What is It, How is It Taxed, and How is It Reported?

Before 1986, investing in foreign mutual funds was all the rage. The United States (US) wanted a way to make US-based mutual funds the preferred method of investing for US taxpayers. You see, mutual funds that were created and held in the US had an imposition of mandatory distribution which resulted in IRS taxation. Non-US-based mutual funds were allowed to defer distribution and therefore, defer tax liability, as well.

Additionally, the US had very limited resources for tracking offshore investments held by US citizens and Green Card holders. To encourage US citizens and Green Card holders to invest in US-based mutual funds rather than foreign mutual funds, the US enacted The Tax Reform Act of 1986. This legislation imposed additional reporting requirements on all PFICs and designed a tax structure that was extremely burdensome to US citizens and Green Card holders.

Due to the enactment of the Tax Reform Act of 1986, foreign investments now make your US taxes more complicated, especially when you throw foreign mutual funds in the mix. Why? Because these accounts – like British mutual funds and Unit Trusts, for example – are typically considered Passive Foreign Investment Companies and come with additional reporting requirements.

What is a PFIC?

PFIC stands for Passive Foreign Investment Company. Under US tax law, any pooled investment that is registered outside of the US would qualify as a PFIC. This includes multiple types of funds (mutual fund or ETF), life insurance policies, investment trusts and certain foreign pension investments. PFICs are taxed through a much more complex system with much stricter rules than US mutual funds or exchange traded funds.

How to Identify a PFIC?

A common question we hear is, “How do I identify a PFIC?” A key point to understand is that mutual funds from US companies with international investments (i.e. Vanguard International Index Fund/ETF) are generally not considered PFICs. If, however, you open a foreign brokerage account and invest in a mutual fund/ETF on a foreign exchange, that fund/ETF would be considered a PFIC.

You can generally tell if a foreign corporation or foreign investment fund is considered a PFIC if it meets one of the following characteristics:

  • 75% or more of its gross income for the taxable year is passive income
  • At least 50% of its assets are held to produce passive income

Passive income is income generated passively (through investment vehicles) instead of actively (income earned in exchange for goods and services). Passive income includes:

  • Dividends, interest, royalties, rents or annuities
  • Excess gains from certain asset sales or exchanges, certain commodities transactions (including futures), and foreign currency
  • Income equivalent to interest
  • Income from notional principal contracts
  • Payments in lieu of dividends

How are PFICs Taxed?

There are three ways a PFIC can be taxed: 

  • Excess distribution
  • Mark-to-Market (MTM)
  • Qualified Electing Fund (QEF)

Excess Distribution (§1291 Fund): The default taxation method is excess distribution as a §1291 Fund. If you choose this route, you’re taxed on excess distributions and realize gain on the sale or disposition of stockholdings.

Mark-to-Market (MTM): With an MTM election, your PFICs yearly increases in value are taxed as ordinary gains. At the end of the year, the marketable stock you hold is then treated like you’d sold and repurchased it at its fair market value on that last business day. The value on the last business day of the year will determine the ordinary gains and losses of the fund. Keep in mind, if you want to go this route, you need to make that election in the first year. If you don’t, your PFIC will default to being taxed as excess distribution.

Qualified Electing Fund (QEF): On a QEF election, your PFIC is taxed on your PFIC’s pro-rata share of undistributed earnings for both ordinary income and long-term capital gain. However, this method is tough to employ due to the documentation requirements associated with making the election.

What Are My PFIC Reporting Requirements if I Have Shares in a Foreign Mutual Fund?

PFIC reporting requirements and PFIC rules are complex and extremely detailed. In general, if you have shares in a foreign mutual fund, you’ll have to report it to the IRS. There are also a few reporting requirements you may have:

  • Form 8621 – Return by a Shareholder of a Passive Foreign Investment Company or a Qualified Electing Fund
  • FBAR – Foreign Bank Account Report
  • Form 8938 – FATCA reporting form

What if I Failed to File Form 8621? Is There a Penalty for Failure-to-File?

The failure to timely file a Form 8621 (or timely filing a Form 8621, but one which was incorrect or incomplete) is not subject to a financial penalty itself, but depending on the value of your foreign financial assets, may lead to a penalty under a failure to file an associated report or form (FBAR report or Form 8938), or an incomplete/incorrectly filed report, which could result in a $10,000 penalty. 

Instead of having its own financial penalty, the failure to file Form 8621 when required will ‘freeze’ the statute of limitations for the tax return to which the form should have been attached. In turn, a frozen statute of limitations for the tax return means that any unpaid tax due that year – whether from the PFIC or any other source – can always be assessed by the IRS. This only changes when three years have passed after the delinquent Form 8621 is filed.

Bottom-line, investing in foreign mutual funds can sometimes be costlier than any economic benefit you might gain. If you can, we recommend you open US-based funds. If you’re dead set on an international fund, it’s important to talk to a CPA or EA who has experience with international tax to make sure you’re handling foreign investments in the best way possibleUS expat taxes aren’t easy to start with. A CPA/EA with international tax knowledge by your side can make a difference to your wallet come tax season. 

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