Why IRS Taxes You Heavily on Passive Overseas Investments

Why Does IRS Tax You Heavily on Passive Overseas Investments?

Why Does IRS Tax You Heavily on Passive Overseas Investments?

PFIC refers to a ‘Passive Foreign Investment Company’. And, the reason why a PFIC is a U.S. tax trap is because a U.S. person who has ownership or interest in pooled funds (such as foreign mutual funds and ETFs) can also be subject to the harsh and expensive PFIC tax regime – even though technically, they do not own a ‘company’ per se. In other words, for many taxpayers, the primary reason they become subject to the PFIC tax regime is that they own foreign mutual funds or ETFs. Making matters worse is that, in any given year, if a taxpayer receives an excess distribution (assuming no timely election was made), they may be subject to extensive taxes and interest payments beyond what they would ordinarily pay for a long-term or short-term capital gain. Let’s take a brief look at five common examples of PFIC tax traps.

Example 1: Becoming a US Person with Foreign Funds

One of the most common PFIC scenarios for taxpayers is when they become a US person after having owned mutual funds and ETFs in a foreign country. For example, if a taxpayer owns various mutual funds and then becomes a US person, then when they become a US person, they may become subject to the PFIC tax regime even though they have not technically acquired any new foreign funds while being a US person.

Example 2: Owning UK (Stock and Shares) ISAs

When a US person previously lived or worked in the United Kingdom and acquired a stock and shares ISA, chances are they will have foreign mutual funds and ETFs in the investment account. While these types of investment accounts may be tax exempt in the UK during the growth phase, from a U.S. tax perspective, the ISA is not technically a pension fund — and therefore, there are potential income tax, reporting, and PFIC implications. 

Example 3: Canadian TFSA

Many taxpayers who are Canadian citizens and residents invest in pension funds such as RRSPs and registered investments, such as a TFSA (Tax Free Savings Account). In Canada,  a TFSA typically comprises various investments, including stocks, GICs, foreign mutual funds, and ETFs. And, while these investments in the TFSA grow tax-free under Canadian tax law, U.S. tax law does not recognize TFSA accumulated income as tax-exempt (Like it does for an RRSP or RRIF)

Example 4: Australia CommSec ETFs

Taxpayers who live and work in Australia may open various types of investment and bank accounts, including superannuation pension plans and CommSec investment accounts. Through Commsec, taxpayers can purchase foreign ETFs (which is a category of ‘pooled funds’ similar to a mutual fund). These types of investments are typically going to be categorized as PFIC under U.S. tax law

Mutual Fund Portfolios (India, Hong Kong, Taiwan, China, Singapore, and More)

Similar to how US persons acquire mutual funds and other investments through financial institutions such as Schwab, Vanguard, and Fidelity, taxpayers may also invest in similar foreign financial institutions that offer these types of investment accounts and portfolios. When the US taxpayer invests in foreign funds, the funds themselves may become subject to PFIC reporting and tax compliance. This can get very complicated for taxpayers who have an investment account with different types of investments — since not all of those investments will be treated as PFIC.

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and/or other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist Taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Late-Filing Disclosure Options

If a Taxpayer is out of compliance, there are various international offshore tax amnesty programs that they can apply to safely get into compliance. Depending on the specific facts and circumstances of the Taxpayers’ noncompliance, they can determine which program will work best for them.

*Below please find separate links to each program with extensive details about the reporting requirements and examples.

Streamlined Filing Compliance Procedures (SFCP, Non-Willful)

The Streamlined Filing Compliance Procedures is one of the most common programs used by Taxpayers who are non-willful and qualify for either the Streamlined Domestic Offshore Procedures or Streamlined Foreign Offshore Procedures.

Streamlined Domestic Offshore Procedures (SDOP, Non-Willful)

Taxpayers who are considered U.S. residents and file timely tax returns each year but fail to report foreign income and/or assets may consider the Streamlined Domestic Offshore Procedures.

Streamlined Foreign Offshore Procedures (SFOP, Non-Willful)

Taxpayers who are foreign residents may consider the Streamlined Foreign Offshore Procedures which is typically the preferred program of the two streamlined procedures. That is because under this program Taxpayers can file original returns and the 5% title 26 miscellaneous offshore penalty is waived.

Delinquent FBAR Submission Procedures (DFSP, Non-Willful/Reasonable Cause)

Taxpayers who only missed the FBAR reporting and do not have any unreported income or other international information reporting forms to file may consider the Delinquent FBAR Submission Procedures — which may include a penalty waiver.

Delinquent International Information Returns Submission Procedures (DIIRSP, Reasonable Cause)

Taxpayers who have undisclosed foreign accounts and assets beyond just the FBAR — but have no unreported income — may consider the Delinquent International Information Return Submission Procedures. Before November 2020, the IRS was more inclined to issue a penalty waiver, but since then this type of delinquency procedure submission has morphed into a reasonable cause request to waive or abate penalties.

IRS Voluntary Disclosure Procedures (VDP, Willful)

For Taxpayers who are considered willful, the IRS offers a separate program referred to as the IRS Voluntary Disclosure Program (VDP). This program is used by Taxpayers to disclose both unreported domestic and offshore assets and income (before 2018, there was a separate program that only dealt with offshore assets (OVDP), but that program merged back into the traditional voluntary disclosure program (VDP).

Quiet Disclosure

Quiet disclosure is when a Taxpayer submits information to the IRS regarding the undisclosed foreign accounts, assets, and income but they do not go through one of the approved offshore disclosure programs. This is illegal and the IRS has indicated they have every intention of investigating Taxpayers who they discover intentionally sought to file delinquent forms to avoid the penalty instead of submitting to one of the approved methods identified above.

Current Year vs. Prior Year Non-Compliance

Once a Taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, Taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for Taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting. 

*This resource may help Taxpayers seeking to hire offshore tax counsel: How to Hire an Offshore Disclosure Lawyer.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure.

Contact our firm today for assistance.