Preparation of 8621 for PFIC & Other QEF Questions

[ethanpurdy]

I've decided going forward I am going to do my own taxes in future years. I think I have a handle on most aspects but am still trying to wrap my head around 8621.

I have not yet made any non-RRSP (tax sheltered) investments so I don't yet own any 8621-requiring investments. But I am just going to buy funds that provide information required for 8621 (iShares or Vanguard funds which generally provide required information). My understanding (and can someone please correct me if I'm wrong) is that under a QEF election Capital gains on a PFIC will be treated as long term capital gains but dividends are still taxed at ordinary income rate. In Canada, the dividend tax rate is not too dissimilar from the US ordinary tax rate so this isn't too big of a deal either.

If I purchase a PFIC today, next year I will need to file 8621. As far as I can tell there are 4 elections relevant for a QEF fund - A (Election to treat PFIC as QEF), B (Election to Extent Time for Payment of a Tax), D (Deemed sale election), E (Deemed Dividend Election). It seems that D and E are both applicable only if the initial election for the PFIC was not QEF.

So as a new QEF-eligible PFIC owner Elections A and B would be the only sections required?

Also, reviewing Election B (for extended the time for payment of the tax on its share of the undistributed earnings) it mentions interest must be paid. Am I correct in understanding that this is saying interest will be owed on capital gains at the time the investment is sold?

Given this, is it best to only select Election A? And then every year pay tax on distributed dividends (as ordinary income) and pay tax on unrealized (phantom) capital gains? Some years will be unrealized capital loss; how would that work?


This PFIC and 8621 is pretty complicated but can anyone help me figure out if I have this right?

Thanks very much!!

[MGeorge]

Hi ethanpurdy,

You're correct - the QEF election ensures that any realized long term capital gains resulting from trading assets within the fund (ie. by the fund manager) will be given the long term treatment by US tax principles. The dividends, interest, and any short term realized gains would come out as "ordinary earnings" and you're right, they would not be qualified dividends, just ordinary income reported on the "other income" line. Unrealized gains will still be unrealized with a QEF election - that's the good news.

I agree with you - election A is probably the only one you would make. Election B would be if you had significant "phantom gains" and therefore no Canadian taxes to offset it with a credit. In my experience, the QEF income is more often higher than the actual distributions from the funds - but it can be more or less. Only use Election B if you need it, because it is complicated, and there is an interest charge, so it only makes sense if you are severely limiting on tax credits for taxes paid to Canada.

Cheers.

[ethanpurdy]

Thanks MGeorge! You seem to be the most knowledgeable on PFICs and QEFs on the forum and I've reviewed several of your very helpful posts to figure out 8621! Thanks for sharing your knowledge!

So going with Election A every year I would pay ordinary tax rate on distributions (which would mostly be offset by a credit on Canadian taxes on dividends) and unrealized capital gains, assuming I don't sell the fund.

In this case would I claim a credit to Canada for the unrealized capital gains paid to the US? When I eventually sell the fund how do I ensure I'm not double taxed? For example, if I hold a fund for 10 years every year I'll pay tax on unrealized capital gains to the IRS. At year 10 when the fund is sold I would have already paid taxes on most of the capital gains. Is this just accounted for in adjusting the cost basis every year so by the time I sell the cost basis will have risen to account for taxes paid on unrealized cap gains?

How do I ensure I don't get double taxed by Canada?

[MGeorge]

Hi ethanpurdy,

The QEF income from a Canadian ETF/mutual fund is all considered to be Canadian sourced, so you wouldn't claim, on your Canadian tax return, a foreign tax credit for taxes paid to the US.

Even if you held "XUS", a Canadian domiciled ETF of US securities. The QEF "ordinary income" would still be considered of Canadian source.

The important thing is that the taxes you pay to Canada should be creditable on your US tax return. The long term capital gain part is usually taxed more heavily by Canada, so you hopefully won't pay any additional taxes to the US. If you get a lot of Canadian dividends from an ETF, the QEF treatment of these as ordinary income could mean that the Canadian FTC doesn't completely eliminate your US tax on this income.

You are a resident of Canada right?

[MGeorge]

Hi ethanpurdy,

I just re-read your message. If you hold the fund for 10 years, you will not pay any US tax on unrealized gains with a QEF election.

You might get phantom income with the QEF election because, there might be realize gains from the fund's own internal trading of securities, and these gain might be higher than the resulting CAD gains. Even with index ETFs, the fund may trade securities with a goal of having $0 of CAD capital gain distributions by balancing losses with gains. This won't necessarily work when these trades are considered for USD gain/loss. Also, some USD gains could be short term, meaning they would get added to "ordinary income". This is why QEF income is usually higher than the actual distribution received.

Again - no US taxes payable on unrealized gains.

I hope this helps!

[nelsona]

Just a reminder that even if the capital gains were somehow sourced as from US, Canada would not grant any FTC on the US tax paid on those gains. That is because the US tax would only be incurred because you are a US citizen, and the treaty allows Canada to deny any such claim for FTC.

[ethanpurdy]

MGeorge, I must have misunderstood something about the QEF reporting; if I provide an example would you point out where I am misunderstanding?

The example (from https://expattaxtools.com/wp-content/up ... orting.pdf)"


Supposed I buy 10,000 shares of RBC O’Shaughnessy U.S. Value Fund. Price per share is: $12.5578 USD (13.05 CAD). Total purchase is $125,578 USD

Say I buy in late January and hold through December 31 (e.g. hold for 330 days of the year).

At tax time I get the PFIC annual statement from RBC with the following:

Ordinary Earnings—$0.0010755706 per share per day
Net Capital Gains—$0.0061606207 per share per day
Cash/Property Distributions—$0.2751653668 per share annually => My distributions = $2488 => $0.2751653668 * 10,000 shares * (330/365) years [Note: this is just an approximation and would be replaced with actual distributions received]



On my tax return I would include:

Ordinary Earnings on 1040 Line 21 = $3549 => 0.0010755706 × 10,000 shares × 330 days
(Unrealized) Capital Gains on Schedule D = $20,330 => 0.0061606207 × 10,000 × 330 days

My cost basis would be adjusted to $146,969 => $125,578 (Original) + $3549 (Ordinary Earnings) + $20,330 (Capital Gains) - $2488 (Distributions)


Based on this would I not owe tax on the $20,330 of unrealized capital gains as reported on Schedule D? My cost basis is adjusted so when I eventually sell my tax owing would be reduced but I would owe tax today?



Thanks so much for your help and please execuse me if these are rudimentary questions.

[MGeorge]

Hi ethanpurdy,

Based on your example below, I think you are pretty close to having this correct. Check the RBC PFIC statements though, I think they use July 1 to June 30 as their reporting period. As you purchased the fund in late Jan, you would only have to report for the 148 days during the PFIC's tax year.

I agree with your calculations - provided that you use 148 days instead of 330 days.

Also - as you mentioned, you adjust your basis in the shares using the actual dividends received. The PFIC statement's amount of 0.275 per share might be due to a big distribution in December 2015 when you didn't hold the fund.

Your question about schedule D inclusion amounts - you would owe tax on these amounts, you're reporting $20,330 on schedule D as capital gain - and these are realized capital gains due to the fund's trading activities. I think this should only be $9,118 because it should be 148 days.

Your next question; Yes you're right, the net cap gain inclusion on your return is "phantom income" since the fund didn't not distribution gains as it didn't have any CAD gains, or very little ($2,488?). When you eventually sell the fund, you will either report a significantly lower gain, or a loss because of the basis adjustment you had to make.

Your example might be a good reason to use election B - to defer payment of tax. This way, you might be better synchronized with Canadian taxes for FTCs. All of this PFIC income is Canadian sourced remember.

QEFs are complicated. I think they're worse than mark-2-market elections....

Cheers!

[nelsona]

So MGeorge,

How are you, or how do you suggest, handling the US/Canada tax mismatch? It would seem that year-over-year, one must pay US tax 'early', but that eventually the Cdn tax catches up. Or do the distributions on the Cdn side match up fairly close.

Is it worth, say, generating Cdn cap gains in year 2, to use as a carry back to year 1 on your US return, if you get what I'm saying.

[MGeorge]

Hi nelsona,

That's a good question - in the cases that I've seen, the QEF income inclusion has been higher than the actual distributions from the fund - but it could go both ways. The QEFs I've had to deal with have been mostly index ETFs and mutual funds with very low fund turnover. I imagine actively managed funds might be worse. Still, it is possible to have a good match between the QEF income and actual distribution, but I don't see this often. I think this year, the RBC Canadian index fund had good distribution alignment with the QEF income.

Your 2 year capital gain realization and then carry back sounds like a good approach. I think that technique would work very well - plus you'd get long term capital gains on the US side which is essential. That's a good idea.

If someone is really stuck with early QEF income, the election to defer the payment of tax might work well, there is an interest charge though for the deferral, but this could be much smaller than unusable foreign tax credits showing up down the road when the fund distributes or is sold.

I do like your idea. That deferral election is complicated, and I haven't done it yet.

Best Regards,

MGeorge.

[nelsona]

I doubt that CRA would accept that the deferral would mean that the US tax could be used as a credit in a later year. CRA would contend that the tax was accrued in the year it was deferred, not paid.

[MGeorge]

The income from a PFIC would be considered purely Canadian sourced for US tax purposes, and for Canadian purposes, the source of any dividends would be determined by the fund and reported on T3. None of the US taxes arising from QEF income could be creditable on the Canadian return.
On the US return, any taxes paid to Canada for Canadian sourced income would be available for a form 1116 FTC. Either the deferral election, or the 2 year sell-and-realize gain methods you proposed would work.

Cheers!

[nelsona]

Of course -- silly me -- there is no FTC available in Canada.

But, then, does the deferral method allow you to use Cdn tax as FTC in the year you pay the US tax, or only in the year it was accrued for US purposes.

Deferring would seem not to change the timing of FTCs. Say a QEF inclusion in 2016 results in $20K of US taxable income, and only $5K of Cdn taxable gain. Deferring PAYMENT of the US tax does nothing to the fact that this tax occurred in 2016. It won't allow you to wait until, say, 2020 when, you sell the Cdn fund, incur a Cdn cap gain, and use this 2020 tax towards that 2016 US tax, will it?

You still get an unresolvable mismatch, no?