How to build portfolios for U.S. taxpayer clients

Investing isn’t easy for Canadian residents who must file annual tax returns to the IRS. American law sees the typical Canada-based mutual fund or ETF as a Passive Foreign Investment Company (PFIC), which creates a host of asset location and currency exposure problems.

But with careful planning, you can keep clients’ PFIC headaches to a minimum.

What to avoid

Clients should avoid holding Canada-based funds outside a registered account unless the issuer provides a PFIC Annual Information Statement (AIS), says Peter Guay, portfolio manager at PWL Capital in Montreal.

The AIS provides information the client needs to fill out Form 8621. “If the fund company’s not creating an annual information statement, you won’t get that information [yourself]. It’s internal information to the fund [and] is not otherwise published.” (See sample AIS documents here and here.)

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Guay says that without a correctly filed Form 8621, everything gets painted as ordinary income—even unrealized gains. A correctly filed Form 8621 means clients will pay the proper level of tax for the type of gain they’ve earned.

“For instance, if you hold a Canadian mutual fund that […] has received U.S.-sourced dividends, [with] that annual information statement those U.S. dividends you received—by proxy, as a holder of that mutual fund—will get taxed as U.S.-sourced dividends on your IRS return, [i.e.,] advantageously.”

Problem solved?

We’re not out of the woods yet. Let’s say every fund your client likes has an AIS. The issue now is out-of-control accounting costs, says Guay. “You’re essentially filing a separate, mini-tax return for each PFIC position.”

Completing Form 8621 is not for the faint of heart. It’s a major burden and not advisable even for sophisticated clients. If they get a pro to do it, they’re looking at $100 to $200 a pop.

Depending on how much RRSP room a client has, it may be possible to meet asset location, asset allocation, tax efficiency and currency exposure goals without having to file a single Form 8621.

U.S. tax filers should not hold a TFSA. It is not recognized as a tax-free account by Canada’s tax treaty with the U.S.

“You can hold PFICs in registered accounts—RRSPs, RRIFs, LIRAs, etc.—and not have to file [Form 8621] because the tax treaty recognizes them as tax-deferred accounts,” notes Guay. So, if clients have enough room, they should hold [all] their PFIC positions in the RRSP or other registered account.

When the registered account doesn’t have enough room for all PFIC funds, advisors should find PFICs that incorporate multiple mandates within a single vehicle, suggests Guay. For example, instead of buying individual funds for U.S. and global exposures, find a vehicle that includes both. That way, you’ll have one Form 8621 to fill out for both mandates, instead of two.

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Guay says deciding how many PFICs to hold comes down to how you negotiate competing priorities: You could sidestep PFIC accounting costs altogether by putting all non-registered assets in U.S.-based ETFs, but then “you’re going to have a whole lot more U.S.-dollar exposure than you would otherwise have using Canadian equivalents of those funds,” says Guay.

He adds: “I don’t want [that] much U.S.-dollar exposure, so I’m willing to buy certain Canadian-based PFIC funds to make sure I’m properly balanced on my currency exposure—not to the extent that tax filing is a huge pain, but to the extent that the portfolio is reasonably allocated across different currencies in the different asset classes.”

That magic number depends on the client, his or her asset mix, RRSP room, size of the non-registered account and multiple other factors. But Guay says a typical portfolio for a U.S taxpayer will have three to five PFICs and about 12 U.S.-based ETFs.

What goes where

Guay says bond exposures should go in the registered account since they’re taxed as regular income. “That golden rule doesn’t stop being true just because you’re a U.S. tax filer.”

That creates a happy coincidence, because it’s also advisable to have bond exposures in Canadian dollars, which implies exposure via a PFIC fund. “You’re not going to find a good product in the U.S. ETF space that solely buys Canadian bonds.”

Non-Canadian bond exposures should always be hedged back to Canadian dollars, which again implies exposure through PFICs. “In holding bonds, you want to be in the safe part of your portfolio and you don’t want to take any currency risk,” says Guay.

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In a standard 60%/40% mix, 10% of the fixed-income portion should be roughly evenly split between REITs, high-yield bonds and utilities, suggests Guay. “They provide higher cash flow, whether it’s interest or dividends, but exhibit lower volatility than equity investments.”

Equity exposures go in the taxable account. Guay gets Canadian equity exposure via an MSCI Canada ETF that trades on the U.S. exchange. “I get around the PFIC issue that way. I’m still getting Canadian equity exposure without getting it on the Canadian exchange.” He also uses U.S.-based ETFs for U.S., emerging market, and non-U.S. developed equity exposures.