Investment in Foreign Mutual Funds and Corporations Under PFIC Regime
Many Americans are still under the impression that by investing in offshore funds or corporations they will save thousands of dollars in taxes. This is due to the fact that there is little to no tax in the foreign jurisdiction. But it would be wrong to assume that an expat’s earnings are taxed according to regular US law when they exist in the form of stocks or dividends. In fact, this would be a huge mistake. Under most circumstances, a foreign mutual fund is viewed as a Passive Foreign Investment Company (PFIC).
A PFIC is defined as any foreign corporation that derives 75% or more of its income from passive activities. Or, a PFIC may be comprised of at least 50% passive (investment) assets. Because nearly all of the income garnered from mutual funds is passive income, these funds are almost always viewed as passive foreign investment companies. As such, they are subject to the strict and weighty PFIC tax regime.
PFIC Regime Definition
Since 1986, PFICs have been taxed in such as way as to afford no tax benefits to investors from the US. A PFIC may be taxed in one of three ways:
- Excess Distribution Method (Code Sec. 1291)
The Excess Distribution Method is the taxation method that will be used automatically if another method is not/cannot be chosen. Under this method, the US shareholders of the deemed PFIC are subject to high taxation every time they receive a distribution or sell their holdings in the PFIC stock. The distribution, in part, is subject to the highest possible tax rate, hugely affecting investors who thought they were in the PFIC as a way of ensuring tax relief. The intricacies of the Excess Distribution Method are complicated, but essentially mean that all distributions will be divided up according to how long the shareholder has owned the stock. The portions of the distribution that are allocated to the current year as well as any years prior to the mutual fund’s establishment as a PFIC will not be taxed as capital gain but rather as standard income. All other allocations will be taxed at whatever was the highest possible rate for each relevant year. Additionally, interest will be compounded from the date of the taxpayer’s Federal return from that year.
- QEF (Code Sec. 1293 and 1295)
Under certain rules (that should be explained in detail by an accountant) a PFIC can sometimes be treated as a QEF (if the shareholder elects). When this is the case, the shareholder will be required to include each year in gross income the pro rata share of earnings of the QEF and include as long term capital gain the pro rata share of net capital gain of the QEF.
- Mark to Market Method (Code Sec. 1296)
Under this election, shareholders must include each year as ordinary income, the excess of the fair market value of the PFIC stock as of the close of the tax year over its adjusted basis in the shareholder´s books. If the stock has declined in value, an ordinary loss deduction is allowed, but it is limited to the amount of gain previously included in income.
Beginning in 2010, US shareholders who own shares in PFICs are now required to annually report their holdings to the IRS. This new requirement is regulated by the “Hire Act”.
It would be both unwise and false to assume that foreign funds still allow investors any tax benefits above that of domestic funds. In fact, foreign funds can be a great deal more costly because of the rules surrounding PFICs. Apart from PFICs, foreign investments also come with other tax liabilities and should be avoided altogether unless directed under the guidance of a qualified and experienced international tax professional.
I.J. Zemelman, EA is the founder of Taxes for Expats