Falling Down The Foreign Mutual Fund Rabbit Hole

If you are a U.S. citizen or resident (i.e. “Green-Card Holder”) and have investments in a foreign financial institution that includes foreign mutual funds, you need to learn what Passive Foreign Investment Companies (PFICs) are very quickly.
The passage of the Foreign Account Tax Compliance Act (FATCA) is bringing about a new era of dramatically heightened enforcement by the U.S. of laws regarding taxation of and reporting on investments held outside the U.S. by U.S. taxpayers. Thus, it is becoming increasingly more difficult if not impossible to be ignorant of filing requirements, including the filing requirements of PFICs.
One of the most confusing aspects of foreign investing is the difference (and the fact that there is a difference) in the reporting and taxation of foreign mutual funds as compared to U.S.-based mutual funds.
It is very clear that the US tax laws have been designed to deter US persons from investing in mutual funds outside the US but oftentimes US taxpayers are caught unaware (usually after the fact) about the reality of the investment in PFICs that they have. Investing in a mutual fund outside of the U.S. and PFICs in general is a trap of mammoth proportions for the unwary.

Non-U.S. Mutual Funds Are PFICs

The Internal Revenue Service has been informing for years that investments made in non-U.S. mutual funds and certain other types of entities may be subject to U.S. income taxation as investments in passive foreign investment companies (“PFICs”).
PFICs are any corporation organized under the laws of a non-U.S. jurisdiction, which satisfies either an income test or an asset test.

• The income test is satisfied if 75% or more of the foreign corporation’s gross income is passive income.
• The asset test is satisfied if 50% or more of the foreign corporation’s assets produce or are held to produce passive income.

Generally, income earned from dividends, interest, royalties, rents, annuities, capital gains from sale or exchange of property which produces such income, foreign currency gains, etc. will be characterized as passive income.

What are PFICs?

Many U.S. taxpayers when first encountering the term PFIC (Passive Foreign Investment Company), immediately shrug and assume that they do not have any of these investments because the term itself is an enigma.
For many unsuspecting Americans abroad, this conclusion would be a mistake and the consequences of making this mistake are about to become very significant.
PFICs are simply “pooled investments” registered outside of the United States. This includes almost all foreign mutual funds, hedge funds and many insurance products. It might even encompass your bank account if that account is a money-market fund rather than just a straight deposit account because money market accounts are essentially short-maturity fixed-income mutual funds.
Furthermore, the rules that apply to PFICs can and generally do 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, which is frequently not the case.
The tax treatment of PFICs is extremely punitive compared to the tax treatment of mutual funds in the U.S and it is not unheard that after taxes and interest are applied to these investments that they leave a significant and devastating impact on any investment gains.

The Reporting Pain Of PFICs

As if the tax treatment wasn’t bad enough for holding a PFIC, the disclosure and reporting requirement on Form 8621 is a tangled web of complexity.
With PFICs, the U.S. taxpayer is subject to one of 3 alternative methods to determine the amount of income the taxpayer will recognize as a result of investment in the fund.
Two of the methods are elective options subject to strict rules and timing of election. While the third, is the default method absent any election (it should be noted that the default method is the most common reporting method as most taxpayers become aware of their holding of PFICs after its too late to make an election).

1. Qualified Electing Fund Method

For most investors, the most favorable method of taxation will be to treat the PFIC as a “qualified electing fund” (“QEF” for short). The QEF election allows the taxpayer to distinguish between capital gain and ordinary income of the PFIC (in contrast to the “excess distribution” method described in the default method below).
However, in order for the QEF election to be effective, the PFIC must provide the taxpayer with a “PFIC Annual Information Statement” setting forth sufficient information to enable the taxpayer to accurately determine the taxpayer’s pro rata share of the PFIC’s ordinary income and capital gain for the taxable year.
So you may be asking, “why doesn’t everyone make a QEF election for foreign mutual fund shares?”
It’s simple. The reason that few investors make QEF elections for foreign mutual fund shares is that it is impossible to do so in most cases.
Foreign mutual funds, even those that are essentially offshore clones of U.S. funds, simply do not keep U.S. books and tax records and provide U.S. tax information to their shareholders, which is a requirement for making the QEF election.
I am not aware of any publicly traded foreign mutual funds that keep records that allow shareholders to make a QEF election for U.S. tax purposes.

2. Mark-To-Market Election Method

If it is not possible to make a QEF election, U.S. taxpayers holding PFICs may elect to annually treat the investment on a “mark-to-market” basis. In order to make the mark-to-market election, the units the investor owns in the PFIC must be “marketable stock.”

The term “marketable stock” is defined by the Code to mean stock regularly traded on a national securities exchange that is regulated by a foreign government (equivalent to the SEC in the United States).
The mark-to-market election allows the taxpayer to include in gross income the difference between the taxpayer’s basis for the investment in the PFIC (the “mark”) and the investment’s fair market value (the “market”) at the end of the taxable year (this is known as the “mark-to-market gain”). Any mark-to-market gain, as well as any gain on sale or disposition of the investment in the PFIC is treated as ordinary income.
Both the QEF and mark-to-market elections are made on Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund
must generally be made by the regular due date of the tax return.

3. Section 1291 Method – The “Excess Distribution” Method

When these elections are not made on a timely basis, the taxpayer will be taxed under the excess distribution method described in Code Section 1291. This is the default method.
The excess distribution method applies to any distribution (also known as a dividend) in excess of 125% of the average distributions received by the investor over the immediately preceding three-year period or any disposition (sale of mutual fund shares). The excess distribution is deemed to have been earned ratably over the period of the taxpayer’s investment in the PFIC. For a disposition, any gain is treated as having been earned ratably over the investment period as well.
The tax that would have been paid in prior years is computed at the highest ordinary income rate (yes, you heard that correctly) and interest at the underpayment rate as determined under Code Section 6621 as if the tax was due at the conclusion of each holding period year. In sum, a significant amount of taxes and interest can accrue. But perhaps equally grave is the complexity to calculate the excess distribution tax and interest. To make matters worse, if there is a loss on disposition, it cannot be claimed as a deduction or capital loss. 

Compliance Taint of PFICs

Although too complex to be fully elaborated on here, high taxation rates are not the only big disadvantage of PFICs for American investors. The other major complicating factor of PFICs is simply the onerous task of simply complying with IRS reporting rules for PFICs as alluded to above.
Ownership is most common among expatriate Americans, many of whom employ tax professionals specializing in 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. While the field of tax professionals that specialize in expatriate tax returns is small, the field that is familiar with and experienced in the reporting and taxation of PFICs and Form 8621 is even significantly smaller.
I often see that the taxpayer inadvertently fails to divulge (and the tax professional fails to request or inquire further) about any possible PFIC holdings.
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 and preparation time for the complex Form 8621 required to be filed for each PFIC investment owned is estimated by the IRS to be 46 hours per mutual fund, per year. In other words, it is neither a simple or inexpensive undertaking.
The Form 8621 must be filed annually for each separate PFIC investment (i.e. each different mutual fund) – in the past the Form 8621 only had to be filed in years in which there was an election, distribution or disposition. But starting with tax years 2013 and later, the Form 8621 must be filed annually for all holdings.
As a result, it does not take long to realize that filing the requisite Form 8621 for three to four PFIC investments (or more) can quickly escalate into an expensive undertaking, no matter how much (or little) the underlying investments are worth or how well they have performed.
This scary picture gets even worse – the trap is worse because it is impossible for most tax professionals (not to mention taxpayers) to properly prepare the Form 8621. It is far too complex and requires far too many onerous calculations that far outweigh the savings to self-prepare.

FATCA Makes PFIC Reporting Essential

As a US taxpayer, you may be thinking about an obvious question. If PFICs are 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. With FATCA information sharing and disclosures made by taxpayers, it won’t be long before the IRS starts to focus on these known investments and the companies that promote them.
In the past, the IRS has shown interest in the disclosure of PFICs as part of the Offshore Voluntary Disclosure Program and the expectation is that the interest may ultimately be the same or expand under the newly changed OVDP and streamlined programs and the IRS will be looking to make sure that the requisite filing of the Form 8621 and proper tax calculations have been made.
Failure to file Form 8621 and properly report PFICs has hardly ever resulted in an audit or a prosecution for tax fraud. The PFIC issue has been safely ignored until now, even by professional tax preparers. But times have changed. With a potential penalty of $10,000 for failure to report and disclosure of the underlying investment accounts as part of the FBAR (with the FinCen Form 114) and Form 8938 disclosures, there is a significant risk to not report.
The FATCA legislation not only requires new self-reporting on PFICs and other foreign held financial assets, but also requires all “foreign financial institutions” to report on 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 fact is that industry observers expect nearly universal compliance with the new rules by banks, brokerages, insurance companies, mutual funds (anything “financial”) around the world, because of the severe sanctions the FATCA law imposed on non-compliant financial institutions. In fact, most foreign governments, which have similar tax compliance issues with their own citizens are only too eager to trade information.
The result is that all U.S. citizens must assume that as of July 1, 2014, the IRS will have a direct and easily accessible window onto their holdings in foreign financial institutions. It may not happen for many years to come, but it’s almost a forgone conclusion that it will be easy to cross-reference direct reports by these institutions to the IRS with the FinCen Form 114, Form 8938 and Form 8621 that have or have not been filed by a taxpayer and determine whether or not PFIC investments have been properly reported and that the tax has been properly calculated and paid.

PFIC Avoidance Strategy

As a general rule, a U.S. taxpayer would be in far better position to invest directly in the stock of foreign corporations that are not PFICs or to invest in a U.S. mutual fund that invests in foreign stocks or foreign mutual funds.
Whichever of the foregoing 3 methods is chosen, an IRS Form 8621 must be filed. Whatever you do, be sure it is filed and prepared correctly. Failure to file the 8621 when required to do so can result in a $10,000 fine.
The bottom line? Don’t believe any foreign investment adviser regarding the U.S. tax consequences of any investment. Know the consequences of investing in foreign mutual funds before you invest by getting tax advice from a qualified U.S. tax practitioner.