Passive Foreign Investment Company | Practical Info You Need To Know
Many portions of the U.S. tax code contain confusing and sometimes harsh rulings. The rules for passive foreign investment companies (PFIC) are incomparable in their complexity and almost draconian features.
Countless times, Americans overseas have come to us to prepare what they thought would be straightforward tax returns, only to learn later that they had made investments into a non-US mutual fund and subjected themselves to all the onerous significant filing requirements and tax obligations that apply to owning a PFIC.
It is beyond the scope of this article to cover all the numerous details of the PFIC reporting requirements. Nevertheless, we hope to provide guidance and insight into the world of PFICs so you can avoid them whenever possible.
What Is A Passive Foreign Investment Company (PFIC)?
Any foreign company that meets either the asset or income test is a passive foreign investment company.
The asset test is met if 50% or more of the foreign corporation’s assets produce or could produce passive income.
The income test is met if 75% or more of the foreign corporation’s gross income is passive income, which includes income such as
- Rents and royalties derived in the active conduct of a trade or business
- Interest and dividends
- Annuities
In other words, the company’s income is based primarily on investments rather than a standard operating business that provides a service or produces a product.
U.S. taxpayers commonly encounter passive foreign investment companies in foreign-based mutual funds or other pooled investment vehicles such as ETFs (exchange-traded funds).
‘’PFICs are oftentimes “pooled investments” registered outside of the United States encompassing mutual funds, non-US pension plans, hedge funds, and insurance products.’’
Why PFIC Taxation?
The Tax Reform Act of 1986 introduced the PFIC tax regime to create a fairer investment environment for U.S. mutual funds and their foreign counterparts.
Before this legislation, U.S.-based mutual funds had to distribute all their investment income to investors, making it immediately taxable. On the other hand, foreign mutual funds could shelter their income, deferring U.S. taxes until the income was distributed to American investors.
The Tax Reform Act of 1986 changed this dynamic by imposing stricter tax rules on PFICs, effectively eliminating the tax deferral advantage that foreign mutual funds had enjoyed. This legislation made it financially burdensome for U.S. investors to delay income distribution from foreign mutual funds, thereby leveling the playing field between domestic and foreign investment funds.
Tax Rates for PFIC Investments
Calculating the tax rates for PFICs is quite complex. The default Section 1291 taxes the income at the highest tax bracket rate, plus an interest charge.
- All income distributions deemed excess are taxed at the highest tax bracket rate.
- The capital gain tax rate does not apply. Instead, all gains are taxed at the highest tax bracket rate unless a timely election is made (mark-to-market or QEF election).
- Deferred gains get an interest charge for the period that gains are held in the PFIC.
PFIC Reporting
Report PFICs on Tax Form 8621, which details actual distributions, gains, income, and increases. The form is so complex and tedious that the IRS estimates it can take over 40 hours to complete.
Generally, the PFIC rules are anti-deferral, which helps prevent U.S. citizens from deferring foreign income and U.S. tax liability. The tax laws and guidelines involving PFICs are highly complex and strict. Unfortunately, only a few U.S. taxpayers know the additional filing requirements.
Dealing with your PFIC investment can also come at a hefty compliance cost (for accounting and record-keeping), but doing nothing is not a logical solution.
‘’The tax treatment of PFICS is extremely punitive compared to … similar investments incorporated in the U.S.”
Reporting Methods
When dealing with PFICs, you have three methods for determining the total income you’ll recognize as a result of your investment in the fund.
- Section 1291 Fund
You can also call this the “excess distribution” method, the default taxation regime. This method has two parts: an amount taxed in the current year as ordinary income and an “excess distribution amount” liable to unfavorable U.S. tax treatment.
“Excess distributions” include any capital gains from the sale of PFIC shares, distributions received in the current tax year exceeding 125% of the average distributions received during the previous three tax years, or distributions allocated to taxes and interest each year since the most recent excess distribution.
Depending on the circumstances, you must report dividends on Schedule B or as an excess distribution, and you should not report capital gains on Schedule D.
- Qualified Election Fund (QEF)
A more straightforward option for reporting is the Qualified Election Fund (QEF) method, for it treats PFIC like a U.S.-based mutual fund. This method requires the taxpayer to report a pro-rata share of the PFIC’s earnings and profits in their gross income.
One hiccup investors might encounter with the QEF election is if the PFIC fails to provide an annual information statement, this method will not be available. Many foreign financial institutions and brokerages will not concern themselves with U.S. PFIC reporting or prepare a proper information statement.
- Mark-to-Market Election
Finally, the mark-to-market accounting method taxes all PFIC gains at the marginal rate determined by the taxpayer’s income level. At the same time, a loss would be considered an ordinary income loss (to the extent of unreversed inclusions).
To qualify, the PFIC must be traded on a major international stock exchange and can only apply to the current and future tax years. With this method, you can also claim the losses attributable to your asset in one or more PFICs.
To have your PFIC taxed with this method, you must elect mark-to-market and file Form 8621, along with other required documents, with your U.S. tax return annually.
A mark-to-market election must be made in the first year of ownership on a timely filed return. Otherwise, the default Section 1291 treatment will apply.
Pro Tip: Choose the PFIC reporting method that fits your tax situation and investment strategy. Section 1291 often increases taxes due to excess distribution calculations and interest charges. The QEF method simplifies reporting but requires an annual statement from the PFIC. The mark-to-market method is only for publicly traded PFICs. Consulting a tax professional can help you navigate these complex rules and make the best choice for your financial situation.
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Penalties For Failure To File Form 8621
Fortunately, there is no explicit penalty for failure to file Form 8621. However, failing to file Form 8621 or inaccurately reporting PFICs can have serious consequences, and other penalties related to underreporting income or underreporting foreign assets may apply. Here’s what you need to know about the penalties and risks involved:
1. Frozen Statute of Limitations
One of the most significant consequences of failing to file Form 8621 is that the statute of limitations on your entire tax return remains open indefinitely. Without the required Form 8621, the IRS deems your return incomplete, and the statute of limitations the IRS has to audit the return does not begin. This means the IRS can audit your tax return at any time in the future, not just within the typical three-year window. This perpetual audit risk applies to any tax year you did not file Form 8621 as required.
2. Potential Penalties
While there is no direct monetary penalty specified for not filing Form 8621, the implications of an incomplete tax return can lead to other substantial penalties:
- Accuracy-Related Penalties. If the failure to file results in an underpayment of tax, accuracy-related penalties can apply. Typically, 20% of the underpayment is attributable to the failure to properly report PFIC income.
- Penalties Under Form 8938: Failure to file Form 8621 may also lead to penalties associated with Form 8938 (FATCA reporting). You use the form to report specified foreign financial assets. If the PFIC reporting is part of the required FATCA filing, penalties can include $10,000 for failing to file, with additional penalties for continued non-compliance, potentially reaching up to $50,000.
- Interest on Underpayments: Any underpayments of tax due to unreported PFIC income will incur interest charges, which can accumulate significantly over time
3. Criminal Implications
The IRS could initiate a criminal investigation in severe cases. This mainly occurs when there is evidence of intentional failure to report income, such as tax fraud or evasion. This is especially relevant if the underreporting involves significant amounts or if there is a pattern of non-compliance.
PFIC Pitfalls For U.S. Taxpayers
Investing in Passive Foreign Investment Companies (PFICs) can be highly disadvantageous for U.S. taxpayers, including those living abroad. The key pitfalls are:
1. High Taxes and Interest
PFIC investments can lead to substantial taxes and interest charges. When you sell a foreign mutual fund, you owe taxes and interest for the years you held the investment. These taxes are calculated at each year’s highest ordinary income tax rate. This often results in paying significantly more taxes than if the investment had been a U.S.-based product. For example, a fund that invests in the S&P 500 but organized in a foreign country will qualify as a PFIC and subject to adverse U.S. tax consequences. The U.S. counterpart of that fund organized in the U.S. may have very similar performance but would not be deemed a PFIC and qualify for regular capital gain tax treatment in the U.S.
2. Complex Tax Reporting
Handling PFICs is particularly challenging due to the severe and intricate tax rules involved. Most tax professionals and even taxpayers struggle to complete Form 8621 correctly. It requires complex calculations that often outweigh any potential savings from attempting to do it yourself.
Shareholders must maintain extensive records of all transactions, including purchases, dividends, and sales. The detailed reporting requirements and tax calculations are both burdensome and time-consuming.
3. Compliance Costs
When clients and tax preparers agree on a fixed fee, preparers may hesitate to investigate potential pooled investments. This reluctance stems from the IRS’s estimate that the record-keeping and preparation time for the complex Form 8621, required for each investment owned, is around 40 hours per mutual fund per year. This process is neither simple nor inexpensive.
You must file Form 8621 annually for each PFIC investment, such as each mutual fund. While elections are available to reduce the severity of taxes, they do not lessen the compliance costs. The ongoing need for detailed record-keeping, frequent calculations, and professional assistance to navigate the intricate tax rules results in high compliance costs.
4. Limited Expertise
Many American expats own foreign mutual funds and often hire tax specialists for expat tax preparation. However, having an expat tax specialist doesn’t guarantee correct PFIC-related filings and tax payments. There are only a few experts in expat tax returns, and even fewer have expertise in PFIC reporting and taxation, including Form 8621. Tax Samaritan is one firm with substantial expertise in this area.
At Tax Samaritan, we frequently see taxpayers unintentionally overlook disclosing their pooled investment holdings, and tax professionals often don’t ask or inquire further about them.
In summary, U.S. taxpayers are generally better off avoiding PFICs and investing through U.S.-based products due to the high taxes, interest charges, and complex and costly compliance requirements. However, if you already own and hold PFICs, consult a U.S. tax specialist, such as Tax Samaritan. They can carefully navigate and determine the best strategy, given your circumstances.
‘’PFICs almost always result in a costly mess for U.S. taxpayers.’’
Wrapping It Up
If you’re investing outside the U.S. or considering foreign investments, make sure that you understand the U.S. tax implications. This will help to reduce unnecessary interest and income tax. Remember that the tax rules for U.S. expats are complex and can be confusing. Check with a tax professional to ensure you’re always on top of your tax obligations.
Tax Samaritan aims to provide our clients with the best counsel, advocacy, and personal service. We are not only expat tax preparation and representation experts but strive to become valued business partners. Tax Samaritan understands our clients’ unique needs; every tax situation requires a personal approach to providing realistic and effective solutions.