Why U.S. Expats Should Steer Clear of Foreign Mutual Funds
Perhaps the most common and most significant investment mistake made by Americans abroad is buying a foreign (non-U.S.) mutual fund (including ETFs or other types of non-U.S.-based funds). The U.S. tax code categorizes non-U.S. registered mutual funds as Passive Foreign Investment Companies (PFICs), and PFICs are taxed very punitively by the U.S. Furthermore, each PFIC must be reported annually on U.S. Tax Form 8621, which requires complex accounting and is very time consuming to complete.
For many years following the passage of the original 1986 PFIC legislation, U.S. expats comfortably ignored the PFIC rules. The lack of cross-border financial transparency made it impossible for the IRS to collect the information needed to enforce the PFIC tax provisions.
However, this changed in 2010 with the passage of the Foreign Account Tax Compliance Act (FATCA) which ushered in a new era of dramatically increased cross-border tax transparency. Foreign financial institutions are now required to report non-U.S. accounts held by U.S. citizens and other U.S. taxable persons.
Therefore, for U.S. taxpayers, failure to properly report PFICs on a U.S. tax return exposes them to high risk that the IRS will eventually uncover the lack of disclosure and impose tax, interest, and penalty charges that can potentially consume most of the return on investment.
What is a PFIC?
The acronym “Passive Foreign Investment Company” or PFIC bears a resemblance to exotic and highly specialized investments. As a result, many Americans automatically assume that they do not own any. For many unsuspecting Americans abroad, this conclusion is a mistake.
PFICs are simply foreign companies that either earn more than 75% of their income from passive sources (interest, dividends, capital gains, rent and certain royalties) OR have more than 50% of their assets “held for the production of passive income.” Meaning, any investment that’s not a participation in a business including holding cash.
Most PFICs are simply “pooled investments” incorporated outside of the United States. These include foreign mutual funds, exchange-traded funds (ETFs), closed-end funds, hedge funds, insurance products and investments held in some non-U.S. pension plans. Money-market funds can also be PFICs, even if held in a bank account, as these funds are essentially short-term fixed-income mutual funds.
In addition, PFIC rules apply to investments held inside foreign pension funds, unless those pension plans are recognized by the U.S. as “qualified” under the terms of a double-taxation treaty between the U.S. and the host country. Due to FATCA, the likelihood that the IRS will eventually identify unreported PFICs has increased dramatically. Finally, PFIC rules apply equally to Americans abroad, as well as Americans living in the U.S., although the problem remains much more common among American taxpayers living abroad.
What is PFIC tax?
The tax treatment of PFICs is extremely punitive compared to that of similar investments incorporated in the U.S. For example, an American holder of a U.S. incorporated mutual fund invested in European stocks pays the low long-term U.S. capital gains tax rate of 0%, 15% or 20% if the fund is held for more than one year. The same American investor holding a nearly identical fund listed in Singapore, the UK, or any place outside the U.S., will find their investment subject to the PFIC taxation regime, which counts all income (including capital gains) as ordinary income.
This income is tax-allocated across all years since the PFIC was acquired. For the current year it is taxed ‘normally’ for each prior year it is subject to income tax at the highest marginal rate in place in that year—not the shareholder’s marginal rate.
Additionally, interest is payable for all taxes compounded daily from the date of acquisition. The total tax on a PFIC investment may eliminate the amount of the distribution from the PFIC. Furthermore, capital losses on a PFIC can only offset other investment gains in limited circumstances, as it cannot offset gains from a different PFIC.
PFICs include foreign incorporated funds
Lastly, it should be stated clearly that PFICs are foreign incorporated funds, not funds that invest in foreign investments. For example, a fund incorporated in Ireland that invests in U.S. stocks is a PFIC, as opposed to a U.S.-registered fund that invests in European stocks.
“The tax treatment of PFICS is extremely punitive compared to … similar investments incorporated in the U.S.”
PFIC compliance for foreign mutual funds
High tax rates are not the only disadvantage of PFICs for American investors. The other major PFIC complication is the onerous task of simply complying with IRS reporting rules for PFICs. Ownership is most common among expatriate Americans, many of whom employ accountants specializing in cross-border tax preparation for Americans abroad. However, hiring an expatriate tax specialist does not guarantee that the proper PFIC related filings are being made, and the taxes paid.
Often, the client inadvertently fails to divulge (and the tax accountant fails to request) the necessary information on the client’s mutual funds, ETFs, hedge funds, or other financial instruments. In other cases, if the client and the tax preparer have negotiated a fixed fee for tax preparation, the preparer may be reluctant to ask about possible PFICs because record keeping (16 hours) and preparation time (20 hours) for the complicated Form 8621 is estimated by the IRS to be 36 hours per year!
Each PFIC requires a separate Form 8621
As a result of the 2010 FATCA, a separate Form 8621 must be filed every year for each PFIC. Form 8621 used to only be filed for the years in which the fund paid distributions to the fund holders. It does not take long to realize that filing Form 8621 for multiple PFIC investments might quickly run up a tax preparation bill to many thousands of dollars, no matter how much (or little) the underlying investments are worth, or their performance over time.
This scary picture raises an obvious question: If this is such a big trap, why has there not been more discussion of the issue, and why have I never read about it before? The reason is that until now the IRS faced many obstacles to enforcing the PFIC rules and lacked the resources to go after filers on the issue. Before FATCA, failure to file Form 8621, and properly report PFICs rarely resulted in an audit or a prosecution for tax fraud. The PFIC issue had been safely ignored until FATCA, even by professional tax preparers. Times have changed since the passage of FATCA.
FATCA makes PFIC reporting mandatory
Not only does FATCA require new self-reporting on PFICs and other foreign-held financial assets, it also requires all “foreign financial institutions” to report the assets held by U.S. citizens, and U.S. permanent residents, directly to the IRS. While it may seem hard to believe that foreign financial institutions would willingly comply with such reporting requirements, the severe sanctions imposed by the IRS on non-compliant financial institutions have led to nearly universal compliance with FATCA-induced regulations.
All U.S. citizens must assume that the IRS has a detailed view of their holdings in foreign financial institutions. It will be easy to cross-reference reports by these institutions to the IRS with the Form 8938 and Form 8621 filed by the taxpayer. With this information, the IRS can determine whether your PFIC investments have been properly reported, and the tax properly calculated and paid.
There are no simple ways to avoid PFIC reporting once you have this issue. Gifting a PFIC to a non-resident non-citizen, for example, will give rise to both U.S. gift tax reporting requirements and the very income tax and reporting you may be trying to avoid.
PFIC compliant investments
It is necessary for all American expatriates to understand that international financial planning complications are magnified by the various tax regimes affecting cross-border or international investors. PFIC rules are just one of many reasons why American investors need to keep their investment funds in U.S. accounts, even if they are investing globally.
A thorough analysis of the tax, reporting, cost, and security issues of foreign investments invariably leads to the conclusion that savvy American investors must remain globally invested and avoid holding foreign mutual funds. Moreover, do so through U.S. financial institutions with experienced cross-border financial advisers to help navigate the myriad of tax and regulatory issues.
Request a meeting with a Wealth Manager from Creative Planning International to discuss your unique situation as an American expat and get the comprehensive wealth management solutions you deserve.