David Kuenzi of Thun Financial Advisors weighs in on the perils of U.S. expats investing in foreign mutual funds.
U.S. expats commit their fair share of investing mistakes. One of the most disastrous, in my view, is owning non-U.S. mutual funds.
For U.S. tax purposes, non-U.S. mutual funds qualify as Passive Foreign Investment Companies (PFICs). PFICs almost always result in a costly mess for U.S. taxpayers.
Here are two main reasons why:
1) PFIC investment income is generally subject to highly punitive U.S. federal income tax rates of no less than 39.6% and potentially much higher. Losses in PFICs usually cannot be used to offset gains in non-PFIC investments, and gains are taxed annually, whether realized or not. In contrast, long-term capital gains rates for U.S.-registered mutual funds range from 15% to 23.8% and the tax is deferred indefinitely until realized through sale.
2) U.S. reporting rules require that each separate PFIC investment must be reported yearly on tax Form 8621. Completing Form 8621 requires meticulous annual record-keeping and complex reporting. The IRS estimates that each Form 8621 requires more than 30 hours of accounting time a year to prepare and file. Not surprisingly, paying a tax preparer to properly report a handful of PFICs can cost thousands of dollars.
Beware of where the dreaded PFIC may lurk
Non-U.S. investment accounts are an obvious place to look for PFICs in your portfolio. But Americans abroad must also look within their foreign pension accounts and even their foreign life insurance policies. As in the U.S., foreign pensions frequently offer a selection of funds in which the pension assets can be invested. These investment options are virtually always PFICs. If the PFIC is held within a foreign pension scheme qualified in the U.S. via an applicable Income Tax Treaty — which the U.S. has with a handful of countries, including the U.K. and Canada –the PFIC issue is irrelevant because taxation of the investment is determined at the account level without reference to the tax treatment of the underlying investment. However, of the 46 Income Tax Treaties that the U.S. maintains with foreign countries, only a small handful recognizes the other country’s pension plans as “qualified” in U.S. tax terms.
Likewise, universal, private placement or whole life insurance policies issued outside the U.S. almost always fail to meet the definition of insurance for U.S. tax purposes. As a result, the IRS will require these policies to be taxed as if they are regular investment accounts rather than insurance policies. If the policy’s underlying investments are investment funds, they need to be reported as PFICs.
1) Taxpayers who dig into the PFIC tax rules will discover the Qualified Electing Fund (QEF) reporting option. The QEF election removes most of the onerous aspects of PFIC taxation. Unfortunately, the QEF election is available only for the tiny minority of PFICs that report to U.S. accounting standards.
2) Another key consideration is the impact of new Fatca (Foreign Account Tax Compliance Act) law on PFIC reporting. Before Fatca, PFIC rules were rarely enforced because the IRS did not and could not know who owned PFICs except when self-reported. Starting in 2014, all foreign financial institutions are now required to report to the IRS on accounts owned by Americans. Individual tax returns have to match the data supplied by foreign financial institutions, or the IRS will begin asking questions and launching audits. Ignoring the PFIC rules has worked in the past. It will not work going forward.
If I own a PFIC that has not been properly reported, what should I do?
One piece of good news is that in 2014 the IRS created a $25,000 exemption amount for PFICs. If cumulative PFIC holdings do not exceed that amount ($50,000 for a couple married, filing jointly), then PFIC reporting is not required. Where PFIC reporting is required, the blunt but almost always correct advice is to sell the PFIC immediately. The punitive tax implications and the reporting burden only compound the longer the investment is owned. If the PFIC is owned within a foreign pension plan that is not qualified by a foreign tax treaty, consult a qualified tax preparer; there may be a way to report the pension account that exempts the underlying investments from having to be reported as PFICs.
PFICs are almost always poor investments in addition to being tax nightmares. There is rarely a foreign mutual fund that does not have a U.S. equivalent with much lower fees and associated expenses. Buying a U.S. on-shore fund with an equivalent investment strategy is very likely to yield a better long-term investment outcome.
This article has been corrected to reflect that losses in PFICs usually cannot be used to offset gains in non-PFIC investments. An earlier version omitted the word “usually.”
Mr. Kuenzi is the Director of International Wealth Management. Prior to joining Creative Planning, he founded Thun Financial Advisors, a leading independent advisory firm serving Americans abroad and investors across the globe.