Why the right tax plan can make all the difference for U.S. citizens investing in Canadian start-ups

Canada is an attractive investment area for many U.S.-based investors due to its proximity, strong tech ecosystem, and cheaper cost for tech talent. According to a CPE Media report, U.S.-based venture capitalists deployed $3.3 billion in Canadian companies in 2019. For growing companies, access to U.S. money and expertise can mean the difference between reaching the next level or stagnating. 

However, U.S. investors have important tax implications to consider, including U.S. rules which discourage citizens from deferring taxes through foreign investment. The Passive Foreign Investment Company regime (PFIC) regulates investing in certain foreign corporations - often including tech start-ups. 

"It's about the company being proactive in conjunction with their advisors and investors," says Katri Ulmonen, MNP's National Director of U.S. Tax Services. "This process is not as much of a problem if you manage it upfront."

What is a PFIC?

PFIC status is determined annually using the corporation's tax year, and a foreign corporation is a PFIC if it falls under one of two buckets:

1) At least 75 percent of its gross income (i.e. revenue minus the cost of goods sold) is passive income, or

2) At least 50 percent of its assets are held to produce, or may produce, passive income. 

Passive income sources include dividends, interest, rents, and royalties. Cash is always considered a passive asset, which is why start-ups often fall under these rules - they're often raising cash over their lifetimes, and rarely with a profitable product. 

"The IP may not be at a point where it can be valued accurately, which often just leaves the cash," says Ulmonen. "That product or innovation will have value in the future but it doesn't have value currently."

How would the PFIC apply to me?

Even owning a single stock of a PFIC would trigger PFIC rules. There are no exemption thresholds for the percentage of stock owned. If the taxpayer is subject to vesting restrictions, only vested options would be included. 

There is a de minimis exception - where the aggregate fair market value of all the taxpayer's PFIC investments is $25,000 or less on the last day of the shareholder's tax year, and doubled if the taxpayer files jointly - but this amount is so insignificant it doesn't warrant consideration.

What are some taxation rules for PFIC investments? 

Each shareholder must file form 8621 with their annual tax return. There are several taxation methods to consider for PFICs. 

1291 Fund: The default method of PFIC taxation

When a PFIC makes a distribution or a shareholder recognizes a gain on the shares of a PFIC, the amount is taxed at regular rates. Not preferential rates applicable to qualified dividends or long-term capital gains (0, 15 and 20%).

An interest charge is applied to the deferred tax which may be quite high if the investment has been held for a significant period. A shareholder can avoid this by choosing one of two alternative ways of taxing the PFIC income and gains.

Mark to market

For publicly traded stock, a shareholder can recognize gain based on the fair market value of the shares as of the end of the year. However, this can be difficult for start-ups that don't yet have a product. 

Ulmonen gives the example of an MNP client and cancer researcher who came to Canada from the U.S. under a federal program which allows people around the world to become research chairs at Canadian universities.

"While he incorporated his ideas, all he had was that and a slide deck," she says.

"It's a collection of thoughts in his head, so how do you value something like that? Especially if they haven't done any testing or have a minimum viable product to work with."

Qualified electing fund (QEF)

A shareholder can pay tax on their share of the income earned within the PFIC. Capital gains, both within the PFIC and on the sale of shares of the PFIC, are subject to the preferential rates. All other income, including dividends, are taxed at regular rates.

The QEF option may provide the best outcome for U.S. shareholders: While the compliance cost of aligning the financial books with U.S. tax principles may not be practical for private companies from the outset, it's still worth considering. Especially if they expect more U.S.-based investment.

Ulmonen stresses the importance of asking two important questions of a potential start-up investment:

1) Does the company believe it's a PFIC?

2) If the company is a PFIC, would the it provide the QEF statements for investors?

To allow for the election required under QEF, the corporation must issue a QEF Annual Information Statement (AIS), indicating the PFIC's ordinary earnings and capital gains computed under U.S. tax principles - as well as the distributions made to the shareholder. The AIS must include a statement indicating the PFIC will permit the shareholder to inspect the books and records to determine the income and gain allocated.

To learn more about these rules and how MNP can help you optimize your investment tax strategy, contact Katri Ulmonen, CPA, CA at 604.637.1507 [email protected]