Avoiding PFICs

First and foremost — please do your own research in this area. PFICs are complicated, and I certainly do not know everything about them. That said, I do think it’s possible to avoid them relatively easily while engaging in cross-border investing.

Why do we want to avoid PFICs?

IRS regulations around Passive Foreign Investment Companies (aka PFICs) mean that investing Canadian mutual funds and ETFs can lead to complex filing requirements. To avoid these requirements, hold US domiciled ETFs in your taxable accounts, or individual Canadian stocks. Hold Canadian domiciled ETFs only with registered accounts (like an RRSP).

One of the first things I learned about when I started researching crossborder investing was the importance of avoiding Passive Foreign Investment Companies (aka PFICs). As I’ve said before, my investing approach is very simple — low-cost index funds. The bad news is that foreign index funds count as PFICs. That doesn’t make them illegal to invest in, but they come with a bunch of extra tax reporting requirements that I would like to avoid. Plus, they are taxed at a higher rate, with all of the income (including capital gains) being taxed as ordinary income.

What is a PFIC?

So what is a PFIC, exactly? A non-US corporation is a PFIC if either of the following things are true:

  1. If 75% or more of its income in a given year comes from a passive source like dividends, interest, rent, etc. OR
  2. If the value of its passive assets (like stocks, bonds, or cash) accounts for 50% or more of the assets of the corporation.

What does this mean for us? Basically, any foreign-registered (aka foreign-domiciled) mutual fund falls into this category. And, as you’ll recall, we love low-cost index funds. One key thing to remember here is that it matters where the fund is registered, not where it invests. You can (and definitely should) invest in foreign stock mutual funds. If you’re an American citizen, though, you should do this using US-domiciled funds (rather than foreign-domiciled funds).

How Can I Tell Where a Fund is Domiciled?

The easiest way to make sure you’re investing in US-domiciled funds is to invest in ETFs belonging to US companies (ie Vanguard) in US currency.

For example, if you’re looking to invest in a Vanguard US Total Stock Market index fund, there is both a US-domiciled version (VTI) and a Canadian-domiciled version (VUN). If I look at the ETF fact sheet for both, it is clear which is which.

Here’s a clip from the ETF fact sheet for VUN:

So, as you can see, VUN is offered by Vanguard Investments Canada, traders on the Toronto Stock Exchange (TSX) and is in Canadian dollars. Thus, Canadian-domiciled, and would be considered a PFIC.

On the other hand, here’s the same information from the VTI ETF fact sheet.

It doesn’t tell us what currency it’s in explicitly, but it does tell us that it is traded on the New York Stock Exchange (NYSE). Thus, US-domiciled. Another thing to notice is the difference in expense ratio — the US version has an expense ratio of .03% while the Canadian version has one of .16%. That’s still a good expense ratio, but it’s over 5 times higher!

So, in Canada, one way to avoid PFICs in your non-registered account is to hold that account in USD at a brokerage that allows that and invest in US-domiciled ETFs. One downside of this, though, is that our investments will be in USD, so there is some currency risk. And upside, though, is that we typically get better expense ratios. So it isn’t ideal but, to me, it’s better than dealing with PFICs.

So, while the bulk of our income was in USD, we continued to invest in US-domiciled ETFs (VTI and VXUS) in a Canadian USD non-registered brokerage account. When our income shifts to CAD, though, my plan is to first use our RRSP room and, if we have additional money to invest, invest in individual Canadian stocks in a CAD non-registered brokerage account. While investing in individual stocks isn’t generally our approach, I’m thinking I’ll do this for three reasons:

  1. We will avoid having to do PFIC paperwork.
  2. We add some Canadian equities to our asset allocation.
  3. We can take advantage of the favorable taxation of Canadian dividends.

I’m planning to follow the principles outlined here:

Passively managing individual stocks

https://cutthecrapinvesting.com/2020/01/11/how-do-you-invest-in-the-canadian-stock-market/

https://cutthecrapinvesting.com/2020/10/25/building-the-canadian-stock-portfolio-on-weekend-reads/

https://www.dividendgrowthinvestingandretirement.com/2020/09/each-every-wide-moat-stock-in-canada/

There are some individual stocks that are actually PFICs (think something like Berkshire Hathaway — if it was a foreign company it would be a PFIC). The vast majority of individual stocks are not, though. Ultimately, I don’t expect this to become a large portion of our overall asset allocation — probably around 5 or 10%, depending on how quickly I shift down to part-time work or full retirement. If we were earlier in our accumulation phase, I think I’d look to convert our CAD to USD and invest in US-domiciled ETFs.

What do you think? Does this approach make sense?

Where can you hold PFICs safely?

One important caveat to this. As a US citizen, you can hold PFICs in treaty-protected retirement account (for example, an RRSP), you’re OK. The US government doesn’t care what you hold in there, because it will be taxed as income when it’s withdrawn.

What about cash?

Apparently, many money market funds are considered PFICs. If you get the money directly from a bank, though (like a GIC) you should be OK. Again, though, I am not an expert — just a DIY investor doing my best to understand things.

More info on PFICs

Why Americans Should Never Own Shares in a Non-US Mutual Fund (PFIC)

Passive Foreign Investment Company (PFIC) Rules

Choosing Funds | Table of Contents

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