The nightmare of U.S. taxation of foreign investments

Beacon Financial Education aims to help people with their financial well-being and provides individuals with the information they need for financial control, stability and simplicity.

For several years now, Beacon Financial Education has been very active in informing and educating Americans and U.S. connected individuals in the Netherlands about the headache FATCA (the United States’ Foreign Account Tax Compliance Act) causes this group of expatriates through their local seminars, webinars, newsletters and articles. Especially those with a U.S. nexus are not always fully aware of what their connection with the United States entails.

In this article, BFE will explain about PFICs, Passive Foreign (read: non-U.S.) Investment Companies, the complexity of investing as an American / U.S. connected person and the draconian taxation these PFICs are subject to.

What is a PFIC?

A PFIC is a Passive Foreign Investment Company, a corporation based outside of the U.S. which meets the requirements of either the income test, or the asset test.

Income test

If 75% or more of the company’s gross income for its tax year is passive of nature (income from investments such as earned interest, dividends or capital gains), the corporation is deemed a PFIC (as defined in section 1297(b) of the Internal Revenue code).

Asset test

At least 50% of the foreign corporation’s average percentage of assets (could) produce passive income (investments which produce income in the form of earned interest, dividends or capital gains) or are held for the production of passive income such as cash or bare land.

PFICs include almost all non-U.S. based mutual funds, hedge funds, pooled investment funds, exchange traded funds (ETFs) and many insurance or retirement provision products / foreign pension plans.

So, if you’re investing your money outside the United States, chances are you have to do so with PFICs. And while you might not be taxed in the PFICs country, you need to be aware that probably is not the case in the States. After all, U.S. taxation applies to all U.S. taxpayers and with FATCA enacted, it has become impossible to avoid it (due to new self-reporting PFIC requirements, as well as the obligation of Foreign Financial Institutions (FFIs for short) to report on assets held by U.S. citizens to the IRS).

The purpose of an investment’s PFIC status

The 1986 tax reforms and the implementation of FATCA in 2010 were designed to close tax avoidance loopholes. Offshore investments with foreign financial institutions that include foreign mutual funds were brought under U.S. taxation at very high rates and with extremely complicated IRS tax rulings (laid down in Section 1291 through 1297 in the U.S. tax code), discouraging U.S. taxpayers to continue to practice this form of investing – and hence this form of tax evasion.

The reporting foreign mutual funds as compared to those based in the United States are more complex, confusing, to say the least, time-consuming and expensive, and gains are taxed at much higher, very unfavorable rates.

PFICs: A taxpayer’s nightmare

If a U.S. citizen has a distribution of income from a passive foreign investment company or a direct or indirect ownership interest in a PFIC, they are required to fill out and file Form 8621. How you will be taxed depends on the election you made.

Mark-To-Market

The first one is “Mark-To-Market” (MTM) and taxation is based on the publicly listed prices of the foreign mutual funds, if the stock is so-called “marketable stock”. However, IRS regulations are so stringent that there are only a few foreign funds that would qualify.

Qualified Electing Fund (QEF)

The second is called a QEF or “Qualified Electing Fund”. It requires extensive reporting from the PFIC: the PFIC Annual Information Statement must accurately reproduce the taxpayer’s pro rata share of the QEF’s ordinary earnings and net capital gain for the taxable year.

Complex

The Section 1291 fund is the default option and comes into effect when the shareholder does not elect to treat the PFIC as either a QEF or mark-to-market fund. Consequences? A distribution may be treated – partly or wholly – like an excess distribution (distribution on the current tax year is greater than 125% of the average distributions received in respect to such stock by the shareholders during the three preceding tax years) and will be taxed at the highest marginal individual income tax rate.

Okay, this probably already gives you a headache… right? But, in fact, the PFIC tax rulings are far more complex than above-simplified descriptions. Twenty-seven pages long complicated. Adjustments, exemptions, referrals to other rules in the tax code, consequences… not to mention the difficult wording. You’d definitely need an expert tax advisor to help you with this. Besides, you have to file a Form 8621 for each and every PFIC you’ve invested in. Filing your taxes could take a full day up to a full work week.

Offshore investing impossible for U.S. persons?

Beacon has raised awareness for U.S. expats and U.S. connected individuals about the consequences and implications of FATCA for years. After all, no one wants to risk the high penalties of not reporting offshore financial assets or risk possible bank account lockouts.

FATCA has made expat financial planning for Americans more challenging and more complicated and investing virtually impossible – or unprofitable. FATCA after all, makes PFIC reporting a prerequisite.

Avoiding investing in PFICs, therefore, seems the most logical thing to do, especially with tax reporting being so incredibly complex. However, you might already be subject to PFIC reporting without knowing it. If you – as a cross-border professional – have worked in multiple countries and made social security and / or pension payments, you may have to do PFIC reporting, as these payments may have been placed with investment companies that are deemed PFICs by the IRS.

Having a PFIC, therefore, may be hard to avoid, but it is important to minimize the number you have, and to invest in only those that are Qualified Electing Funds (QEFs). It is important that your offshore investments are compliant with U.S. tax regulations (in order to have the potential to be taxed as capital gain rather than to be considered as regular income, and taxed as such), that you get yourself a qualified quality investment manager, and that the PFIC meets the IRS’s requirements for tax reporting.

New investment options

Recently, new investment options for U.S. citizens and U.S. connected persons have become available. Options that make investing more accessible than before, options that are FATCA-proof and comply with IRS Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund) stipulations.

Whether these options are appropriate for an individual can only be determined during a consultation, in which a licensed investment advisor will go over that person’s personal financial and tax situation. But these new investment opportunities are worth considering, especially if you want to be in control of your own money and your own wealth.

Beacon Financial Education has access to a global network of financial, tax and investment advisors. You can sign up here for a free consultation with one of their preferred partners in the Netherlands.

Beacon Financial Education does not provide financial, tax or legal advice. None of the information on this site should be considered financial, tax or legal advice. You should consult your financial, tax or legal advisers for information concerning your own specific tax/legal situation.