A mutual fund that is invested in European stocks, but incorporated in the US may be taxed at a long term capital gains rate of 15%, but if the US taxpayer buys an identical fund listed outside the US, they will find their investment may be taxed at up to 50%
The first de minimis rule applies if the aggregate value of all of the PFIC stock owned by the shareholder (directly or indirectly) does not exceed $25,000 ($50,000 for joint filers).
The second de minimis rule applies if the PFIC stock is owned indirectly by the shareholder through another PFIC and is valued at $5,000 or less.
The de minimis rules apply only if the shareholder: (i) has not made a Qualifying Electing Fund (“QEF”) election, (ii) has not received an excess distribution during the year, and (iii) does not recognize gain treated as an excess distribution during the year.
Understand PFIC and make wiser investment decisions
As a U.S. Expat working overseas, you have a wide variety of domestic and foreign investment options at your fingertips. If you are like most US Expats, you may believe: “As long as I report all of my foreign financial accounts on FBAR, it doesn’t matter where I keep my money.”
Technically speaking, that’s true; the Department of Treasury isn’t interested in taking your money or dictating the place(s) in which it can be held or invested. The IRS, on the other hand, is not only interested in your reporting foreign financial account information; it’s interested in taxing your income from foreign investment accounts at the highest possible percentage – even at a rate of up to 50%!
This article will focus on a common type of foreign investment known as PFIC (Passive Foreign Investment Corporation).
Understanding PFIC’s and how they can affect your U.S. expat tax return will help you make wiser investment decisions and save money both now and in the future.
Definition of PFIC
Before we get into the method of taxing a PFIC, let’s first take a look at what it is. A PFIC is an investment structure designed by a foreign establishment that meets one of the following qualifications:
- At least 75% of its income is generated passively. Different types of passive income include: Capital gains, dividends, interest, royalties, and a variety of other types of income for which continuous work is not required.
- At least 50% of its funds and assets are being held for the sole purpose of manufacturing passive income.
Whether you realize it or not, these conditions apply to practically all foreign investment accounts including hedge funds, money market accounts, mutual funds, pension and retirement accounts, private equity funds, and a long list of other foreign investments. Generally speaking, these non-U.S. domiciled investment products are distributed by foreign financial advisors and brokers who have zero or very limited knowledge of how the United States will be taxing your investment account as a U.S. Citizen or Green Card Holder. As such, they are unable to adequately structure your investment and payout plan to put you in as favorable of a tax position as possible with the IRS when filing your U.S. expat tax return.
History of the United States and the PFIC
Before 1986, investing in foreign mutual funds was all the rage; and the United States wanted a way to make U.S.-based mutual funds the preferred method of investing for U.S. taxpayers. You see, mutual funds that were created and held in the United States had an imposition of mandatory distribution which resulted in IRS taxation; non-U.S.-based mutual funds were allowed to defer distribution and therefore defer tax liability, as well.
Additionally, the United States at the time had very limited resources for tracking offshore investments. To encourage United States Citizens to invest in U.S.-based mutual funds rather than foreign mutual funds, the U.S. enacted The Tax Reform Act of 1986. This legislation imposed additional reporting requirements on all PFIC’s and designed a tax structure that was extremely burdensome to U.S. Citizens and Green Card Holders.
Mark-to-Market Accounting Method
With the Mark-to-Market Accounting Method, all of your PFIC gains will be taxed at the marginal tax rate determined by your income level. This applies to both realized and unrealized gains, so you won’t accumulate interest for distribution deferral. Also by using this method, you will be able to claim your losses attributable to your investment in one or more PFIC’s. This will allow you to lower your taxable income, possibly placing you in a lower marginal tax bracket.
Even though you will qualify to have your PFIC capital gains taxed at your marginal tax rate, you will still not qualify for the preferential long-term capital gains rates. Even when using the Mark-to-Market Accounting Method, PFIC capital gains are still viewed by the IRS as regular income and taxable as such.
To elect to have your PFIC taxed with the Mark-to-Market Accounting Method, you will need to elect this method with your PFIC account manager and file Form 8621, Information Return for Passive Foreign Investment Company with your U.S. expat tax return. These steps ARE NOT only taken once; in order to have this treatment on your PFIC account, you will be required to repeat these steps every year.
For most U.S. Expats, the reality is that PFIC’s are simply not as profitable investment options as those based in the United States. Even by changing the structure of your PFIC, the best tax rate you can get is your marginal tax rate for regular income. There is no tax deferral, there are no special capital gains tax rates, and you’re at a higher risk of being charged excessive interest and penalties. For some U.S. Expats in certain financial situations, it may make sense to invest in a PFIC. To see if this is an ideal investment strategy for you, compare your prospective PFIC(s) with other investment options, taking time to calculate your profit after taxes, fees, and interest.
Don’t leave your current and future financial health to chance. Remember that many of the tax rules and regulations pertaining to U.S. Expats are somewhat vague and the details aren’t clear to many U.S.-based tax advisors. Filing a U.S. expat tax return and saving as much as possible when investing in PFIC’s can be an extremely complicated process. Make sure you’re working with an international tax expert who is experienced in working with PFIC’s so you can avoid unnecessarily high fees and tax rates and get the most back from your investment portfolio.
Even if you prepared your own taxes when you lived in the US you should really consider hiring an expat tax expert while you are living abroad. Expatriate tax return is significantly more complicated than a normal U.S. tax return. We recommend Ines (IJ) Zemelman MBA, EA President and Founder. Ines (IJ) Zemelman is a renowned tax expert. She leads the team of tax advisors for Taxes for Expats.
Ms. Zemelman has over 25 years experience in international tax preparation, helping clients manage their unique tax situations that arise for U.S. citizens living abroad. Her area of specialization is resolving complex international tax issues for individuals and small business owners, such as FBAR and foreign information reporting, IRS voluntary disclosure program participation, and U.S. taxation of foreign trusts and retirement arrangements.
Ines is an Enrolled Agent and has also received an MBA in International Taxation from the Zicklin School of Business . She has lived in various European countries and is fluent in five European languages. In her spare time away from the office, she enjoys gardening and interior design.
For more information please visit Taxes for Expats.