What Is A PFIC?
Your Definitive Guide To Passive Foreign Investment Companies and Form 8621
If you have overseas investments or are considering such investments, even through mutual funds, you should understand the tax consequences involved. Whether you are asking yourself for the first time: “What Is A PFIC?”, or even if you are already familiar with some of its intricacies, This guide will help you fully understand your obligations, which in turn will help you avoid unnecessary taxes, penalties, and interest.
Private foreign investment companies, or PFICs, can add profitable dimensions to your portfolio. But they also require filing considerations that you might not have foreseen. PFIC tax rates can exceed 50% in some cases, a rate that only increases with penalties for incorrect filings.
If you are considering adding PFICs to your portfolio, please consider the elements discussed here before doing so. If after reading this guide you would like to review investments you already hold that expose you to PFICs, there will be an option at the end of the article to contact us for a review of your situation and guidance as to what you’ll need to stay on the right side of the law. We also offer Form 8621 Preparation if you would like to have your forms professionally prepared.
Informed Decisions are Wise Decisions – Understand What a PFIC is.
US citizens living overseas have a range of investment options not available to them at home. Many expats consider themselves covered when they file a report of their foreign bank & financial accounts (the FBAR, for short). That’s often true, but not always.
The FBAR serves a number of different purposes for different government departments and agencies. The Treasury Department, for example, uses the FBAR to investigate financial crimes, and otherwise tends not to care about the nature of your holdings. The IRS, of course, is another story. Along with information about your accounts, the IRS seeks to tax the income you earn from foreign investment accounts, and to do so at the highest possible rate.
Perhaps the most common types of foreign investments are those involving PFICs. The rest of this guide will focus exclusively on the tax ramifications of PFICs. But first, let’s define them in detail.
What Exactly is a PFIC?
A PFIC is any type of pooled investment registered outside the United States. These include mutual funds, hedge funds, insurance vehicles, and pension plans established overseas.
To qualify as a PFIC, an investment must meet one of these two criteria:
- Generates At least 75% of its total income through passive means. Passive income includes dividends, interest, royalties, capital gains upon sale, and any other income that the investor received independent of his/her direct involvement.
- It holds At least 50% of its assets solely to produce passive income.
That covers quite a bit of ground, including nearly every mutual fund, hedge fund, private equity fund, pension, or money market account you might consider.
Since these are investment products registered overseas, there’s typically no good reason for the institutions and brokers who represent them to advise you on your tax obligations as a US resident. It’s even possible that a given product’s structure and payout scheme work perfectly well for citizens of its home country while exposing you to a larger US tax burden than you otherwise might have shouldered.
You should study every investment you make, regardless of where it is registered, but be especially careful of those registered overseas. The standard documentation and disclosures behind a given foreign financial product might, even in good faith, fail to address everything you need to know as a US taxpayer.
What is PFIC? And How Did PFICs Come to Be?
Not all that long ago, savvy investors tended to prefer foreign-based mutual funds to those registered in the US. As recently as 1986, this was a good way to avoid mandatory distributions, sometimes deferring them and their attendant tax liabilities indefinitely.
That came to an end with the Tax Reform Act of 1986, which gave the IRS the authority to tax foreign-based mutual funds and similar pooled-investment products at a far higher rate than those based in the US. Interest in foreign funds cooled dramatically, and all that business stayed at home. The same legislation introduced new reporting requirements on PFICs, giving the Treasure Department and the IRS a new way to account for overseas investments.
PFICs and the IRS
The IRS treats PFICs as entirely different entities from domestically registered funds. When you own a mutual fund, say, incorporated in the US, you’ll pay the long-term capital gains rate on any gains you realize when you sell a position. That turns out to be a pretty good deal, especially when compared to the rules governing PFICs.
Positions held by a US taxpayer in a PFIC are taxable under three IRS rules:
- Capital gains are taxed as regular income, and at the highest federal tax rate, regardless of the marginal tax rate that applies to the payer’s total income.
- All distributions are also taxed as regular income, and also at the highest federal tax rate.
- Deferred gains are subject to non-deductible interest charges. What’s worse, these interest charges compound indefinitely.
Taken together, these charges can easily represent a total tax rate of more than 50%. To avoid them, investors have two options: avoid foreign passive-income products altogether, or use the mark-to-market accounting method when filing.
Straying from the IRS’s standard tax-calculation methods can be a bit risky, so before you consider mark-to-market, you’ll want to have an advisor on your side who thoroughly understands both US tax law and international investment. The surest way to find that combination is to limit yourself to financial advisors based in the US, and to narrow your search to those who have demonstrable expertise in international accounting.
With that in mind, let’s take a closer look at the mark-to-market method, with an eye toward learning whether it’s a good fit for your situation.
The Mark-to-Market Election
The Mark-to-market election seeks to assess the fair market value of a taxpayer’s assets, not just the historical facts of prices paid and received. This can be a problem in sharply declining markets—mark-to-market accounting may have deepened the Great Depression by devaluing the assets held by banks as the crisis worsened—but it has some significant advantages for US taxpayers investing in PFICs.
Most importantly, mark-to-market accounting allows you to treat all of your unrealized PFIC-related gains as ordinary income. This lets them be taxed at the same rate as your overall income level. For anyone not already in the top bracket, that’s good news.
Your income-determined tax rate applies to all gains from your PFIC investments, both realized and unrealized. As a result, you won’t accumulate interest on deferred distributions. And then you can lower your overall taxable income by claiming losses related to your PFIC investments.
On the other hand, because your capital gains will be viewed as regular income, they will not be taxed at the more favorable long-term capital gains rate. There’s simply no way around that one under current tax law: when it comes to mutual funds, hedge funds, and other products that qualify as PFICs, only domestic investments qualify for the long-term capital gains rate.
Consult your PFIC account manager and ask to how you can elect the mark-to-market method. At the same time, fill out IRS Form 8621, Information Return for Passive Foreign Investment Company, and submit it with your tax return. Form 8621 can take a good deal of work: a 26-line, four-page form in its most recent incarnation, it requires a comprehensive view of your PFIC investments and some savvy judgment (Part II contains eight election options, and that’s before you’ve even come to line six).
Each of these steps, even the initial decision to go with the mark-to-market method, should be repeated each year: you cannot simply point back to a previous year’s return.
This guidance applies for most taxpayers, but if your PFIC investments are relatively small, you may not have to file Form 8621 at all. The IRS’s de minimis rules may exempt you from having to file one more form, without affecting the rest of your return. These rules, then, can save you a bit of time and keep your return a bit more streamlined, but they apply only in certain situations.
If you have not made a Qualifying Electing Fund (or QEF) election, haven’t received an excess distribution during the tax year, and have not realized a gain treated as an excess distribution, you’ll be exempt from filing Form 8621 under the following conditions:
- When the aggregate value of all your PFIC investments—including direct and indirect ownership of shares—is less than $25,000 for single filers or $50,000 for joint filers, you do not have a requirement to file Form 8621.
- In the event you own shares of a PFIC stock indirectly—through another PFIC, say—and your investment holds $5,000 or less, you need not file Form 8621.
What is a PFIC – in Perspective
In most circumstances, the tax disadvantages alone of PFICs make them poor investment choices for US taxpayers living abroad. With some extra work, and an extra form or two to fill out, you can keep the tax hit from becoming too terribly punishing, but not to a point where your gains will enjoy anything like the going tax rate on long-term capital gains.
You won’t be able to defer taxation on your gains, either, and depending on the accounting method available to you, you may find yourself paying interest and penalties that grow as long as you hold your investment.
At the same time, some opportunities may make sense for certain US expats. If an investment appears to have no clear US-based counterpart, for instance, it might be worth the tax disadvantages and extra paperwork.
Only you can make that determination, and neither this guide nor any other general source of information can tell you which investments make sense for your portfolio and which you should ignore.
One thing, though, is certain: before you commit to any PFIC you should compare it with at least a few similar investment options and calculate the entire cost of each. That means determining what levels of profit you are likely to realize under various scenarios, and the fees, taxes, and interest that apply to each possible outcome.
If you have filed taxes while living overseas, you already know that the rules and regulations applying to US expats can be confusing and vague. More often than not, this is because your particular situation simply hasn’t been anticipated in its every detail by the IRS. Even the rules governing withholding for US employees working overseas for US companies can be confusing and frustrating for employees and payroll managers.
The same goes for many US-based tax advisors. Performing your due diligence on a PFIC means more than just studying the risks and potential benefits of the investment itself.
Similar effort as finding an experienced international tax advisor with a comprehensive knowledge of US tax law and practice.
With that kind of expert guidance you can be confident that a given investment will truly support your best interests, or that you have taken every possible step toward letting it benefit you without incurring unnecessary taxes, fees, interest, and penalties.