CHAPTER 5: PASSIVE FOREIGN INVESTMENT

COMPANIES & MUTUAL FUNDS

By: Tanzeela Ayub / Peter Megoudis

IRC sections: 1291; 1296; 1297, 1298; 957 (CFC); 951(b)

A. Passive Foreign Income Company (PFIC):

A PFIC is a passive foreign investment company. A foreign corporation is classified as a PFIC if, in
any year,: (1) 75% or more of its gross income for a taxable year is passive income the Foreign
Personal Holding Company Income (FPHCI) 1 (the "passive income" test) or (2) at least 50% of its
assets produce or are held for the production of passive income (the "passive asset" test). Deductions
and liabilities dont count in the determination. There are no categories of income and assets are
classified as either passive or non-passive.

B. When a filing is required:

Generally, an 8621 is required to be filed by a U.S. Person that is a direct or indirect shareholder of a
PFIC for each tax year in which that U.S. Person recognizes gain on a direct or indirect disposition of
PFIC stock, receives certain direct or indirect distributions from a PFIC, or is making a QEF Election,
Deemed Sale Election, Deemed Dividend Election, Election to Extend Time for Payment of Tax, or a
Mark-to-Market Election, or has a made a QEF or Mark-to-market election (to report current year
income generally resulting in flow-through treatment of PFIC income, or the change in value of stock
held).

NEW for the tax year 2012: The HIRE Act imposed new reporting requirements for PFICs:
Effective for years beginning after 3/28/2010 (i.e. 2011 calendar year for most individuals) all US
owners of PFICs are required to file an annual information statement. However, Notice 2011-55
issued before the filing season for the tax year 2011 provided that pending the release of the revised
Form 8621, the filing requirements under section 1298(f) were suspended, but the filing for the
suspended taxable year had to be attached to their next income tax or information return required to
be filed with the IRS. The Service recently revised Form 8621 (rev. December 2012) and its
accompanying instructions. The revised Form 8621 and instructions indicate that the IRS continues
to suspend the potential expansion of the filing requirements authorized in 2010 by Section 1298(f)
until the underlying regulations are published. The revised Form 8621 contains a new Part I,
Summary of Annual Information, which will expand reporting requirements, but it is currently
reserved for future use. The revised instructions also indicate that new Part I is not required until the
Section 1298(f) regulations are published.

In addition, the revised instructions re-order the elections in Part II without making any material
changes. Finally, the revised instructions include a minor administrative change in the Form of a field
that has been added to request the reporting of a PFIC or a QEF Reference ID Number

1
Generally FPHCI is:
Dividends, interest, rents and royalties,
Certain property transactions,
Commodities transactions, and
Foreign currency gains.
Capital gains on passive assets
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Generally, the PFIC rules apply only to U.S. taxpayers. In addition, special rules may apply to foreign
taxpayers that are classified as PFICs or controlled foreign corporations 2 for U.S. federal income tax
purposes. Note: If a foreign corporation is a CFC with respect to a certain shareholder, the CFC
provisions will trump PFIC provisions.

C. Taxation of U.S. holders in a PFIC:

1. Absent a QEF Election: Unless a U.S. holder makes a QEF election as defined in Section 1295
of the Internal Revenue Code, (1) distributions of earnings and profits from a PFIC would
generally be subject to tax in the year received and (2) such distributions would not be eligible to
be treated as "qualified dividend income." In addition, a U.S. holder will be subject to special
rules with respect to (1) any "excess distributions" and (2) any gain realized on the sale or other
disposition of their ownership interest in a PFIC.

Excess Distributions: "Excess distributions" are distributions received by a U.S. holder in a

PFIC in a taxable year that are greater than 125% of the average annual distributions received
by such holder in the three preceding taxable years, or, such holder's holding period, if
holders holding period is less than the three taxable years. If there is an "excess distribution,"
the excess distribution amount is allocated pro rata to each day the holder owned the
investment in the PFIC. The amount allocated to the current year is included as ordinary
income in the holder's gross income for the current year. Any amounts allocated to prior years
would be subject to tax at the highest rate of tax in effect for the applicable class of taxpayer
for that year, and an interest charge would be imposed with respect to the resulting tax
attributable to each such other taxable year (the deferred amount.).

Gain on Sale or Other Disposition: If a U.S. holder disposes of their ownership interest in a
PFIC, any gain resulting from the disposition generally is treated as an "excess distribution,"
and subject to the rules set forth above. Any loss on the sale of a PFIC is treated as a capital
loss.

Termination of PFIC Status: If a foreign corporation is classified as a PFIC for any year
during which a U.S. holder has an ownership interest, the foreign corporation generally will
continue to be treated as a PFIC in the case of such U.S. holder for all succeeding years
during which such U.S. holder maintains an ownership interest, regardless of whether the
foreign corporation ceases to be classified as a PFIC for other U.S. holders.

2. If a QEF Election is made: Generally: By making a QEF election, a U.S. holder will not be
subject to the special rules discussed above under "Absent a QEF Election." Instead, such holder
will include its pro rata share of the PFIC's ordinary earnings and net capital gain for the taxable
year in income, regardless of whether any amounts are distributed to such holder during such
taxable year.

Impact of QEF Election: A U.S. holder who has made a QEF election includes its pro rata
share of the PFIC's ordinary earnings and net capital gain in the holders income for each
taxable year. No portion of such inclusions of ordinary earnings would qualify as "qualified
dividend income." The U.S. holder would increase the tax basis in its PFIC ownership

2
Controlled Foreign Corporation (CFC): An entity classified as a foreign corporation, more than 50% of the total combined voting
power of, OR the total value of stock is owned by US shareholders. Ownership for this purpose includes attribution from certain
other US persons.
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interest to reflect their pro rata share of the PFICs ordinary earnings and net capital gain.
Any distribution would be excluded from income upon receipt by such holder, and such
holder would decrease the tax basis of its ownership interest by such distribution.

Timing Considerations: The QEF election can generally only be made for the first year in
which an investor holds the shares. The QEF election is effective for the taxable year in
which the election is made and all subsequent taxable years in which an investor holds an
ownership interest.

PFIC Losses: A U.S. holder would not be entitled to a deduction for its pro rata share of any
losses incurred by the PFIC for such year.

How is a QEF election made?: The QEF election is made by completing and attaching Form
8621 to the U.S. federal income tax return filed by the due date of the return, including
extensions.

If a QEF election is not made for the initial year that a U.S. holder holds PFIC shares, can one
be made in future years?: Yes, but complicated rules apply to U.S. holders that do not have a
QEF election in effect with respect to PFIC shares throughout the period that they own such
shares. A U.S. holder may make a QEF election in a subsequent year provided that they elect
to treat the PFIC shares as being sold on the first day of the year in which the QEF election is
made and pay the deferred tax owing with respect to any resulting gain from the deemed sale.
The QEF regime will apply to the PFIC shares for the subsequent taxable years. Each U.S.
Holder should consult their own tax advisors with respect to the U.S. Federal, state, local and
other tax consequences of making such a QEF election.

What if the U.S. holder makes a mark to market election?: As a third alternative to the
general rules and the QEF election mentioned above, a mark-to-market election to recognize
a gain or loss annually to reflect changes in the value of shares may be available. Due
consideration needs to be given about eligibility and procedures for, and appropriateness in
such holders particular circumstances of, making this mark-to-market election.

D. Issues and Positions:

1. Is a Canadian Mutual Fund a PFIC to a US taxpayer?

Many Canadian mutual funds are classified as trusts for Canadian tax purposes. However, even if
a mutual fund is structured as a trust under the Canadian tax rules, under U.S. Internal Revenue
Code regulations it is treated either as a corporation or a partnership (if check the box election is
made). As the Canadian mutual funds typically hold passive investments and have passive
income i.e. they generally meet the income and asset test, and if they are treated as a corporation
(i.e. check the box election is not made) they are more likely than not PFICs for U.S. tax
purposes.

2. Filing Position where investment in a widely held publicly traded Canadian mutual fund is not
significant:

It is the Firms position that in such instances we will not file form 8621, as it may be difficult to
determine conclusively whether the fund is in fact a PFIC, and even if it is, it may be difficult to
obtain the information required to complete the form 8621.
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Instead, the following statement will be included with Form 1040 in each year investments are
held in a mutual fund:

At the end of the tax year, the taxpayer held units in various publicly traded Canadian mutual
fund trusts or corporations which may be considered Passive Foreign Investment Corporations
(PFICs) under IRC section 1295. In this regard, it is not possible for the taxpayer to obtain from
the mutual funds the information needed to complete Form 8621. However, it should be noted
that any income distributed to the taxpayer in the year has been reported on Form 1040. The
investments are publicly traded and the taxpayer holds a small interest in the mutual funds. Fund
names and other information can be provided upon request.

3. How do we report interest and income from Mutual Funds on Form 1040 if form 8621 is not filed
and a QEF or mark to market election is not made?
As a more conservative approach, all distributions from mutual funds (including return of capital)
should be reported as ordinary dividends on Schedule B of form 1040. This includes items
reported as capital gains, eligible and non-eligible dividend income, business income, other (trust)
income, and foreign income on the T3 slip.

4. What constitutes a significant investment?

There is no technically correct answer, as this is an area in which we are simply recommending a
practical solution to a difficult technical area. To a large extent, the definition of significant
may depend on the judgment of the person signing the return. By way of guidance, we would
suggest that an investment of less than $10,000 in a particular Canadian mutual fund, and
combined investments of less than $50,000 in all Canadian mutual fund trusts, can be taken as
insignificant.

Note: The above filing position is applicable to U.S. persons who have insignificant investments
in Canadian mutual funds (i.e. it will cover many program services clients). For U.S. persons with
significant investments in widely held publicly traded Canadian mutual funds, every attempt
should be made to file a QEF election in the first year the interest in the entity is acquired, and to
receive information on each years allocable capital gains and other (ordinary) income from the
fund, for inclusion on the U.S. persons tax return on a modified flow-through basis, pursuant to
the QEF rules.

5. Does the above apply to insignificant investments in a Canadian mutual fund held within an
RESP or TFSA?
Yes, as an RESP or TFSA are typically grantor trusts, the same considerations would apply as if
the mutual funds were held directly.

6. What about Canadian mutual funds held within an RRSP?

While not totally free from doubt, there is a filing position that RRSP accounts for which a treaty
Form 8891 election has been filed on an annual basis lose their look through character. As a
result, if you have filed the treaty based Form 8891 election in each year in which the RRSP
account has been held by a US taxpayer, you can assume that the PFIC reporting and filing
requirements do not apply. You can thus continue reporting the RRSP account on the Form 8891
only.

7. Does the above policy apply to segregated funds issued by Canadian insurance companies?
No. Though the Act deems such funds as being trusts for Canadian tax purposes, and the investor
receives a T3 slip reporting the income, they are not actually trusts, nor are they corporations or
partnerships.
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Instead, they tend to be simple derivative contracts with the insurance company. As a result, we
would suggest that any profit realized by the investor, and reported on the T3 slip, should be
reported as other income on the 1040. You should note that items reported as segregated fund
capital losses on the T3 slip should be netted off against other income and capital gains.

If the losses exceed all the other income and gains for the year, the excess losses should be carried
forward and applied against other income and capital gains in a future year. When the investor
sells his segregated fund interest, if he is still carrying a net loss, such loss should be claimed as a
capital loss on the US return.

8. Does the above policy apply to insignificant interests in private closely held holding
corporations?
No. The investor should be able to obtain the necessary information to determine whether the
corporation is a PFIC, and if it is, to complete a form 8621, file a QEF election, and report his
share of the corporations annual capital gains and other income.