Buyer Beware: Expats with Non-US Investments Face PFIC Taxation and Form 8621 Reporting
As any financial advisor will tell you, investing for your future is an important financial consideration for you and your family.
What your advisor might fail to mention is the fact that for U.S. expats, investing in certain non-U.S. funds may trigger very harsh “PFIC” tax and reporting rules.
In this blog, we briefly review the rules of PFIC taxation with an emphasis on the reporting required on IRS Form 8621.
PFICs – A Background
One of the hallmarks of the U.S. tax system is its complex set of “anti-deferral” rules. These rules are designed to prevent U.S. taxpayers from deferring or delaying tax on income or earnings by shifting the income or earnings to foreign companies.
One of the more far-reaching anti-deferral tax regimes is the passive foreign investment company (PFIC) regimes.
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. In practice, a number of foreign investment products are classified as PFICs for U.S. federal tax purposes.
Most foreign mutual funds, for instance, fall within the definition of a PFIC. This can be the case even if such funds are held through a tax-deferred savings account (for instance, individual savings accounts (“ISAs”) for U.S. expats in the UK, tax-free savings accounts (“TFSAs”) for U.S. expats in Canada) or a non-qualified pension and retirement account.
For U.S. expats, it is important to understand that the treatment of non-U.S. investments by your country of residence may differ dramatically from the U.S. treatment because of the PFIC regime.
Taxation of PFICs
PFIC taxation is triggered in two basic scenarios: (i) investment income resulting from a distribution from a PFIC, or (ii) a sale of a PFIC interest.
Either transaction triggers tax in the hands of the U.S. investor at the highest marginal tax rate (regardless of whether a lower rate would otherwise apply). On top of this, the IRS charges interest that compounds regularly in order to compensate the IRS, so to speak, for the time value of the cash taxes that were deferred when the PFIC generated earnings that were not immediately taxed in the U.S.
Two main elections can be made to mitigate the above the default PFIC tax rules:
- A “QEF election” – the individual is required to include each year in gross income the pro rata share of earnings of the QEF and include as long-term capital gain the pro rata share of net capital gain of the QEF.
- A “mark-to-market” election – the individual is required to include each year as ordinary income, the excess of the fair market value of the PFIC stock as of the close of the tax year over its adjusted basis in the shareholder´s books.
In order to make a QEF election, a shareholder must have received a PFIC Annual Information Statement from the PFIC. Often times, investors are not provided such a statement from the PFIC, so the QEF election is not available.
The mark-to-market election is generally available only with respect to marketable (i.e., traded) securities. However, since many PFIC investments consist of marketable securities, the mark-to-market election is the far more accessible election for the typical U.S. expat investor.
PFIC Reporting and Form 8621
Yes, the PFIC tax rules are complex, but perhaps even more daunting are the reporting requirements on IRS Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund).
Generally, a U.S. person that is a direct or indirect shareholder of a PFIC must file Form 8621 for each tax year under the following five circumstances - if the U.S. person:
- Receives certain direct or indirect distributions from a PFIC;
- Recognizes gain on a direct or indirect disposition (e.g., a sale) of PFIC stock;
- Is reporting information with respect to a QEF or mark-to-market election;
- Is making an election reportable in Part II of the form; or
- Is otherwise required to file an annual report pursuant to section 1298(f).
A separate Form 8621 must generally be filed for each PFIC in which stock is held directly or indirectly. Duplicative reporting may be avoided under certain circumstances.
Information Required on Form 8621
Form 8621 demands quite a lot of information from taxpayers. The types of information requested include the following:
- Description of the PFIC shares (amount, value, etc.)
- Elections made with respect to the PFIC shares
- Income from a QEF, if applicable
- Gain (or loss) from a mark-to-market election, if applicable
- Distributions from or dispositions of a non-electing PFIC, if applicable
Gathering financial documents related to your PFIC interests as early as possible is key to having the information you need to accurately file the form.
Exceptions to PFIC Reporting on Form 8621
Fortunately for US expats, there are several notable and relevant exceptions to PFIC reporting.
For instance, a U.S. owner of a PFIC interest is not required to file the Form 8621 if:
(i) the shareholder has not made a QEF or mark-to-market election,
(ii) is not treated as receiving an excess distribution or recognizing gain treated as such during the shareholder’s tax year, and
(iii) either (A) the aggregate value of all PFIC stock owned at year-end does not exceed $25,000 ($50,000 for a joint return), or (B) the PFIC stock is owned through another PFIC, and the shareholder’s proportionate share of the upper-tier PFIC’s interest in the lower-tier PFIC does not exceed $5,000 in value.
A further exception applies in the case of a PFIC held by a foreign pension fund when, pursuant to a tax treaty, the income earned by the pension fund may be taxed as the income of the U.S. person only upon a distribution to the U.S. person.
The Form 8621 Due Date
Form 8621 must be attached to the shareholder's tax return and filed by the due date, including extensions, of the return.
For expats, this normally means June 15, but in response to the coronavirus pandemic, the IRS has announced a special automatic extension to July 15, 2020 for the filing of the U.S. tax return and attachments this year. As in most years, taxpayers can request an extension to October 15 if needed.
Interestingly, unlike most other information returns, Form 8621 does not carry a specific 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, so filing Form 8621 is essential for U.S. owners of PFICs.