Last week the U.S. Justice Department asked a federal district court in San Francisco to…
Watch Out for PFIC Status
If you invest internationally a Passive Foreign Investment Company (PFIC) could be a nightmare that could become a reality if you happen to invest in what the IRS deems a PFIC, which are taxed at exorbitant rates and have highly complex reporting rules. Most foreign mutual funds are PFICs, as are certain foreign stocks.
It is not illegal to invest in a PFIC, but practically speaking, the costs of doing it are so incredibly onerous that it’s prohibitively expensive in the vast majority of cases.
What Is a PFIC Investment?
If a foreign corporation or investment vehicle meets either of the two conditions below, it will be deemed to be a PFIC.
1) If passive income accounts for 75% or more of gross income (passive income includes income from interest, dividends, annuities, and certain rents and royalties) or
2) 50% or more of its assets are assets that produce passive income.
If you own a foreign mutual fund it probably (and unfortunately) qualifies as a PFIC. An offshore investment entity that makes an election (which is rare) to be classified as a disregarded entity or a partnership is not a PFIC.
What Are the Implications of the PFIC Rules?
The consequences of owning a PFIC are severe. The IRS estimates it takes up to 30 hours of tax preparation time to complete Form 8621, which needs to be filed for each PFIC every year. As a result, the benefit of holding a PFIC often outweighs even the cost of reporting it.
Aside from the aforementioned complexity, unless a PFIC investor makes one of the elections explained below, he suffers the following punitive tax rates and special rules:
- For any year in which you receive a dividend or sell any PFIC shares, you face a complex calculation that involves prorating the PFIC’s return over your entire holding period and applying an interest charge.
- Most capital gains are taxed at a top federal rate of 20%, plus the Obamacare surcharge of 3.8%, for a total of 23.8%, which is favorable compared to the top ordinary federal income tax rate of 39.6%. Capital gains in PFICs, however, are effectively taxed at the highest ordinary income rate plus the interest charge mentioned above. The tax and interest due can eat up 70% or more of your gain.
- A capital loss on a PFIC cannot be used to offset capital gains on other investments.
Due to the Foreign Account Tax Compliance Act (FATCA), which forces every single financial institution to submit information on their American clients to the IRS, PFIC rules will be enforced.
Fortunately, there are a few solutions out of PFIC status:
- First, if the PFIC meets certain accounting and reporting requirements (which is rare), the US investor can elect to treat the PFIC as a Qualified Electing Fund (QEF), which eliminates the punitive tax rates.
- Second, generally speaking, there is an exemption from PFIC reporting if PFIC holdings do not exceed $25,000 ($50,000 for married couples filing jointly).
- Third, if you hold a PFIC through an IRA or other certain retirement accounts, you may be exempt from Form 8621 filing requirements.
With the complexity and unfavorable tax rates that come with them, it is clearly better to avoid owning PFICs when investing offshore.