Many British expatriates living in America have Passive Foreign Investment Companies (PFICs). In this blog, we will limit our discussion to collective investments, such as mutual funds, ETFs, investment trusts, REITs, etc. There are other forms of investment, such as stocks, bonds, and directly owned real estate, but these are not addressed here.
About US-based Investments
A US-based investment is a mutual fund or ETF that is registered and regulated in the US. A US-based investment can invest in domestic stocks, international stocks, etc. – the investment allocation is unrelated to whether it is US-based. A non-US-based investment refers to a mutual fund or ETF that is not registered and regulated in the US, for example, an S&P 500 index fund that is registered and regulated in the European Union (EU).
About Passive Foreign Investment Companies (PFICs)
It’s common for expats to own Non-US Investments (PFICs) and it’s usually a problem.
Many people relocate to the US with existing collective investments, and many acquire them later on. For example, you inherit a GBP investment account and leave it as is because the exchange rate isn’t attractive.
In most cases, the US views non-US collective investment funds unfavourably. Although they may seem mainstream and benign, those collective investments are usually categorised by the US as Passive Foreign Investment Companies (PFICs).
Furthermore, many wrappers (a wrapper = account type like a pension, ISA, endowment, insurance bond, etc.) will not provide any protection from tax treatment as a PFIC.
A very common example of this is the investment ISA. In the UK an ISA wrapper provides a level of tax protection, but the US does not recognize an ISA and, as far as we are aware, there is nothing in the US:UK Tax Treaty that protects that favourable tax treatment of ISAs. Instead, the US looks straight through the ISA wrapper to the underlying PFIC holdings. As a result, your ISA transforms from a highly tax advantageous wrapper in the UK to punitively taxed investments in the US that, furthermore, are costly to report.
PFIC Tax & Reporting
**This is an oversimplified explanation. Do not rely on it to calculate your PFIC liabilities. Please see the “Further Resources” links for more detailed explanations and examples**
Unless certain steps have been taken, most PFIC distributions will be considered “Excess Distributions” and will suffer punitive tax, interest, and reporting requirements in the US. A distribution represents the earnings of a fund being passed on to the individual investor.
At the US federal level, the tax rate applied to most dividend distributions and capital gains upon sale is the top rate of income tax during the holding period. Not capital gains tax and not qualified dividend tax, which are much lower, and, other than the slice attributable to the current tax year, not a taxpayer’s marginal income tax rate, but the highest income tax rate in each tax year an excess distribution is deemed to apply. That’s currently 37%, regardless of what your personal top marginal rate of tax is.
But it gets worse. The US taxes income (dividends/coupons) and capital gains (e.g from disposals made with funds) as they arise on an annual basis. If an investor in a non-US investment was accumulating income and gains and not paying tax, then the US thinks it has lost out. To reclaim this “loss” they will apply interest to the tax on your gain for each year other than the current year, which isn’t considered “late”.
They slice up your gain by the holding period and apply interest to the taxes due on each slice. For example, if you hold a UK mutual fund for 10 years and make a $100k gain. This gain will be sliced into ten slices of $10k each. Then the taxes due on each slice will have interest applied for 9 years, 8 years, 7 years, etc respectively.
It is more complicated than this and you should visit the Golding Lawyers page for a more detailed example.
This can get very expensive. We have encountered US persons holding PFIC portfolios from the 1980s. When they finally address this, practically all the gains will be taxed federally at the highest income tax rate available in each year plus interest, which on holding periods of 30+ years is going to be substantial. And there is no benefit in waiting, as this interest just builds up each year (not to mention the jeopardy that you’re in from a tax compliance perspective).
Finally, there are the reporting requirements in the US. Taxpayers must file form 8621 for each PFIC each year. One ISA that holds 10 funds requires ten 8621s every year.
There are “elections” that the manager or investor of Non-US Investments (PFICs) can make, such that the investments are taxed in a more friendly way for US persons and the taxpayer can avoid interest charges. The most tax advantageous is known as the QEF election, but these are rare and require the PFIC’s cooperation, which is very unlikely.
The mark-to-market election by the shareholder/taxpayer is more easily available. However, less tax advantageous (earnings – including unrealised earnings – are still taxed as ordinary income, but no interest is charged) and it needs to be “timely” (i.e. actively selected in the first year of ownership or first year of becoming a US person for tax purposes).
The vast majority of investors we encounter holding PFICs have not participated in either election sited above, so we are not going to spend any time discussing them here. If you are holding an international collective investment, such as a GBP mutual fund, OIEC, or ETF, you should probably assume it is a PFIC and you should start working with a cross-border tax adviser immediately to address them
Passive Foreign Investment Companies (PFICs) and Pensions
Most non-US pensions hold PFICs. They are usually denominated in a different currency (i.e. a UK pension is likely invested in GBP investments) and may only offer non-US investments.
If the foreign country has a tax treaty with the US, then the foreign pensions may be recognised as qualified pensions and therefore entitled to favourable tax treatment in the US. In such cases, many tax advisers take the position that PFICs are acceptable investments. Essentially, the US will not “look through” the pension wrapper and tax the PFICs and will not require the 8621 form for each one. The taxation is based on the wrapper, not on the underlying investments, meaning that PFICs can be held in qualified pensions without repercussions. However, there are dissenting opinions on this.
Additionally, not all countries have tax treaties with the US and not all tax treaties address all foreign pensions. You may have a pension in one country, but the US does not consider it a pension, and those investments are caught in the PFIC net.
A Warning to US Citizens
In general, absent a difficult to obtain QEF election or timely mark-to-market election, US taxpayers living in or outside the US, should avoid PFICs in anything except a pension. Even then be sure it qualifies for treatment as a pension in the US and that PFICs will hopefully be protected by the pension “wrapper”. If you own PFICs, address it ASAP. Waiting makes it worse. Don’t try and hide it because 1. It’s illegal and 2. They probably know already (FATCA reporting – your non-US financial institution is probably feeding all this data back to the US). It may cost you to tidy this up, but it will be nothing compared to being audited by the IRS.
As always, consult a cross border tax professional, preferably one with specific knowledge and experience in the country where your non-US assets are located.
Plan First Wealth LLC is a Registered Investment Adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Plan First Wealth does not provide any tax and/or legal advice and strongly recommends that Clients seek their own advice in these areas.