7
Investments
While investing in the US is fundamentally the same as investing in Canada, there are many differences that you should become familiar with. For starters, the US is much larger in terms of size and investment types. Many of the different investment types provide tax advantages that are not available in Canada.
In addition to listing some of the more common investment options and their tax characteristics, we will talk briefly about some of the differences in fees, securities laws, how investment advice is provided in the US, which is significantly different than in Canada.
1. Securities Law
From a regulatory point of view, one of the big differences between the US and Canada is the fact that the US has a national regulatory system, whereas in Canada, securities regulation is a provincial matter. While the US does have the Securities and Exchange Commission (SEC) to oversee securities regulation, some advisors may not be regulated by the SEC. If an advisor is considered a small advisor, meaning that the advisor has $50 million or less of assets under his or her management, the state or states that he or she works in will oversee the advisor’s activity. The point of mentioning this is to make you aware that even though we have a national regulator, not all advisors have the same supervision. We cannot say which is better; we can only point out that they may be different. All SEC registered advisors are subject to the same rules, but the state rules may vary from the SEC and from each other.
Caution: When comparing advisors, beware that from a regulatory point of view, you may not be comparing apples to apples. Be sure to ask whether the advisor is an SEC registered advisor or not.
One question we get a lot that has to do with securities law is whether you, as a nonresident of Canada and resident of the US, can leave your registered and nonregistered accounts in Canada. The Canadian and American securities regulators were established, primarily to protect its residents from abusive and fraudulent sales practices. As long as you are a resident, the government can try to protect your regulations and sanctions of advisors doing business in their country. However, if you are in one country and your investment accounts are in the other country, it becomes much more difficult to protect you.
For years, Canadian advisors were prohibited from advising on any securities people left in Canada. What was happening was that Canadians were leaving their registered accounts (e.g., RRSPs and RRIFs) in Canada after they had moved to the US and they were stuck in the predicament of having to choose between lying to their advisor, telling the truth and having the account frozen (since the advisor could not advise a nonresident), or cash their registered accounts, pay the tax, and bring them to the US. Because of this, the securities regulators agreed to make an exception for Canadians that leave their registered accounts in Canada.
No exception was made for nonregistered accounts such as your typical brokerage account. To date there is still no exception to this rule. If you choose to leave your brokerage account in Canada, it will be frozen. While you can direct your advisor to sell, the advisor cannot buy securities. This rule does not apply to bank accounts such as checkings, savings, or Guaranteed Investment Certificates (GICs), because these accounts are not securities.
2. Mutual Funds
For many years, Canadian mutual funds have been ranked the most expensive in the world. Not one of the most expensive, the most expensive mutual funds in the world. In 2009, Morningstar, Inc., a leading provider of independent investment research in North America, Europe, Australia, and Asia, produced a research report titled Morningstar Global Fund Investor Experience in May of 2009. The research showed that Canadian mutual funds are about twice as expensive as the equivalent US mutual funds. Here is the link to the full report: corporate.morningstar.com/us/documents/ResearchPapers/MRGFI.pdf. Table 7 is a summary of the expenses.
Table 7: SUMMARY OF EXPENSES
| Typical Canadian Mutual Fund Investor | Typical US Mutual Fund Investor | Difference Per Year |
| Fixed Income Fund – 1.25% to 1.49% per year | Fixed Income Fund – less than .75% per year | .5% to .75% (67% to 100% higher) |
| Equity Fund – 2% to 2.5% per year | Equity Fund – less than 1% per year | 1% to 1.5% (100% to 150% higher) |
The report only shows the averages, it does not point out that the US has many more low-cost options than Canada. Index funds and exchange traded funds (ETFs) have very low expenses. For example, Vanguard Funds has an equity index fund that cost as little as 0.05 percent per year. Agreed that this example is extreme, but it is an example of how inexpensive mutual funds can be in the US. If you use index funds or ETFs, you can expect the annual expenses to be about half of the average, or about 0.5 percent per year. While index funds and ETFs are gaining in popularity in Canada, there are still fewer options than in the US. In addition to their low costs, index funds and ETFs are more tax efficient than traditional mutual funds because of the low turnover.
The following sections discuss tax reporting of Canadian mutual funds.
2.1 Passive foreign investment company (PFIC) rules
The following is one of the more ridiculous results of a law that we have seen. In an effort to prevent abuse of foreign corporations owned by US individuals, Congress and the IRS established laws that require rather stringent reporting requirements and potentially serious tax consequences. Those rules have been interpreted as applying to Canadian mutual funds, so now all US taxpayers owning Canadian mutual funds must follow these passive foreign investment company (PFIC) rules.
A PFIC is a foreign (non-US) corporation that meets either an income or asset test. The income test is met if 75 percent or more of the foreign corporation’s gross income is passive income. The asset test is met if at least 50 percent of the assets held by the foreign corporation are assets that produce passive income or that are held for the production of passive income.
Passive income is determined in accordance with the foreign personal holding company provisions, and includes interest, dividends, certain rents and royalties, annuities, capital gains from the sale or exchange of stock or securities, and foreign currency gains. There is no minimum ownership requirement in order for the PFIC rules to apply.
If you are a US taxpayer and receive income from a PFIC or recognize a gain from the sale of PFIC’s shares, you are subject to a special tax and interest regime. The following are methods that may be used to determine the amount of income you will have to recognize as a result of your investment in a Canadian mutual fund.
2.1a Qualified electing fund (QEF)
A PFIC is considered a qualified electing fund if you, as a direct or indirect shareholder of the PFIC, elects to treat the PFIC as a qualified electing fund (QEF). What this means is, the PFIC is a QEF if you make the election to make it a QEF. The election must be made on the Information Return by a Shareholder of a Passive Foreign Investment Company or Qualifying Electing Fund (Form 8621). If the QEF election is made, on an annual basis, you must include in your gross income your pro-rata share of the ordinary earnings, and the net capital gain of the QEF.
In order for the QEF election to apply, the PFIC must provide its shareholders with a PFIC Annual Information Statement. This statement must contain certain information, such as the shareholder’s pro-rata share of the PFIC’s ordinary income and net capital gain for that taxable year, or sufficient information to enable the shareholders to calculate their pro-rata share of the PFIC’s ordinary income and net capital gain for the year.
In addition, the PFIC must either obtain the permission of the IRS to be treated as a PFIC, or provide a statement indicating that it will permit its investors to inspect and copy sufficient information to confirm the PFIC’s ordinary earnings and net capital gains, as determined in accordance with US income tax principles. If neither condition is met, the QEF election cannot be applied.
Note: The QEF election will not be available to US taxpayers who own shares in Canadian mutual funds because the mutual funds are not complying with the rules.
2.1b Mark-to-market election
A shareholder of a PFIC may also elect each year to recognize the gain or loss on the shares as if they had sold the PFIC shares at fair market value at the end of the taxable year. Called a “mark-to-market election,” this election must also be made on Form 8621. The gain is treated as ordinary income, not a capital gain.
The mark-to-market election is only available for marketable shares. Marketable shares are shares that are regularly traded on a US securities exchange that is registered with the US Securities and Exchange Commission (SEC), or on a foreign securities exchange that is regulated or supervised by a governmental authority of the country in which the market is located, and has certain characteristics as described in the US tax code. The problem with this method is that you have no way of knowing what the mutual fund bought the securities for so you have no way of knowing what the gain would be if the securities were mark-to-market and even if you did, who is going to pay for your accountant to go through each of the potentially thousands of securities in your Canadian mutual funds?
2.1c Excess distribution
If neither a QEF election nor a mark-to-market election is made (this will be the typical scenario), or if an election is made, but not on a timely basis, the shareholders will be subject to special rules when they receive an excess distribution. An excess distribution is the part of the distribution received in the current tax year that is greater than 125 percent of the average distributions received by the shareholder during the three preceding tax years. The excess distribution is determined on a per share basis, and is allocated to each day in the shareholder’s holding period of the stock.
The amount allocated to the current year is included as ordinary income in the shareholder’s gross income for the current year. Any amounts allocated to prior years are subject to tax at the highest rate of tax in effect for the applicable class of taxpayer for that year, and an interest charge will be imposed with respect to the resulting tax attributable to each such other taxable year.
Here is another accounting nightmare example: Can you imagine the work involved in determining prior distributions on a per share, per day basis? What if you have held the mutual fund for 5, 10, or 15 years? The government has put you in a no-win situation — spend a fortune on tax preparation or break the law. The only viable option is to cash out all of your Canadian mutual funds, before or shortly after exiting Canada.
3. Tax Reporting Slips
Similar to the T slips you received when you were a resident of Canada and the NR slips you are (or should be) getting from Canada as a nonresident, in the US you will be issued tax slips called 1099s. These tax slips come in a number of varieties such as the following:
• Dividends and Distributions (Form1099-DIV)
• Interest Income (Form 1099-INT)
• Proceeds from Broker and Barter Exchange Transactions (Form 1099-B)
• Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. (Form 1099-R)
• Miscellaneous Income (Form 1099-MISC)
Most 1099 forms are required to be sent to you by January 31, except for the Form 1099-B, which must be sent by February 15. Generally speaking you will receive a 1099 (one for each type of income, from each payor) if you received interest, dividend, or royalty income of at least $10; most others types of income have a $600 threshold before 1099s are issued by a payor.
4. Taxation of Specific Types of Investments
The following sections discuss the taxation of specific types of investments such as municipal and government bonds, annuities, personal residence, and investment real estate.
4.1 Municipal bonds
Municipal bonds (also called “muni bonds”) are issued by state and local (city) governments and the interest paid is generally tax free. There are three types of municipal bonds:
• Public purpose bonds
• Qualified private activity bonds
• Non-qualified private activity bonds.
Public purpose bonds are tax free at the federal level and tax free in the state of the issuer of the bond. In New York and California you can buy mutual funds that invest entirely in that state’s municipal bonds. If you live in another state, you will either have to buy individual bonds or a mutual fund with municipal bonds from many states. If you invest in a mutual fund with municipal bonds from many states, the mutual fund company will provide you a breakout of the percentages for each state. You will need this breakout when preparing your tax return.
Note: Municipal bonds from Puerto Rico, Guam and the Virgin Islands are tax free at the federal level, as well as in all states.
4.2 Government bonds
The US government issues many types of bonds, some of which you can defer the interest for up to 30 years and others are free of state income tax. EE and I (inflation) savings bonds allow you to buy US savings bonds with as little as $25. The interest grows tax deferred until the bond is redeemed, or 30 years, whichever comes first. The bonds must be held for at least 12 months before they can be redeemed. If redeemed in years two through five, you will lose three months of interest.
The difference between the two types of bonds is the EE bonds pay a fixed rate of interest, whereas the I bonds pay a lower fixed rate of interest, but can pay more if inflation increases. The US government also issues Treasury bills, notes, and bonds. The only difference in the different types of treasuries are their length of maturity. Treasuries are taxable on the federal level, but are tax free at the state level.
4.3 Annuities
Annuities in the US are essentially the same as annuities in Canada, with one major exception, the earnings and growth within the annuity is tax deferred until withdrawn. When the money is withdrawn it is taxed as ordinary income, regardless of how it was earned (e.g., interest, dividends, or capital gains). With capital gain and dividend tax rates at 15%, it may be difficult for a deferred annuity to obtain better, after tax returns than a traditional investment portfolio.
If you have an estate that exceeds the exemption amount (a taxable estate), investments that have accrued, but untaxed income at the time of death will be double taxed. The phenomenon is called “income in respect of a decedent” (IRD). Other examples of IRD would include tax-deferred retirement plans such as IRAs and 401(k)s; it would even include wages that you earned but have not been paid (dying in between pay days). It is double taxed because the value of the asset would be in the deceased’s estate and in the beneficiaries’ income when received.
4.4 Personal residence
The definition of a principal residence is very similar to the definition in Canada; it is basically the home you spend most of your time. However, unlike Canada where you are allowed an unlimited exemption from gain on your principal residence, the US allows only $250,000 per person. You qualify for the exclusion if the place was your principal residence for at least two of the last five years. This would apply to your Canadian home as well. One big difference in the tax laws of the US and Canada as it relates to your principal residence is that in the US, you can deduct your mortgage interest and real estate taxes.
4.5 Investment real estate
While the definition of investment property in the US and Canada are essentially the same, the US tax governing real estate for investment is substantially more complex. The very first thing to consider is where you are “active” or “passive” in your real estate investment activity. While a whole chapter could be devoted to this topic, at the most basic level, the IRS uses hours and percent of time spent to determine active verses passive. Most investors will be considered passive, meaning that some or all of their losses will be able to be used in the year they occurred. If you are unable to use your current year’s losses because you are considered passive and exceed the income threshold, you will accumulate those losses (carry them over to future years) until you have passive income or when you sell the asset. Note that you cannot use passive losses to offset active income.
Another couple of US tax laws that are different than Canada are the fact that you must take depreciation (capital cost allowance) each year. Canada allows you the option of taking capital cost allowance or not, but you can never incur a loss due to capital cost allowance. Most investors do not take the capital cost allowance because it is recaptured when the property is sold.
The US allows the gain from real estate to be deferred using a tax-free exchange of “like kind” property. There are specific rules that apply to the like-kind exchange, be sure to seek advice before selling your property.
Also, when you sell the property you can also choose to carry the note over a period of years. This is called an “installment sale.” You only have to report the gain as a percentage of the note (and cash down payment) made. This means that you are able to defer a percentage of the tax on the gain for the duration of the note.
5. Treaty Rules That Affect Your Securities
In Canada, a principal residence is 100 percent excluded from tax. If the former (Canadian) principal residence is retained when moving to the US, the taxpayer’s basis is the fair market value (FMV) on the date of exit. Any appreciation after exit from Canada will be taxable in Canada upon sale. An appraisal or broker’s opinion of the home should be received around the exit date for use in determining the FMV so that when the house is eventually sold you will have an accurate and defensible cost basis number. The US does allow a foreign residence to be a principle residence.
The Treaty has a provision that governs the taxation of real property other than a principle residence. Canada will withhold on the selling price unless a Clearance Certificate is issued. Canada Revenue Agency (CRA) issues the Clearance Certificate. The intent of the Clearance Certificate is to show the CRA the approximate gain on the property. The taxpayer must supply the sales price, purchase price, improvements, and capital cost allowance (depreciation) taken (if any) so that the gain before expenses can be determined. This allows the CRA to withhold on the gain rather than the gross sales price. The taxpayer will need to file a Canadian return by April 30 of the year following the transaction to report the expenses of the sale and receive a refund of the over withholding.
Article XIII, Paragraph 4, of the Treaty governs the taxation of securities sold. Per the Treaty, securities sold in Canada are taxable only in the country of residence (i.e., the US). The nondiscrimination or “savings” clause of the Treaty prevents the reverse from being true. Because as a US citizen you are taxable on your world income, a US citizen in Canada will have to report the sale on both the US and Canadian returns. A foreign tax credit is used to prevent double taxation.