Who should use this guide?
Anyone who has investments outside of the US, including mutual funds. If you have already invested in or areconsidering investing in foreign-incorporated investments, it’s important for you to understand the taxobligations involved and what you can do to avoid paying unnecessarily punitive fees, taxes, and interest.
Why use this guide?
Failure to understand the filing ramifications of PFIC can turn a great investment sour. PFIC tax rates canreach near or above 50%.
How to use this guide?
Apply the considerations we discuss below before investing. If already invested, please get in contact withTaxes for Expats to make sure that you are not in a precarious position. You invest to let your money work foryou, but failure to understand the PFIC regime may unfortunately turn that equation against you.
Step 1
Understand PFIC and make wiser investment decisions
As a U.S. Expat working overseas, you have a wide variety of domestic and foreigninvestment options at your fingertips. If you are like most US Expats, you may believe:“As long as I report all of my foreign financial accounts on FBAR, it doesn’t matter where I keep my money.”
Technically speaking, that’s true; the Department of Treasury isn’t interested in taking your money ordictating the place(s) in which it can be held or invested. The IRS, on the other hand, is not onlyinterested in your reporting foreign financial account information; it’s interested in taxing your incomefrom foreign investment accounts at the highest possible percentage – even at a rate of up to 50%!
This article will focus on a common type of foreign investment known as PFIC (Passive Foreign InvestmentCorporation).
Understanding PFIC’s and how they can affect your U.S. expat tax return will help you make wiserinvestment decisions and save money both now and in the future.
PFICs are simply “pooled investments” registered outside of the United States encompassing mutual funds,non-US pension plans, hedge funds, and insurance products.
A mutual fund that is invested in European stocks, but incorporated in the US may be taxed at a long termcapital gains rate of 15%, but if the US taxpayer buys an identical fund listed outside the US, they willfind their investment may be taxed at up to 50%
Step 2
Definition of PFIC
Before we get into the method of taxing a PFIC, let’s first take a look at what it is. APFIC is an investment structure designed by a foreign establishment that meets one of the followingqualifications:
- At least 75% of its income is generated passively. Different types of passive income include: Capitalgains, dividends, interest, royalties, and a variety of other types of income for which continuous work isnot required.
- At least 50% of its funds and assets are being held for the sole purpose of manufacturing passive income.
Whether you realize it or not, these conditions apply to practically all foreign investment accountsincluding hedge funds, money market accounts, mutual funds, pension and retirement accounts, private equityfunds, and a long list of other foreign investments. Generally speaking, these non-U.S. domiciled investmentproducts are distributed by foreign financial advisors and brokers who have zero or very limited knowledge ofhow the United States will be taxing your investment account as a U.S. Citizen or Green Card Holder. As such,they are unable to adequately structure your investment and payout plan to put you in as favorable of a taxposition as possible with the IRS when filing your U.S. expat tax return.
Step 3
History of the United States and the PFIC
Before 1986, investing in foreign mutual funds was all the rage; and the United States wanted a way to makeU.S.-based mutual funds the preferred method of investing for U.S. taxpayers. You see, mutual funds thatwere created and held in the United States had an imposition of mandatory distribution which resulted in IRStaxation; non-U.S.-based mutual funds were allowed to defer distribution and therefore defer tax liability,as well.
Additionally, the United States at the time had very limited resources for tracking offshore investments. Toencourage United States Citizens to invest in U.S.-based mutual funds rather than foreign mutual funds, theU.S. enacted The Tax Reform Act of 1986. This legislation imposed additional reporting requirements on allPFIC’s and designed a tax structure that was extremely burdensome to U.S. Citizens and Green Card Holders.
A PFIC owned by a U.S. citizen or Green Card holder is subject to the following rules of United Statestaxation, which can easily add up to a tax rate of over 50%:
Step 4
How the IRS taxes PFIC’s
To understand the additional burden placed on you by investing in a PFIC, it’s importantfor you to understand how your U.S.-based mutual fund is taxed. U.S. incorporated mutual funds offer adeferral on capital gains until the time at which they are realized. Additionally, U.S. incorporated mutualfund distributions are eligible to be taxed at preferential long-term capital gains rates.
A PFIC owned by a U.S. citizen or Green Card holder is subject to the following rules of United Statestaxation, which can easily add up to a tax rate of over 50%:
- All distributions are taxed as regular income at the highest possible federal tax rate of early 40%.
- Capital gains are not eligible to be taxed at preferential long-term capital gains rates; they areviewed as regular income and are subject to the highest current federal tax rate – despite the marginaltax rate for which your income level qualifies.
- If you elect to have deferred gains in your PFIC, you will be assessed with a non-deductible penaltyinterest charge that is compounded regularly for the duration of your deferral period; so by the timeyou finally realize gains, you will have accumulated an obscene amount of interest.
It’s important to realize that the aforementioned taxation method of PFIC’s is the default method. Youwill be able to avoid some of these high penalties and rates of taxation by electing to use theMark-to-Market Accounting Method on your PFIC. This is where it comes in handy to not rely on a foreignfinancial advisor or a U.S. based financial advisor who has limited knowledge of international investmentaccounts. If you are going to invest in one or more PFIC’s, make sure you’re working with a U.S. basedfinancial advisor who is well-versed in international investment accounts and their tax relationship tothe IRS. So what is the Mark-to-Market Accounting Method?
Step 5
Mark-to-Market accounting method
With the Mark-to-Market accounting method, all of your PFIC gains will be taxed at themarginal tax rate determined by your income level. This applies to both realized and unrealized gains, soyou won’t accumulate interest for distribution deferral. Also by using this method, you will be able toclaim your losses attributable to your investment in one or more PFIC’s. This will allow you to lower yourtaxable income, possibly placing you in a lower marginal tax bracket.
Even though you will qualify to have your PFIC capital gains taxed at your marginal tax rate, you willstill not qualify for the preferential long-term capital gains rates. Even when using the Mark-to-MarketAccounting Method, PFIC capital gains are still viewed by the IRS as regular income and taxable assuch.
To elect to have your PFIC taxed with the Mark-to-Market Accounting Method, you will need to elect thismethod with your PFIC account manager and file Form 8621, Information Return for Passive ForeignInvestment Company with your U.S. expat tax return. These steps ARE NOT only taken once; in order to havethis treatment on your PFIC account, you will be required to repeat these steps every year.
The first de minimis rule applies if the aggregate value of all of the PFIC stock owned by the shareholder(directly or indirectly) does not exceed $25,000($50,000 for joint filers).
The second de minimis rule applies if the PFIC stock is owned indirectly by the shareholder through anotherPFIC and is valued at $5,000 or less.
The de minimis rules apply only if the shareholder: (i) has not made a Qualifying Electing Fund ("QEF")election, (ii) has not received an excess distribution during the year, and (iii) does not recognize gaintreated as an excess distribution during the year.
Step 6
Final considerations
For most U.S. Expats, the reality is that PFIC’s are simply not as profitable investmentoptions as those based in the United States. Even by changing the structure of your PFIC, the best tax rateyou can get is your marginal tax rate for regular income. There is no tax deferral, there are no specialcapital gains tax rates, and you’re at a higher risk of being charged excessive interest and penalties. Forsome U.S. Expats in certain financial situations, it may make sense to invest in a PFIC. To see if this isan ideal investment strategy for you, compare your prospective PFIC(s) with other investment options, takingtime to calculate your profit after taxes, fees, and interest.
Don’t leave your current and future financial health to chance. Remember that many of the tax rules andregulations pertaining to U.S. Expats are somewhat vague and the details aren’t clear to many U.S.-basedtax advisors. Filing a U.S. expat tax return and saving as much as possible when investing in PFIC’s canbe an extremely complicated process. Make sure you’re working with an international tax expert who isexperienced in working with PFIC’s so you can avoid unnecessarily high fees and tax rates and get the mostback from your investment portfolio.
