The Tax Implications of Foreign Passive Investments

The Tax Implications of Foreign Passive Investments

PFIC Tax Implications

Over the past several years, there has been a significant increase in the number of US Taxpayers who have elected to invest in pooled funds such as U.S. mutual funds, ETFs, and other passive investments (instead of individual stocks and bonds) and this extends to foreign investments as well. For US tax purposes, one of the biggest drawbacks for Taxpayers investing in foreign pooled funds is that oftentimes the investments are considered to be PFIC (Passive Foreign Investment Companies) — and potentially subject to an incredibly harsh tax liability. But, just because the US may invoke the PFIC tax rules on foreign investment funds does not mean the foreign investment is not worthwhile. Likewise, just because a Taxpayer may have already invested in foreign pooled funds does not mean the Taxpayer should run out and dump their current funds either. Let’s take a brief look at some of the basics when buying and selling foreign pooled funds.

Acquiring a Foreign Mutual Fund 

Taxpayers must report foreign investment funds on various international reporting forms such as the FBAR, when the threshold requirements are met. And, depending on whether the funds are in an account or whether they are being held individually can impact the extent of the reporting. In addition, Taxpayers may also have to file several Form 8621s each year — depending on the value of the funds and whether or not there are any excess distributions in the year. Form 8621 can be daunting, as it requires a Taxpayer to report each fund individually, which can become a very overwhelming situation when the Taxpayer has a very large portfolio of foreign funds.  There are various exceptions, exclusions, and limitations to be aware of as well, and these may reduce or eliminate the reporting in a given year.

Making a PFIC Election

In order to minimize the tax implications of having a PFIC, the US government developed various elections that a Taxpayer may make. The two main elections are the Mark-to-Market (MTM) election and the Qualified Electing Fund (QEF) election. Of the two different elections, the QEF election typically results in a better tax outcome for the US person, but it does require some cooperation from the Foreign Financial Institution. Unfortunately, many Foreign Financial Institutions are not in the business of wanting to provide US Taxpayers with the financial information necessary for them to make the QEF election. In fact, even just asking them for the information may put you on their naughty list, since many foreign investment companies do not want to deal with the headache of having a US person investor (thank you, FATCA).

Timely Election vs Late Election

It is important to try to make a timely election, which generally means in the first year of the investment. If the Taxpayer did not make an initial timely election, they may have different options available to them to make a subsequent election. When a Taxpayer wants to make a retroactive election by showing ‘reasonable cause’ there are rigorous requirements for doing so — and it is very difficult to qualify for reasonable cause when it comes to this type of PFIC election. Alternatively, Taxpayers may be able to make a late election, but this also requires them to make a purging election – which may result in a large tax liability under the excess distribution tax regime.

Dividend Reinvestment vs Dividend Distribution

When a Taxpayer invests in foreign pooled funds, it is very important to determine from the outset whether the Taxpayer will be receiving distributions that are being immediately reinvested or if they are first being distributed out of the fund. If the funds are being reinvested, the Taxpayer may be able to circumvent the excess distribution rules depending on how the distributions are being reinvested. If they are being distributed to the Taxpayer first, who must then the funds back in for reinvestment, that may pose a significant tax problem.

Are Dividends Distributed from the Outset

Another important aspect of dividends from foreign mutual funds or other pooled funds is whether the Taxpayer will receive distributions in the initial year of the investment or whether those distributions will begin in a later year. If they begin in the early years — and remain relatively constant — then Taxpayers may be able to sidestep any dividend excess distribution issues. Conversely, if the Taxpayer goes several years without receiving any distribution and then begins to receive large distributions, they may have a significant excess distribution tax, at least in the first few years.

Selling/Redeeming the PFIC

When s Taxpayer sells a PFIC, chances are they will have an excess distribution. With excess distributions, taxpayers do not get taxed at the long-term capital gains rate of 15% or 20%. Rather, the Taxpayer must pay tax at the highest tax rate available at the time, in addition to interest for the time that the investment was sitting in the fund but not distributing any income. 

Switch-Outs and Mirror Funds

There are also several other issues US Taxpayers may have to contend with involving foreign pooled fund investments, such as fund switch-outs. Likewise, not all pooled funds are necessarily PFIC. For example, sometimes a mirror fund may not qualify as PFIC, and something to consider at the time of filing (common with foreign insurance companies).

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