What Is a PFIC and How Is it Taxed and Reported in the US?
One of the most common pieces of investment advice we tend to receive is “invest in a mutual fund.” Indeed, investing in a mutual fund is one of the easiest ways to invest, and it can take some of the risk and planning out of the equation. But while investing in a mutual fund in the U.S. is usually seamless, if you are a U.S. tax resident and have invested in foreign mutual funds, things can get ugly really quickly from a taxation perspective if the investment is considered to be a passive foreign investment company, or PFIC.
A foreign company or fund is a PFIC if at least 75 percent of its gross income is income that is derived from passive investments rather than regular business activities, or if at least 50 percent of its assets are investments that produce income from interest, dividends and capital gains. It is not only foreign mutual funds that are considered PFICs, but also some non-U.S. pension plans and certain insurance-based investments.
While mutual fund reporting in the U.S. is quite straightforward, and qualified dividends and long-term capital gains are normally taxed at either 15 or 20 percent, if an investment is a PFIC, everything changes. Specifically, in this scenario, an analysis has to be performed to determine whether one has met the threshold to report the PFIC, whether there are so-called “excess distributions”, how long you have held the investment for, and so forth. The rules governing PFICs are complex and multiple exceptions exist, not to mention numerous paths one can take when reporting a PFIC on their U.S. tax return (on Form 8621). It goes without saying that taking the wrong path may result in a minefield of taxation issues.
The threshold to report your PFIC holdings on Form 8621 is if the combined balances of all PFICs are more than $25,000 on the last day of the year (this threshold is increased to $50,000 for taxpayers filing a joint tax return). However, even if the aggregate balances of all PFICs you hold did not exceed that threshold, if there were excess distributions, or if you made a gain from the sale of a PFIC, you would still have a reporting requirement for the year.
What’s more, even if you have invested in a mutual fund through an American brokerage firm such as Vanguard, the mutual fund you have invested in might still be considered a PFIC. One of the ways to check whether a fund is a PFIC is through its international securities identification number, or ISIN. If the first two letters of the ISIN are “US”, then more than likely the fund is based in the U.S. and would not be considered a PFIC. However, if the first two letters of the ISIN are “AU” (Australia) or “JP” (Japan) for instance, the fund is more than likely to be a PFIC.
There are numerous ways to report a PFIC, but the only somewhat favorable method is the qualified electing fund (QEF) status, which, if accepted, will allow the PFIC to be treated the same way as a U.S. mutual fund. In this scenario, capital gains would be taxed at the capital gains tax rate. However, the requirements for meeting QEF status are cumbersome because the fund would have to meet strict IRS reporting requirements, which most foreign funds would not be willing or able to do. If one is not able to elect QEF status, then the next most favorable (but not very favorable) method would be the mark-to-market (MTM) method, which would result in the taxpayer paying ordinary income tax on any gain in the fund during the year, even if no distribution was made to the taxpayer. If one does not elect QEF or MTM status on the PFIC, the reporting requirements are even worse – ordinary income tax at the highest rate would be payable for each year that the fund was held by the taxpayer, not to mention interest on the amounts owed.
Please note that in addition to the reporting requirements on Form 8621, if you own PFICs, you may also have an FBAR and Form 8938 reporting requirement. Therefore, if you hold foreign mutual funds or you believe you may have an investment that would be considered a PFIC, please get in touch with us today so that we can assist you with your filing obligations, not to mention help lessen your risk exposure and potential tax liability.