Commentary: U.S. investors in Canadian miners may face tax surprises

Canadian-based mining companies commonly raise capital from U.S. investors. Even if they do not actively seek such investment, they often wind up with some (in particular, dual citizens, U.S. citizens living in Canada and Canadian citizens who are permanent residents of the U.S. – so-called “green card” holders). 

Depending on the phase of the mining operations, the types of income earned, the percentage ownership by U.S. investors and the company’s willingness to provide the U.S. investors with access to its books and records, the U.S. investors may be subject to unexpected, severe U.S. tax consequences that may substantially change their return on investment.

Often this impact is directly related to the applicability of the rules known as the U.S. passive foreign investment company (PFIC) provisions.

For example, if an individual U.S. investor makes an investment in a Canadian mining company that is considered a PFIC and is unable to make certain elections to mitigate their effect (as discussed below), then the U.S. investor will not be entitled to the long-term capital gains tax rate on any gain resulting from the sale of the shares of the PFIC (currently a maximum of 15% if such shares are held for more than one year).  

In addition, the individual U.S. investor will not be entitled to the qualified dividend tax rate (currently also a maximum of 15% through the end of 2012). Instead, any gain is allocated over the period such PFIC shares were held and taxed at the highest tax rate applicable to ordinary income in such year (currently 35%), plus an interest charge.

Likewise, the distributions from the PFIC will generally be taxed as ordinary income (currently at rates up to 35%). Some distributions, however, may be taxed similarly to the gain (which includes an interest charge). Accordingly, the application of these provisions for U.S. investors can result in a much lower than expected return on their investment.

Even large mining companies with many employees can be considered a PFIC. This article discusses the PFIC rules as they apply to common mining operations, as well as how companies can avoid being considered a PFIC and how individuals can mitigate the rules’ effect if the company is considered a PFIC.

Definition of a PFIC

A foreign corporation (non-U.S.) will be considered a PFIC if in any given year it meets either the “75% passive-income test” or the “50% passive-assets test.” 

Under the 75% passive-income test, a foreign corporation is considered a PFIC if 75% or more of its gross income for a taxable year is passive. Passive income is generally defined as income that includes dividends, interest, rents and royalties, annuities, and net gains on the sale of property producing passive income.  

Under the 50% passive-assets test, a foreign corporation is considered a PFIC if at least 50% of the average fair market value of the assets held by the corporation during a taxable year consists of passive assets. Passive assets are generally defined as assets that produce, or are held for the production of, passive income.  

The assets test must be applied annually on a gross basis (without taking into account any liabilities). Internal Revenue Service (IRS) guidance requires the assets test to be based upon the average value of assets for a year, determined using the value of the assets as of the end of each quarter of the taxable year. Foreign corporations (other than controlled foreign corporations (CFCs)) generally measure their assets for this purpose by using the fair market value of those assets.

If a Canadian mining company does business through a variety of entities (for example, partnerships and subsidiaries), special “look-through” rules may apply to these entities’ income and assets to determine the company’s PFIC status.

Are mining income and the related assets considered passive?

Exploration, development and production activities

Under U.S. tax principles, the income derived from exploring, developing, and producing (by extraction) minerals from Canadian mining properties is considered income from “commodities transactions.”  

Passive income for PFIC purposes is generally defined as income which would be “foreign personal holding company income.” Net gains from commodities transactions are generally treated as such foreign personal holding company income (i.e., passive income).  

However, a “commodities exception” is available for “active business” gains and losses from the sale of commodities in certain circumstances that may apply to income derived from mining activities. The rules that apply for transactions entered into before Jan. 1, 2005, are different from the current ones, which is relevant if any of a company’s current U.S. shareholders held shares in the company during any year the company was considered a PFIC.

Active conduct of a trade or business

The concept of an active business, though required for the commodities exception to apply, is not defined in the related section of the tax law or its regulations. These regulations, however, do require a corporation to satisfy the general active trade or business standard in another section of the tax law for purposes of other exceptions to foreign personal holding-company income. Therefore, in determining whether a taxpayer meets the active business requirement for purposes of the commodities exception, we refer to the general active trade or business standard.  

This standard generally provides that whether a trade or business is actively conducted must be determined under all the facts and circumstances. The regulations place significant requirements on the use of employees and officers. The regulations state that, in general, a corporation actively conducts a trade or business only if the officers and employees of the corporation carry out substantial managerial and operational activities. 

Having employees in one entity providing services for related entities is very common. The regulations provide that, in determining whether the officers and employees of the corporation carry out substantial managerial and operational activities, the corporation may take into consideration the activities of the officers and employees of related entities who are made available to and supervised on a day-to-day basis by, but only if these officers’ and employees’ salaries are paid by the corporation (or reimbursed to the related entity by the corporation).

This is one of the many ways Canadian mining companies – even with hundreds of employees – can get caught by these PFIC rules. In such cases, consideration should be given to entering into secondment agreements such that when officers and employees are working for the various related parties, they are considered employees of such related parties. Successful implementation of this planning idea may avoid classification as a PFIC.

It is important to note that the activities of independent contractors are to be disregarded. This is yet another way Canadian mining companies can get caught by the PFIC rules. 

Start-up companies’ investors may want to note that a corporation is not treated as a PFIC for the first taxable year that it has gross income (referred to as the “start-up year”) if no predecessor of such corporation was a PFIC, it is established that the corporation will not be a PFIC for either of the first two taxable years following the start-up year and such corporation is not a PFIC for either of the first two taxable years following the start-up year. 

In mining exploration and development, as well as oil & gas exploration and development (especially oilsands), it is common for the only revenue to be earned in the first several years – let alone the first year – to be interest income on bank deposits (from capital raised and/or borrowed). Generally, large expenditures in these initial years result in losses for both
book and tax purposes. As such, these companies would be unable to satisfy this first-year exception, and as 100% of their gross income (i.e., interest) is passive, they will likely be considered a PFIC during these initial pre-production years.

If a U.S. shareholder holds shares in a company during any year it is considered a PFIC, the company will always be considered a PFIC for that shareholder. Accordingly, if U.S. shareholders invest prior to production beginning (as well as after production begins if the active conduct of a trade or business requirement discussed above is not met), they will likely need to take steps to mitigate the effects of the PFIC classification.

How to mitigate effects of PFIC classification 

The PFIC rules were adopted to prevent U.S. investors from deferring the recognition of passive income earned through a foreign company (as income earned by foreign corporations is generally not taxed in the hands of U.S. investors until such earnings are distributed by way of a dividend) as well as converting ordinary income into capital gains.

There are two elections that an individual U.S. shareholder in a PFIC can make that takes away the benefits of one or both of these perceived abuses. Accordingly, some of the punitive provisions are not applicable. These elections include the “qualifying electing fund” election (QEF election) and the “mark-to-market” election. 

The punitive provisions of the PFIC rules (in general, gains and certain distributions allocated to various years during the holding period and taxed as ordinary income at the highest rates plus interest) do not apply to a taxpayer that makes the QEF election. In general, the company must have been a QEF with respect to the taxpayer for each taxable year (since 1986) for which the company was a PFIC and that included any part of the taxpayer’s holding period.

As a result of the QEF election, the U.S. shareholder must include his or her share of ordinary income of the QEF into income annually (as ordinary income) – whether or not distributed – as well as net capital gains (as long-term capital gain). Note that this election is shareholder-specific and does not affect foreign (non-U.S.) shareholders. In addition, please note that the company must agree to supply an Annual PFIC Statement (generally showing ordinary income and net capital gains per share) and allow such U.S. shareholders access to the company’s books and records.

As mentioned above, a problem with the QEF elections is that it requires the foreign corporation to give detailed information to the U.S. shareholders that make such election. In 1997, the U.S. Congress gave some shareholders another option: the mark-to-market election. This requires that the shareholder mark the foreign stock to market each year. The shareholder must include in gross income the excess, if any, of the fair market value of the stock at the end of the year over its adjusted basis (as ordinary income). In addition, unlike the QEF election, any gain on the sale of the stock is treated as ordinary income.

In order to mark-to-market the stock, the fair market value must be readily determinable. Accordingly, this election applies only to “marketable stock.”

When choosing their investments, U.S. individuals should keep in mind that not all Canadian mining companies are directly involved with exploration, development and production activities. Instead, the company may be formed to invest in certain royalty interests.

Unlike the income from exploration, development and production activities, royalty income is generally considered to be passive income for the purposes of the PFIC income test and the royalty interests themselves are generally considered passive assets for purposes of the PFIC asset test. Accordingly, U.S. investors will likely stay away from investing in Canadian mining companies that are formed to invest in royalty interests.

In conclusion, Canadian mining companies can be good investments for U.S. individuals, as long as they are aware of the potentially unfavourable U.S tax treatment of their income from these investments. As this article illustrates, the rules are complex but investors can avoid the pitfalls with proper and timely planning.

– The authors are both certified public accountants and Practice Leaders of KPMG’s U.S. corporate tax practice in their Toronto and Calgary offices, respectfully. Visit www.kpmg.com for more details.

Note: Information is current to May 2011. The information contained in this article is of a general nature and is not intended to address the circumstances of any particular individual or entity. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.