Dealing with taxes is never easy, especially for expats who have to file their taxes in the United States while working in a different country and earning foreign currency. What’s more dreadful is when they are investing outside the U.S.
For U.S. citizens living or working abroad and investing their money through non-U.S. mutual funds, their investments are dealt differently than those who buy assets with foreign investment providers inside the U.S., and it’s not as straightforward as you think.
For U.S. residents who have foreign investments, you need to learn about Passive Foreign Investment Companies (PFIC), which will subject you to complicated filing requirements and tax obligations. Have a look at the infographic below for a top-to-bottom rundown on what PFIC is, its reporting methods, and the common pitfalls. Let’s get started.
An In-Depth Look into PFIC
The Internal Revenue Service (IRS) developed a detailed deferral regime for things that involve foreign passive income. Special corresponding tax rules apply for expats who purchase ownership units or interest in a Passive Investment Company.
Normally, the U.S. taxes investment income favorably if derived from long-term capital gains or qualified dividends, but with PFICs, it requires a thorough analysis to determine the excess distributions and how long the taxpayer has held onto the investment. It is not a simple proposition to determine the tax impact, which can be significant.
Non-U.S.-based funds are classified as passive foreign investment companies. Because of that, income from these investments are subject to strict and complex tax regulations by the IRS. To better understand the basics, here’s a rundown on the PFIC acronym:
- Passive – Pertains to investment income (like dividends) vs. earned income (employment)
- Foreign – The company is organized outside the U.S.
- Investment – The foreign company generates investment income
- Company – The ownership is an entity, thus, qualifying as a PFIC
American citizens who bought shares of a PFIC will not be taxed until there is a distribution or shares are sold. If a foreign investment company meets either of the following tests, PFIC rules shall apply.
- PFIC Income Test: 75% or more of the corporation’s gross income is passive, including interest, dividends, capital gains, etc.
- PFIC Asset Test: 50% or more of the corporation’s total assets generate passive income, including investments that produce interest, dividends, and capital gains.
PFICs are reported on Tax Form 8621, where actual distribution and gains, income, and increases are reported. The form is so complex and tedious that the IRS estimates it can take over 40 hours to accomplish.
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 complicated and strict. Unfortunately, not many U.S. taxpayers are aware of 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.
Tax Rates for PFIC Investments
Calculating the tax rates for PFICs is quite convoluted. In essence, the income will be taxed at the highest tax bracket rate, plus an interest charge.
- All income distributions are taxed at the highest tax bracket rate.
- The capital gain tax rate does not apply. Rather, 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 whole period that gains are held in the PFIC.
PFIC Reporting Methods
When dealing with PFICs, you have three methods to determine the total income you’ll recognize as a result of investment in the fund.
Section 1291 Fund
This is also called the “excess distribution” method and is the default taxation regime. This method is divided into two parts: an amount taxed in the current year as ordinary income and an “excess distribution amount” that is liable to unfavorable U.S. tax treatment.
The “excess distributions” are either any capital gains acquired from the sale of PFIC shares, distribution received in the current tax year that is more than 125% of the average distributions received during the three prior tax years, or distributions gained from allocation or taxes and interest each year since the most recent excess distribution.
Qualified Election Fund (QEF)
A simpler 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.
Finally, the mark-to-market accounting method is where all the PFIC gains are taxed 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 will also be able to claim your losses attributable to your asset in one or more PFICs.
To have your PFIC taxed with this method, you’ll need to elect mark-to-market and file Form 8621, along with other required documents, with your U.S. tax return annually.
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 different and vague, so you must check with a tax professional to ensure that you’re always on top of your tax obligations.
Are you searching for tax professional services to help you with your taxes as a U.S. citizen living or working abroad? Tax Samaritan offers outstanding tax services for expats that will assist you from filing tax returns to dealing with your PFIC issues and concerns.