Why Should Americans Avoid Foreign Mutual Funds
Should Americans Avoid Foreign Mutual Funds: In general, Mutual Funds and ETF’s can be great investments — especially for those seeking to put together a “lazy portfolio” to generate passive income. Depending on which foreign country a US Person is considering investing in, that percentage can be significantly higher than a comparable investment in the United States. And, while there are many pros to investing in foreign mutual funds, for U.S. citizens and other Americans — there are several tax implications and international reporting requirements to be aware of. This is especially true, since most Foreign Mutual Funds are considered “PFIC.” The complexity will be compounded even further when the Taxpayer ends up having an excess distribution of the foreign mutual fund. The resulting tax liability may negate any tax benefits. Here are 5 tips about why Americans should avoid foreign mutual funds:
PFIC Reporting of Foreign Mutual Funds
Generally, a foreign mutual fund — as well several other types of foreign equity funds — qualify as PFIC (Passive Foreign Investment Companies). And, unlike various other reporting requirements for items such as Form 5471 — there is no minimal threshold ownership requirement for PFIC reporting — technically, even fractional ownership reporting may be necessary, depending on the value of the ownership interest. And, the Form 8621 can become very complicated in any year there is an excess distribution.
Dividend/Capital Gain Excess Distributions
Depending on how the world market is performing at any given time — in addition to whether there is any inflation hedges or other investment tools associated with the fund — there may be unequal distributions of dividends and capital gains in different years. This may inadvertently result in an excess distribution if the current year distribution exceeds more than 125% average of the three prior years (or less if it was owned for less time) — which can result in a significant tax headache.
Excess Distribution Tax Rate of Foreign Mutual Funds
The most obnoxious aspect of the excess distribution is the tax rate at which the gains are taxed — which clocks in at whatever the highest tax rate(s) are for the compliance period in which the investment was held — in addition to any interest that may have compounded overtime for each day within the compliance period that the investment was held. As you can imagine, depending on whether the value has significantly increased or not — along with the length of time of the investment and changing exchange rates — it may lead to a significant tax consequence.
Redemptions and Switch-Outs for Foreign Mutual Funds
Depending on the way that the fund is set up and whether or not it is part of a larger portfolio, it that may contain one more redemptions and switch-outs that result in distributed income. This may result in having to report this information to the IRS along with having to calculate the tax on each different transaction that resulted in a distribution.
Since the intended goal of holding a mutual fund or other equity fund is to simply let it grow overtime and/or to collect dividends, in general foreign mutual funds come with significant headaches and tax implications that Americans should be aware of before diving in to purchase or continue to hold foreign funds as part of their portfolio.
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