Foreign mutual funds = Passive Foreign Investment Companies (PFICs)?

We have had many clients with unreported foreign mutual funds. As a result, it is time to revisit the unfavorable topic of foreign mutual funds as  a “Passive Foreign Investment Companies” (PFICs), which is often a surprise to our clients.

U.S. persons who own foreign mutual funds can sometimes be in for an unpleasant surprise when it comes to filing their taxes. The tax treatment of overseas funds differs considerably from those of domestic funds under the Internal Revenue Code’s rules for “Passive Foreign Investment Companies” (PFICs). Passive income includes dividends, interest, gains from the disposition of stocks and securities, and gains from commodities trading. A foreign company is considered a PFIC if at least 75% of its gross income is passive income and/or if at least 50% of its assets produce passive income. Because most of the income of a mutual fund consists of items that can be defined as passive income, nearly all overseas mutual funds are PFICs. A foreign mutual fund might escape classification as a PFIC if a majority of its holdings consists of large shares of other corporations whose income would be classified as “active” and not passive income.

To avoid certain excise taxes, U.S. based mutual funds generally distribute earnings and capital gains to their shareholders. These amounts are then reported annually to the IRS on a Form 1099. Foreign investment companies are not subject to U.S. taxes or to these disclosure rules. As a result, prior to the passage of the PFIC rules as part of the Tax Reform Act of 1986, U.S. investors in overseas funds would only have taxable income when they sold their stock or received a dividend. This gave investors in overseas funds significant advantages over similarly situated investors in domestic funds. Such investors not only avoided current taxation, but income that would be defined as ordinary income if received currently also became characterized as capital gain income, and received favorable tax treatment as a result. The PFIC rules were designed to restrict the ability of U.S. persons to defer tax on income from foreign investments.

The taxation of PFICs is built on the idea of denying to United States persons – and hence capturing for the U.S. Treasury – the value of deferral of U.S. taxation on all passive investments channeled through foreign entities. The rules achieve this end in one of two ways: first, by directly taxing U.S. investors in PFICs, and second, by indirectly imposing an interest charge on the deferred distributions and gains of these investors.

U.S. investors report their PFIC holdings on Forms 8621 – Return by Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, which are filed with their annual return. A separate Form 8621 is filed for each PFIC investment required to be reported in a given year. If the aggregate value of a US shareholder’s PFIC stock is US$25,000 (US$50,000 for joint filers) or less, and if no MTM or QEF election has been made, the shareholder need not file an annual form 8621.

The PFIC tax regime includes THREE different alternative tax systems for PFIC shareholders:

(1) the excess distribution rules; Under the excess distribution rules, a US PFIC shareholder is generally taxable on receipt of an excess distribution: the total amount received in the year exceeds 125 percent of the actual average distribution to the shareholder in the preceding three years. An excess distribution includes a gain on the sale of PFIC stock. An excess distribution is taxed at the highest ordinary income tax rates for individuals, and interest is based on the allocation of the excess distribution to prior years.

(2) the qualified electing fund (QEF) rules; The QEF rules may mitigate the harsh consequences of the PFIC regime if a US PFIC shareholder timely elects to include in gross income each year his pro rata share of the PFIC’s ordinary income and capital gain; This is usually the best solution but very few mutual funds qualify as a QEF; and

(3) the mark-to-market (MTM) rules. A US PFIC shareholder may be able to elect to include MTM amounts in income and avoid the excess distribution rules. Under the MTM method, you compute tax at the end of each year on the difference between the fair market value (FMV) of the shares at the beginning of the year and the FMV at the end of the year.  The MTM election cannot be made retroactively. The deadline for making such an election is the due date, including extensions, of the electing person’s U.S. income tax return for the year.

U.S. taxpayers should be clear when purchasing foreign mutual funds given the potentially detrimental tax treatment they may face at the time of filing. Those who already own overseas funds would definitely benefit from professional counsel to determine their tax liability, which could be very high in many situations.