American Expats: Don’t Get Caught by U.S. Tax Rules on Foreign Investments
While most expat Americans are aware of the Foreign Account Tax Compliance Act (FATCA) and the increased reporting requirements for foreign holdings, many are still unaware of the IRS’s particularly harsh tax treatment of foreign-incorporated investments such as overseas mutual funds and pension plans. As a direct consequence of increased reporting from FATCA, we are also likely to see more rigorous enforcement of the IRS’s Passive Foreign Investment Corporation (PFIC) rules. This article is intended to help you understand PFIC rules so that you can minimize the U.S. tax consequences of investing overseas and avoid penalties, both now and over the long run.
PFIC Rules Apply to Individual U.S. Expat Investors
PFIC’s corporate-sounding name may cause some individual U.S. expats to mistakenly believe these rules don’t apply to them. Unfortunately, they do. In fact, many overseas Americans are likely to have invested in PFIC structures simply as a matter of course, as PFIC rules can apply to foreign-domiciled mutual funds, money market funds, pension plans, hedge funds, etc. Unfortunately, your U.S. tax preparer or the IFA broker who sold you the investment may not have informed you about PFICs. Non-U.S. financial advisors have little or no knowledge of the complex tax laws that affect American expats. In addition, many U.S. expats rely on U.S.-based tax advisors, who typically have limited knowledge of and experience in dealing with expat tax issues.
Background
The Tax Reform Act of 1986 enacted the PFIC tax regime to put U.S.-based mutual funds on an equal footing with non-U.S. mutual funds and to discourage offshore investing that the IRS could not track. At the time, U.S. mutual funds were required to distribute investment income that resulted in taxable distributions while foreign funds could defer distribution, resulting in a valuable tax deferral. This placed U.S. mutual funds at a distinct disadvantage. The 1986 legislation rectified this, subjecting American shareholders in PFICs to additional reporting requirements and a particularly harsh tax regime on foreign-incorporated investments.
What Is a PFIC?
A PFIC is a foreign entity that meets either of the following tests:
- Seventy-five percent or more of its income is classified as passive income (interest, dividends, capital gains, etc.).
- Fifty percent or more of its assets are held for the purpose of generating passive income.
This covers virtually all foreign mutual funds, money market funds, hedge funds, private equity funds, pension funds, and other investment products incorporated outside the United States and distributed by foreign financial institutions or sold by independent financial advisors (IFAs) or brokers.
In theory, a foreign fund manager could structure payouts and reporting on his fund to qualify for U.S. tax treatment similar to U.S. domestic funds. In reality, most offshore funds have few U.S. investors, their managers are unaware of the U.S. tax consequences to their American clients, and in general it’s not economical for the fund to be structured to meet U.S. rules. Meanwhile, most Americans who invest in PFICs are unaware of their different treatment and tend to report and pay tax on their foreign investments as they would an investment in a U.S. domestic fund, which could open them up to penalties, back taxes, and interest charges.
How Are PFICs Taxed?
Unlike U.S.-incorporated mutual funds, where capital gains are deferred until realized and which are subject to preferential long-term capital gains rates, PFICs are subject to a particularly punitive taxation regime by default (unless you actively choose the “mark-to-market” accounting method outlined below).
- All distributed income is taxed as ordinary income at the highest ordinary federal tax rate (currently 39.6%).
- Capital gains are converted to ordinary income and taxed at the highest current tax rate (currently 39.6%), regardless of your marginal tax rate.
- Deferred gains, which are basically undistributed unrealized gains, are subject to a special non-deductible penalty interest charge that is compounded over the deferral period.
As a result, annualized tax rates on PFIC income can exceed 50% or more.
Mark-to-Market Accounting
Some of the pain can be avoided if the investor elects an accounting method called “mark-to-market” and files Form 8621—Information Return for Passive Foreign Investment Company (PFIC). In this case, all gains earned during the year—whether distributed or not—are taxed at the investor’s marginal tax rate (rather than the highest ordinary tax rate) and the penalty interest rate is avoided. Additionally, by using this method, PFIC losses (realized or unrealized) can be used to offset ordinary income elsewhere. Still, all capital gains are taxed at ordinary income rates rather than preferential long-term capital gains rates and there is no tax deferral. In addition, the investor needs to elect this accounting method and file IRS Form 8621 each year for each PFIC, which can turn into a major accounting chore and increase the cost of tax filing. Still, this may be preferable than the alternative, which is being taxed at the PFIC default rates, penalties and all.
Clearly, the point is to deter investment in funds that are not domiciled in the United States. sWhy buy a non-U.S. mutual fund that charges an expense ratio of 2% per year or more and a 5–7% front-end load, offers no tax deferral, and where the gains are all taxed at your marginal tax rate in the best case and in the worst case are subject to the top marginal tax rate and a penalty interest rate? While investing in PFICs can still make sense in specific, limited cases, it’s important to compare the after-tax, after-fee return with other investment options.
Buyer Beware
The parts of the U.S. tax code that apply to American expats are obscure and have rarely been enforced in the past. As a consequence, even most U.S.-based tax planners are unaware of the rules or are reluctant to ask their expat clients about possible PFIC exposure due to the complexity and time required to fulfill IRS reporting requirements.
Before buying any type of investment or insurance product through a foreign financial institution or offshore broker, be sure to check with a tax advisor who has experience working with American expats. The penalties from failing to do so are not worth it.
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