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INVESTING IN FOREIGN MUTUAL FUNDS

May 26, 2016

By Ephraim Moss, Esq. & Joshua Ashman, CPA

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TAX PERILS OF INVESTING IN FOREIGN MUTUAL FUNDS

If you are a U.S. expat that has invested or is considering investing in foreign mutual funds, there are a number of serious U.S. tax considerations that you should take into account.  These considerations stem mainly from the characterization of most foreign mutual funds as so-called “PFICs” for U.S. tax purposes.  They also stem from the fact that with the advent of FATCA, the IRS is paying closer attention to foreign investments by U.S. persons.  In this blog, we introduce you briefly to the world of PFICs and point out some of the specific tax issues associated with PFIC status:

WHAT IS A PFIC?

Technically, a PFIC is a foreign corporation that has one of the following attributes: (i) At least 75% of its income is considered “passive” (e.g., interest, dividends, royalties), or (ii) At least 50% of its assets are passive-income producing assets.  A U.S. person that holds any interest in a PFIC, directly or indirectly, is subject to the PFIC rules.

Unbeknownst to many expats, most foreign mutual funds fall within the definition of a PFIC. This can be the case even if such funds are held through a tax-deferred savings account (e.g., U.K. individual savings accounts (“ISAs”) and Canadian tax-free savings accounts (“TFSAs”)) or a non-qualified pension and retirement account.

PFIC PUNITIVE TAX RATES

PFIC investment income resulting from a distribution from a PFIC or a sale of a PFIC interest is generally subject to highly punitive U.S. federal tax rates, namely the highest marginal tax rate that can be imposed on an individual taxpayer (regardless of whether capital gains tax rates would normally apply).  A non-deductible penalty interest charge can also compound regularly while holding an interest in a PFIC.  Losses in PFICs generally cannot be used to offset gains in non-PFIC investments.

Several elections are available to mitigate the more onerous aspects of PFIC taxation (e.g., a so-called “QEF election” or “mark-to-market” election).  Special rules apply if such elections are not made for the first year of PFIC stock ownership.

PFIC REPORTING RULES

Aside from the high taxation rates associated with PFICs, there are specific reporting rules associated with PFICs.  There is a specific form, Form 8621 for reporting your PFIC ownership interests.  A separate Form 8621 must generally be filed for each PFIC in which stock is held directly or indirectly.

Good recordkeeping is essential for properly reporting PFIC information on the Form 8621.  Performing PFIC computations for corporations and shareholders that have not been collecting the required information from the beginning can be very challenging, if not impossible, depending on the information available.

Unlike other information returns, Form 8621 does not carry a penalty for not filing the form.  However, failing to file the form does leave open the statute of limitations on all tax matters for that tax year indefinitely.  Also, with FATCA, the IRS is receiving masses of information from the foreign financial institutions about the investments of U.S. persons, which could include information about your foreign mutual fund.  A mismatch between reports can lead to an IRS audit of your entire return.

PROCEEDING WITH CAUTION

U.S. expats considering an investment in a foreign mutual fund should proceed with caution, because this type of investment is often subject to the onerous PFIC tax regime and reporting rules.  The tax perils of investing in foreign mutual funds have even caused some tax advisors to warn against such investments altogether.  We leave that ultimate decision up to your business judgment.

With the right advice from an expat tax professional, the tax burdens associated with PFIC status can be significantly mitigated and the reporting requirements can be fully satisfied.  Contact Expat Tax Professionals for tax assistance with your foreign mutual fund investments.

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