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The PFIC Trap: How U.S. Tax Rules Can Punish Canadian Investors

02.04.26 // Markets & Investing // Blog Article //

Written by: Carson Hamill, CIM®, CRPC™, FCSI® & Dean Moro, BComm, CIM®, CRPC™: Cross-Border Portfolio Managers at Snowbirds Wealth Management

For U.S. taxpayers, including U.S. citizens, green card holders and U.S. tax residents, few areas of cross-border financial planning are as misunderstood—or as costly—as the Passive Foreign Investment Company (PFIC) rules.

What many investors don’t realize is that ordinary Canadian investments, including mutual funds and exchange-traded funds (ETFs), are often classified as PFICs under U.S. tax law. When held in non-registered accounts, or certain Canadian registered accounts such as TFSAs and RESPs, these investments can trigger punitive tax treatment for U.S. taxpayers and complex reporting requirements that can significantly reduce long-term returns.

 

Why the IRS Targets PFICs

The PFIC regime was created to prevent U.S. taxpayers from deferring tax by holding passive investments inside offshore corporations. The definition is intentionally broad. Any non-U.S. corporation that primarily earns passive income or holds passive assets may qualify.

As a result, Canadian-domiciled mutual funds and ETFs which are common, regulated investments for Canadian residents are typically viewed negatively by the IRS as foreign investment corporations when held by U.S. persons.

The Three Core Consequences of PFIC Ownership

Absent special elections, PFICs are taxed under Section 1291 of the U.S. Internal Revenue Code, one of the most punitive tax regimes in the system.

  1. Loss of capital gains treatment - Gains from PFICs generally do not qualify for preferential long-term capital gains rates. Instead, they are taxed as ordinary income, potentially at rates as high as 37%.

     

  2. The deferred interest charge - The IRS assumes the investor avoided tax during the holding period. Gains are retroactively allocated across prior years, and interest is charged on the tax deemed owing for each year. This can materially increase the effective tax rate.

     

  3. Significant reporting complexity - Each PFIC requires its own Form 8621. The IRS estimates that properly completing this form can take 20 hours or more per fund, per year. For investors holding multiple Canadian funds, compliance costs alone can meaningfully erode investment returns.

 

Real-Life Example #1: When Structure Matters More Than Performance

Sarah, a U.S. citizen living in Toronto, invests $100,000 in a high-quality Canadian mutual fund held in a non-registered account. Over five years, the investment grows to $150,000. She sells the fund to finance a home renovation.

Had Sarah instead owned a U.S. domiciled ETF or individual stocks, the $50,000 gain would qualify for long-term capital gains treatment a 15% rate. She would be able to claim a foreign tax credit on her U.S. tax return to the extent of her Canadian tax paid which would typically reduce her U.S. tax on the gain to zero. She would then only be subject to Canadian taxation on the income at her marginal capital gains tax rate.

Because the investment is a Canadian mutual fund classified as a PFIC, the outcome is very different. The gain is taxed as ordinary income for U.S. purposes, and the IRS applies interest charges related to the assumed deferral over the five-year holding period. The combined U.S. tax and interest can approach $24,500 with an effective tax rate of close to 49%. She is then subject to Canadian tax on the gain, assuming her marginal tax rate is 25%, this would result in double taxation due to the 24% higher U.S. tax rate which be cannot fully offset by claiming the Canadian foreign tax credit.

The difference is not market performance. It is investment structure.

Real-Life Example #2: PFICs and the Cross-Border Move

PFIC exposure becomes even more important when a move across the border is involved.

Sandra, a non-U.S. person is relocating from Canada to the United States and holds Canadian mutual funds and ETFs in a non-registered account. Because Canada taxes based on residency, she is required to formally cease Canadian tax residency.

On departure, Canada imposes a deemed disposition, treating Sandra as though she sold all taxable investments at fair market value on her exit date. This triggers Canadian capital gains tax, even if no assets are actually sold.

Once Sandra becomes a U.S. taxpayer, any remaining Canadian mutual funds or ETFs in her non-registered account would generally be classified as PFICs, exposing her to punitive U.S. taxation and ongoing reporting requirements.

Because the Canadian tax event is unavoidable, it is often prudent for individuals in Sandra’s position to actually sell these investments before or at departure. Doing so can eliminate future PFIC exposure and simplify long-term U.S. tax compliance.

Managing PFIC Risk

While PFIC rules are strict, they are not unavoidable.

One common strategy is replacing Canadian-domiciled funds with U.S.-domiciled ETFs or individual stocks, which are not subject to PFIC treatment. In some circumstances, a Qualified Electing Fund (QEF) election may be available which offers a more favorable tax treatment and avoids the IRS interest charge if the fund provider supplies the required annual information. However, if the necessary information is not available from the fund provider or the QEF election is not timely filed in the first year of investment in the PFIC, the QEF election option may not be available.

Account structure also matters. Under the Canada U.S. tax treaty, RRSPs and RRIFs generally preserve tax deferral and do not require annual PFIC reporting. TFSAs and RESPs, however, do not receive the same protection.

The Bottom Line

PFIC rules were designed to deter offshore tax deferral, but in practice they often penalize ordinary cross-border households following standard Canadian investment strategies.

For U.S. persons living in Canada and Canadians planning a move south—the tax structure of an investment can be just as important as its return. Understanding these rules before a problem arises can prevent costly surprises and preserve long-term wealth on both sides of the border.

 

Ready to Plan Your Cross-Border Move?

If you are planning on moving to the USA from Canada, don't leave your finances to chance. Let’s discuss how to transition your U.S. retirement assets without the tax "sticker shock”. We specialize in cross-border financial planning, investments, and wealth management, working closely with your tax accountants and lawyers to ensure a fully integrated strategy.

About Snowbirds Wealth Management

Snowbirds Wealth Management focuses exclusively on the cross-border market.
Gerry Scott, along with Dean Moro and Carson Hamill, provides investment solutions for:

  • Americans living in Canada
  • Canadians living in the U.S.

Licensed in both countries, our team helps minimize tax burdens when moving assets across the border.

👉 Schedule Your Introductory Cross-Border Strategy 📞Call Here

Disclaimer: Statistics and factual data and other information are from sources RJLU believes to be reliable but their accuracy cannot be guaranteed. It is for information purposes only and is not to be construed as an offer or solicitation for the sale or purchase of securities nor is it meant to replace legal, accounting, taxation or other professional advice. We are not tax advisors and we recommend that clients seek independent advice from a professional advisor on tax-related matters. The information is furnished on the basis and understanding that RJLU is to be under no liability whatsoever in respect thereof. Raymond James (USA) Ltd. advisors may only conduct business with residents of the states and/or jurisdictions in which they are properly registered. Investors outside the United States are subject to securities and tax regulations within their applicable jurisdictions that are not addressed on this site. Raymond James (USA) Ltd. is a member of FINRA/SIPC.

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