable previously because of the
existence of a principal-agent relationship. For instance, in Trident Holdings v. Danand
Investments76
the Ontario Court of Appeal found that the beneficiaries were liable for the debts
of the trustee because the parties were in an agency arrangement because of the control that the
beneficiaries had over the agent. The same was found in Advanced Glazing v. Multimetro et al.77
.
There the BC Supreme Court found that the beneficiaries had “the general power to control the
conduct of MMC such that MMC is their agent” and “the broad power of investor control
enables the investors to be personally liable” for the debts of the trustee.78
There is no minimum
legal threshold of control at which an agency relationship is created.79
Each set of facts and
circumstances must be analyzed. As the BC Supreme Court put it in Advanced Glazing, “Where
both agent and trust relations exist, the greater the power of control over the agent/trustee the
greater the likelihood that the principles of agency, rather than the principles of trust, are
applicable.”80
These principles must be applied to mutual fund trusts. Beneficiaries of mutual
fund trusts have powers over the trustees that, very generally, often include the power to change
the investment objectives of the fund, replace the trustees, and increase or decrease the amount
of funds payable to the trust. The RBC Declaration of Trust, for instance, includes a clause that
allows the unitholders to vote over “any other matter in respect of which applicable Securities
Legislation would apply”.81
It is true that the organizing documents of mutual funds generally
restrict the amount of control that a beneficiary can exercise. For instance, they often reserve
specific investment decisions to the trustee. This might suggest a lower level of control that
76
Trident Holdings v. Danand Investments (1988), 64 O.R. (2d) 65, 49 D.L.R. (4th) 1 (Ont. C.A.) [Trident]. 77
Advanced Glazing v. Multimetro et al. 2000 BCSC 804 [Advanced Glazing]. 78
Ibid at para 73. 79
Grosvenor supra note 74 at para 64. 80
Advanced Glazing supra note 77 at para 67. 81
RBC declaration of Trust – article 16.12.1.4.
22
would not rise to the level of agency. However, there is Canadian case law that indicates that
even explicit contractual language does not, at the end of the day, remove power from the
beneficiaries of a business trust. This case law includes:
Orange Capital, L.L.C. v. Partners Real Estate Investment Trust in which, even in the
face of a contract stating otherwise, unitholder voting rights in relation to action by the
trustee (or replacement thereof, as was the case in Orange Capital) will be upheld on the
basis of achieving a “commercially sensible result.”82
Crown Hill Capital Corp. (Re), in which the fiduciary duty of the trustee in a business
trust was held to include obtaining explicit informed consent of the unitholders where
there is reasonable doubt regarding whether the trustee can or cannot enter into a given
contract.83
This was deemed not to be exempt by virtue of the “business judgment rule.”84
Renegade Capital Corp. v. Dominion Citrus Ltd., in which the court found trustees to be
obligated to seek explicit approval of action that may be materially adverse to the
interests of the unitholders themselves despite the fact that the powers of the unitholders
were severely limited by contract.85
The point here is not to draw a firm conclusion as a matter of Canadian law that the Control Risk
means that beneficiaries have liability for the debts and obligations of a Canadian mutual fund
trust. This remains a contentious point under Canadian law. But rather to suggest that this risk is
real enough to arguably push the default US tax classification of Canadian mutual funds to
partnerships – especially in the absence of a statute stating otherwise. The attractiveness of this
82
Orange Capital, L.L.C. v. Partners Real Estate Investment Trust 2014 ONSC 3793 at para. 49 [Orange Capital]. 83
Crown Hill Capital Corp. (Re) 2013 LNONOSC 656 at para. 114 [Crown Hill Capital]. 84
Ibid at para 145. 85
Renegade Capital Corp. v. Dominion Citrus Ltd. 2013 ONSC 1590 at para 138 [Renegade Capital].
23
argument from a US tax perspective is that the Control Risk is widely accepted as a matter of US
law regarding US business trusts.86
That would mean that an American court adjudicating a
dispute over the US tax classification of a Canadian mutual fund trust would be familiar with
why trust beneficiaries may be liable for the debts and obligations of the fund and may be
favorably disposed to it.
x. How does the change in liability status affect the US tax classification of a Canadian mutual
fund trust?
Absent a statute to the contrary, the Control Risk indicates at least some potential liability for the
beneficiaries of mutual fund trusts. If so, between 1997 (when the current regulations were
enacted) and 2004 (or the other appropriate date when the statute granting beneficiaries limited
liability was enacted), beneficiaries of mutual fund trusts did not have limited liability because of
the Control Risk. There were thus, under the entity classification regulations that have been in
place since 1997, classified as partnerships. Then, after the statute was enacted, the liability
status of the beneficiaries changed. However, the US tax classification of the mutual fund trust
did not change. Treasury Regulation section 301.7701-3(a) reads as in part:
An entity whose classification is determined under the default classification retains that
classification (regardless of any changes in the members' liability that occurs at any time
during the time that the entity's classification is relevant as defined in paragraph (d) of
86
“See, e.g.: Williams v. Milton, 102 N.E. 355 (Mass. S.J.C. 1913); Frost v. Thomson, 106 N.E. 1009 (Mass. S.J.C.
1914); Home Lumber v. Hopkins, 190 P. 601 (1920); Neville v. Gifford, 242 Mass. 124, 136 N.E. 160 (1922);
Goldwater v. Altman, 292 P. 624 as noted in Gillen supra note 67; (1930); Levy v. Nellis, I N.E. 2d 251 (1936);
State Street Trust Co. v. Hall, 311 Mass. 299, 41 N.E. 2d 30 (1942); Piff v. Berresheim, 92 N.E.2d 113 (1950), revg
86 N.E.2d 411 (1949); In re Medallion Really Trust, 120 B.R. 245 (1990 D. Mass.); and In Re Eastmare, 150 B.R.
495 (1993 Bankr. D. Mass.); but see contra Lawyer's Title Guarantee Fund v. Koch, 397 So. 2d 455 (Fla. App.
1981); See also the discussion in Symposium, "Closely Held Businesses in Trust: Planning, Drafting and
Administration" (1981), 16 Real Prop. Prob. & Trust J. 341.” As cited in Gillen supra note 67 at 337, note 36.
24
this section) until the entity makes an election to change that classification under paragraph
(c)(1) of this section. [Emphasis added]
In other words, a mutual fund trust retains its initial default classification until an election is
made otherwise. A mutual fund trust established prior to the enactment of the statutes, was
arguably a partnership for US tax purposes. Because of the above Treasury Regulation, it
remains a partnership for US tax purposes until it elects otherwise despite the subsequent change
in its liability status. To my knowledge, no Canadian mutual fund trusts have made any US entity
classification elections even though they are able to do so.87
Partnerships can’t be PFICs. So
there is a good case that Canadian mutual fund trusts established prior to 2004 are not PFICs.
xi. Classification of Canadian mutual funds prior to 1997
The current rules for entity classification were adopted in 1997. Thus, funds formed after January
1, 1997 but prior to 2004, the above argument will apply perfectly. More consideration needs to
be given to funds that were organized prior to 1997. In short, there is still a good argument that
funds formed prior to 1997 were classified under the previous set of US entity classification
regulations (known as the “Kintner regulations”) were (and remain) classified as partnerships for
US tax purposes. That classification needs to be examined.
a) Application of the Kintner regulations to Canadian mutual fund trusts
It is arguable that under the Kintner regulations, which were in effect between 1960-1997,
Canadian mutual fund trusts were classified as partnerships for US tax purposes. The Kintner
regulations used a four factor test to determine entity classification. The four factors were: free
transferability of interests, continuity of life, limited liability, and centralized management. An
87
Reed supra note 3 at 36.
25
entity that had at least three of these four factors was considered a corporation. Take these four
factors in turn:
i. Continuity of life - . Continuity of life meant whether the entity continued
after the death or exit of one member from the entity. 88
This is clearly the
case for Canadian mutual fund trusts.
ii. Centralized management and control - Centralized management means
that an identifiable group of people, distinct from the entire membership of
the entity had the power to make management decisions on behalf of the
entity. 89
As discussed above, because of the fiduciary relationship
between the trustee and the beneficiaries of a mutual fund trust, the
beneficiaries have a certain amount of control over the trustee that is
inherent in the structure of the trust and applicable regardless of what the
organizing document states. This level of control by the beneficiaries
might rise to the level necessary to constitute a lack of centralized
management – especially in light of some of the cases discussed above.
The management structure of a Canadian mutual fund trust might be
another indicator of a lack of central management and control. Often, the
trustee of the mutual fund trust has the power to appoint a manager.
Whether this delegation is sufficient to conclude that there is a lack of
central management and control is unclear. Against these two points lies
the broad authority of a trustee of a mutual fund trust to make investment
decisions over which the beneficiaries have little say. In sum, it’s not 88
Treas. Reg. § 301.7701-2(a)(1). 89
Treas. Reg. § 301.7701-2(c)(1).
26
clear whether the mutual fund trust would be considered to have
centralized management and control.
iii. Limited liability - Limited liability had the same meaning that it does
under the post-1997 regulations. For the reasons described above, it is
arguable that not all members of the fund had limited liability.
iv. Free Transferability of interests –The interests in a mutual fund trust are
transferrable only if each of an entity's members had the power to transfer
all attributes of ownership to a person not currently a member of the
organization without consent from the other members.90
There is a
reasonable argument that units of the typical Canadian mutual fund are not
freely transferrable because, unlike corporate shares, they can only be sold
back to the fund itself or transferred with consent of the fund
administrator.
b. Transition between the Kintner regulations and the check the box regulations
To fully understand the current default classification of Canadian mutual fund trusts in the post-
1997 era, it is necessary to examine the transition between the Kintner regulations and the
“check-the-box” regulations. Generally, unless it elected otherwise, an entity retained its
classification under the check-the-box regulations that it had under the Kintner regulations. 91
Thus, because there is an argument that Canadian mutual fund trusts were partnerships under the
pre-1997 regulations, that classification can carryforward to the post-1997 era as well. Absent an
90
Treas. Reg. § 301.7701-2(e)(1). 91
Treas. Reg. § 301.7701-3(b)(3) (as amended by T.D. 8697, 1997-2 I.R.B. 11) (providing that entity not making
election will have same classification as claimed prior to new regulations).
27
election, the IRS will respect the claimed pre-1997 classification of an entity in the post 1997
period if : a) under the pre-1997 rules the entity had a “reasonable basis” for its claimed
classification; b) any change of the entity’s status within 60 months prior to January 1, 1997 was
recognized by all its members; c) and the IRS did not notify the entity before May 8, 1996 that
the entity’s classification was under review.92
All three criteria can be satisfied. The position
described above that the pre-1997 period classification of a Canadian mutual fund trust was a
partnership is clearly “reasonable”. That status likely did not change within 60 months of 1997
and the IRS likely didn’t notify Canadian mutual fund trusts of the change in classification. In
short, there is an acceptable position to take that a Canadian mutual fund trust was a partnership
under the Kintner regulations. If there is a reasonable basis for the pre-1997 position, the IRS
will respect it in the post-1997 period.
Consider the alternative. What if a US court did not accept that under the Kintner regulations a
Canadian mutual fund trust was a partnership for US tax purposes? Two scenarios are possible.
First, assume the court concludes that the Canadian mutual fund trust was a corporation under
the Kintner regulations and also, despite all of the arguments to the contrary above, under the
check-the-box regulations. If so, the US Person Investor would have continuously owned shares
in a foreign corporation since he/she purchased the shares. If the foreign corporation was a PFIC,
then the results could be very expensive. Second, assume that a US court accepted that a
Canadian mutual fund trust was a partnership for US tax purposes under the check-the-box
regulations, but not under the Kintner regulations. Further assume that if the trust was a
corporation then it was also a PFIC. Under this scenario, the Canadian mutual fund trust ceased
92
Treas. Reg. § 301.7701-3(h)(2).
28
to be a corporation for US tax purposes on January 1, 1997 when the check-the-box regulations
came into effect. This would result in a liquidation of the fund for US tax purposes and gain and
thus PFIC tax recognizable by all US Person Investors in the trust in 1997. At first glance, this
might appear to be a bad result. But if US Person Investors who currently invest in a trust didn’t
own their investment in 1997 they don’t have to worry about any liquidation. The trust itself is
not subject to US tax– only its US Person Investors’ interests in it are. For US Person Investors
who did own an interest in a fund that underwent liquidation in 1997, then this year is likely
statute barred so as a practical matter it is irrelevant. Put simply, for US tax reasons the
conversion of the trust from a corporation to a partnership is only relevant to those who owned
an interest in the fund at that time and even then any tax consequence is barred by the statute of
limitations. In short, although the classification is more complicated for funds organized prior
to 1997, there remains a good argument that the funds were and remain partnerships for US tax
purposes.
xii. Conclusion –
There is a good argument that certain Canadian mutual fund trusts that were organized prior to
the enactment of the limited liability statutes are partnerships for US tax purposes and not
corporations and thus not PFICs. This is because the beneficiaries of these funds did not have
limited liability. This position is not risk free. Even prior to the enactment of the limited liability
statutes, the liability exposure of beneficiaries of Canadian mutual fund trusts was theoretical. It
is thus possible that a US court would conclude that the liability is so abstract and theoretical that
for the purposes of US law it does not count and that all of the members of the mutual fund do
indeed have limited liability.
29
This possibility is illustrated through an analogy to a Canadian corporation. Everyone agrees that
Canadian corporations provide limited liability. As such, they are automatically treated as
corporations for US tax purposes. Even so, shareholders of Canadian corporations will
occasionally be subject to liability for the debts and obligations of the corporation. Canadian
courts will pierce the corporate veil and subject the shareholders to liability for the debts and
obligations of the corporation if it is just and equitable to do so.93
US courts, without any
reference to Canadian mutual funds, have made this analogy. In Yamagata v. US the US federal
court of claims held that the remote possibility that a Japanese kabushiki kaisha was a
corporation for US tax purposes despite the fact that the owners had some theoretical liability for
the debts of the entity.94
Nevertheless, the above analysis shows that such liability was possible – even though it wasn’t
likely. In litigation, often the simplest argument wins. The position that Canadian mutual funds
formed prior to the enactment of the limited liability statues aren’t PFICs is relatively easy to
grasp. There was a problem (liability exposure for beneficiaries of mutual fund trusts) prior to
2004. The mutual fund industry lobbied for the problem to change. So governments introduced a
new law to solve the problem. The entity classification status for a Canadian mutual fund trust
organized prior to 2004 is frozen until an election is made otherwise. Therefore, Canadian
mutual fund trusts were partnerships and remain partnerships for US tax purposes.
Equity also supports this position. It is unfair to expose US Person Investors in Canada to the
punitive PFIC rules when their only course of action was to simply buy common consumer
financial products in a jurisdiction with much higher tax rates than the USA. It is thus more
93
Kosmopoulos v. Constitution Insurance Co. [1987] 1 SCR 2; 1987 CanLII 75 [Kosmopoulos]. 94
US Court of Federal Claims, Nos. 07-698T, 07-704T
30
likely than not that a US court reviewing this position would conclude that funds formed prior to
the enactment of limited liability statutes are, as of today, not corporations for US tax purposes
and thus cannot be PFICs.
xiii. Reporting this position
Under this position, the Canadian mutual fund trust is a partnership for US tax purposes. The US
investor will thus own a small fraction of a foreign partnership. The income from this partnership
would, of course, need to be reported on Form 1040 as income of its type would normally be
reported. No additional forms are necessary unless the person contributes over $100,000 to a
single Canadian mutual fund in a given year.95
Form 8865 is required if a US person has greater
than a 10% interest in a foreign partnership or if that person contributes over USD $100,000 to a
foreign partnership in a given year. The vast majority of Canadian investors in large mutual
funds will not fall into either of these scenarios. A more cautious taxpayer adopting this position
may want to pre-emptively disclose the position taken to the IRS on Form 8275 which is used to
disclose unorthodox tax positions. Filing it insulates the taxpayer from some penalties and may
shorten the statute of limitations (the time that the IRS has to audit a return).96
7. Canadian mutual fund trusts not subject to the limited liability statutes are not
PFICs
There is a certain, smaller subset, of Canadian mutual fund trusts to which the limited liability
statutes do not apply. These mutual fund trusts are still exposed to the Control Risk and thus for
the reasons outlined above they may be, by default, partnerships for US tax purposes. There are
two groups of funds to which this analysis might apply. First, Canadian mutual fund trusts
organized in a jurisdiction where there is no limited liability statute are obviously not covered by
95
IRC § 6038. 96
IRC § 6662 (d)(2)(B)(ii)(I).
31
such a statute. Second, the limited liability statutes only apply to certain Canadian mutual fund
trusts. For instance, the Ontario statute only applies to trusts that are “reporting issuers”.97
Thus,
for funds that are not “reporting issuers” under the relevant provincial securities legislation may
not be corporations for US tax purposes and thus may not be PFICs.
8. Election partnership classification for a Canadian mutual fund trust
Section 6 outlines that Canadian mutual fund trusts are foreign eligible entities under the US
entity classification regime.98
This is confirmed by PLR 200752029 described above. Such an
election is made by filing Form 8832. It must be made at the fund level. The election would work
very well for newly created funds. From the start, they would indisputably partnerships for US
tax purposes. A Private Letter Ruling could be easily obtained if additional comfort was
required. It might also work to formalize one of the positions outlined in section 6, 7, or 9. The
risk is with this option is that, if prior to making this election, the trust was considered a
corporation for US tax purposes then the conversion from a corporation to a partnership would
constitute a liquidation and trigger PFIC tax for the investors.
9. All Canadian mutual funds are not PFICs.
The natural extension of the argument developed in section 6 is to see if it is applicable to all
Canadian mutual funds – not just those organized prior to the enactment of the limited liability
statutes. There is an argument to this effect. It is a “reasonable position” required under code
section 6662. But the argument is risky. And it might not hold up in the US tax court in
litigation. It runs as follows.
97
Supra note 23 98
Treasury Regulation Reg. §301.7701-3(a)
32
Regardless of any legislation in place, beneficiaries of a Canadian mutual fund trust have they
are subject to the Control Risk described in section 6 above. Arguably, the limitation of liability
statutes only protect against the Indemnification Risk and not the Control Risk. Take the Ontario
Trust Beneficiaries Act as an example. Section 1(1) of the Act reads as follows:
The beneficiaries of a trust are not, as beneficiaries, liable for any act, default, obligation
or liability of the trust or any of its trustees if, when the act or default occurs or the
obligation or liability arises.99
The plain meaning of this provision only protects the beneficiaries from liability as beneficiaries
– not as principals for the acts of their agents.100
So the beneficiaries are still subject to the
Control Risk. The text of the Alberta statute is the same. This is a theoretical point. There is no
case law on it. Given the legislature’s intention to protect beneficiaries of Canadian business
trusts, a Canadian court may be reluctant to hold the beneficiaries personally liable.
Nevertheless, the liability risk remains. It may be sufficient to classify the fund as a partnership
for US tax purposes or to at least adopt this as a filing position.
There are other scenarios in which the beneficiaries of a mutual fund trust covered by a
limitation of liability statute have liability risks. Assume, for example, the mutual fund trust
invests in a REIT outside of a jurisdiction that has a statute granting limited liability to mutual
fund trusts. The investment generates liability for the mutual fund trust. But there is no statute to
protect the beneficiaries. As such, the creditors of the mutual fund trust may be able to attempt to
collect the debts and obligations of the mutual fund trust from the beneficiaries. This risk is
specifically disclosed in the documentation of many mutual fund trusts. For instance, RBC’s
Simplified Prospectus states:
99
Supra note 23 at s. 1 100
Gillen supra note 67 at 362.
33
A fund that invests in trusts faces the risk that, as a holder of units of a trust, the fund may be
held liable and subject to levy or execution for satisfaction of all obligations and claims of
the trust. This risk may arise with income trusts, which include real estate investment trusts
and other forms of business trusts. The risk is considered remote. Alberta, Ontario,
Saskatchewan, British Columbia and Manitoba have legislation to eliminate this risk in
respect of holders of units of trusts that are reporting issuers organized under the laws of such
provinces. To the extent that the funds are subject to such claims and such claims are
not satisfied by the fund, there is a risk that a unit holder of the fund could be held
personally liable for the obligations of the trust. The possibility of a unit holder incurring
personal liability of this nature is considered extremely remote.101
[emphasis added]
As the RBC disclosure statement indicates, the risk is “extremely remote” but that they exist.
Given that the Treasury Regulations state that there is no limited liability where there is the
potential for personal liability for “any” debts of the trust, then this liability risk, identified by but
not exclusive to RBC, may be sufficient to support a position that a Canadian mutual fund trust is
by default, not a corporation for US tax purposes. It may be unlikely that a US court would this
risk as sufficient to support the conclusion that a beneficiary of a mutual fund trust would have
sufficient liability exposure so that the mutual fund trust would be classified as a partnership for
US tax purposes. Regardless, this position may be sufficiently meritorious to take on a US tax
return.
For the beneficiaries of Canadian mutual fund trusts that are covered by a limitation of liability
statute, there is a position that can be taken, albeit a high-risk position, that despite the statutes,
the mutual fund trusts are still partnerships for US tax purposes. Similarly to section 6 above, no
reporting would be necessary. Again, a cautious taxpayer may wish to report this position on
Form 8275 by reference to the documentation of his/her own specific mutual fund.
10. Publicly traded partnership rules
101
Royal Bank of Canada, Simplified Prospectus at page 8.
34
Even if Canadian mutual fund trusts are not corporations under the check-the-box regulations,
and are thus partnerships for US tax purposes, they may constitute corporations for US federal
tax purposes if they are deemed to be “publicly traded partnerships”. Section 7704 of the Code
provides that a publicly traded partnership is treated as a corporation for all federal tax purposes
(including the application of the PFIC rules).102
A partnership is “publicly traded” if interests in
it are “traded on an established securities market” or are “readily tradable on a secondary market
or the substantial equivalent thereof”103
Most Canadian mutual fund trusts available to the public
will meet these criteria.104
Thankfully, there is an exception. An entity deemed a publicly traded
partnership will not constitute a corporation for a taxable year, if for such taxable year, and each
preceding taxable during which the partnership was in existence, 90% of the gross income of the
partnership is “qualifying income”.105
In turn, “qualifying income” includes: interest, dividends,
rents from real property, gain from the sale of real property, gain from the sale of stock, income
and gains from commodities, and a few other more esoteric items.106
Many Canadian mutual
fund trusts being used as investment vehicles will meet this threshold and will thus likely be
exempt from tax treatment as a corporation for due to the publicly traded partnership rules.
11. US estate tax considerations
For Canadian mutual fund trusts adopting a partnership classification at an institutional level,
there is another US tax issue to think about – the US estate tax. The US estate tax applies to
decedents, including Canadians who are not US Persons, who have US situs assets at their death.
102
IRC § 7704(a). 103
IRC § 7704(b). 104
Treas. Reg. § 1.7704-1(c)(1); Treas. Reg. § 1.7704-1(c)(2). 105
Code section 7704(c) 106
Code section 7704(d)
35
Stocks issued by a US corporation are US situs assets and thus subject to the estate tax even. 107
The question is whether US stocks owned through a Canadian mutual fund trust are US situs
assets. If the Canadian mutual fund trust is a corporation for US tax purposes, there will be no
US estate tax exposure. However, partnerships are flow through entities for US tax purposes.
Thus, the owners of the partnership are assumed to own the assets directly. It is unclear whether
owning US situs assets through a foreign partnership subjects a non-US Person to the US estate
tax. It may be that a foreign partnership interest (such as an interest in a Canadian mutual fund
trust that is adopting a partnership classification for US tax purposes) is foreign intangible
property and not subject to the US estate tax.108
The IRS refuses to clarify this and will not issue
rulings on it.109
Even if the partnership structure does expose the non-US Person investor in a
Canadian mutual fund trust to the US estate tax, Canadian residents benefit from a significant
exemption from the US estate tax under the Canada-US Tax Treaty. A full discussion about the
US estate tax consequences of Canadian mutual fund trusts adopting a partnership structure is
beyond the scope of this article. Nevertheless, this remains an important consideration for
Canadian mutual fund trusts considering adopting a partnership structure at an institutional level.
They should be aware of the US estate tax risks to their Canadian clients who are not US
Persons. This risk doesn’t matter for individual US citizen investors in Canada considering
adopting these positions on a US tax return. They are already subject to the US estate tax by
virtue of their citizenship.
12. Conclusion
107
Code section 2104(a) 108
Reg §21.2014‐1(a)(1) 109
Reg §20.2105‐1(e), Rev Proc 2000‐7
36
The US tax classification of Canadian mutual fund trusts used as investment vehicles is of key
importance to both US Person Investors resident in Canada, the Canadian institutions creating
these vehicles, and US resident investors. The conventional wisdom is that Canadian mutual
fund trusts are corporations for US tax purposes and thus likely PFICs. I have presented seven
options to avoid the PFIC Problem. At the investor level, there are a few strategies that can be
used to negate or eliminate the PFIC risk. Investments in Canadian mutual fund trusts held in an
RRSP should not have PFIC problems. For investments held outside of an RRSP, the QEF and
mark-to-market elections can be used – although these have problems of their own.
Alternatively, there is a good argument that Canadian mutual fund trusts organized prior to 2004
are not corporations for US tax purposes and thus not PFICs. While this argument is not entirely
without risk, it has equity on its side. It is unfair, especially for Canadian resident US Person
Investors, to be subjected to a punitive tax regime simply by buying common Canadian financial
products. Canadian mutual fund trusts organized in provinces that do not have legislation
guaranteeing beneficiaries limited liability, may not be corporations for US tax purposes and thus
not PFICs. Similarly, Canadian mutual fund trusts that are not covered by the limited liability
statutes may benefit from this position. Finally, there is a version of this argument that, due to the
liability exposure of the beneficiaries, no Canadian mutual fund trusts are corporations for US
tax purposes. Such a position is risky, but is certainly sufficiently reasonable to be taken on a US
tax return. In sum, there are a variety of strategies available to avoid the PFIC Problem.