PFICs and Form 8621: Expat Tax Implications

By ZM Ishmurzina

United States citizens and residents both need to understand the tax implications of having an investment in a foreign financial institution that includes foreign mutual funds. Knowing what a Passive Foreign Investment Company (PFIC) and Form 8621 could save you time and money later on.

FATCA, PFIC, Form 8621 and US Expat tax problems

The financial life of a US taxpayer changed dramatically with the passage of the Foreign Account Tax Compliance Act (FACTA). This has brought on a new protocol of heightened enforcement of US tax laws and reporting of investments to those living and/or investing outside of the states. This is making it increasingly difficult, if not impossible, for any US taxpayer to be ignorant of their filing requirements, including those pertaining to PFICs.

What is often most confusing for those involved in foreign investing is that there is a distinct difference between the reporting and taxation of foreign mutual funds compared to those which are based in the United States.

Foreign financial advisors usually offer foreign mutual funds as a favorable tax-free investment since earnings are reinvested. There are countless stories told by taxpayers about investments made in offshore mutual funds where they were lured in by a promise of tax-free earnings until the profits are repatriated to the United States. These supposed deals are usually offered in the form of an insurance policy or retirement account, and each year, US citizens and residents fall for that same pitch.

The advice provided by these foreign investment advisors is correct, however, they are not aware of US tax issues faced by US persons that own PFICs. No matter where the money is invested, or where the taxpayer lives, US tax codes will apply.

When compared with the taxation of US based mutual funds, the tax treatment of PFICs is extremely punitive. It is not uncommon to find that after the taxes and interest has been applied, any gain has been devastatingly impacted. 

What is a PFIC?

For years the Internal Revenue Service (IRS) has been making it clear that investments made in foreign mutual funds and other types of entities could be subject to US income taxation as an investment in a PFIC.

PFICs stands for Passive Foreign Investment Companies. A PFIC is defined as being any corporation organized under the laws of a non- US jurisdiction, which can satisfy either an income or asset test.

  • An income test is satisfied when at least 75% of the foreign corporation’s gross income is passive income.
  • An asset test is satisfied if at least half of the foreign corporation’s assets either produce or are held to produce passive income.

The IRS characterizes passive income as being income which is earned through dividends, interest, royalties, rents, annuities, capital gains from the sale or exchange of property, foreign currency gains and other types of investment products.

It is not uncommon for a US taxpayer to assume that the term PFIC does not apply to them when it is first encountered or that they do not have any of these types of investments. This is due to a misunderstanding of what a PFIC is. For the naïve taxpayer living abroad, this assumption could lead to grave consequences when it comes time to file their US tax documents with the IRS.

The broad definition of a PFIC is a pooled investment which is registered outside of the United States. Ownership in any foreign entity generating substantial passive earnings can be categorized  within the PFIC regime. Based on interaction with various IRS agents, it appears that if the account is traded on a public foreign exchange in shares of a foreign entity, IRS will make a statement that it is a PFIC unless the taxpayer can show otherwise

Further complicating the rules is that a PFIC definition will generally apply to investments that are held as a part of a foreign pension fund, unless the pension fund is held in a country that qualifies under the terms of a double taxation treaty with the United States, yet this is not a frequent occurrence.

Reporting of PFICs

The tax treatment of a PFIC is very complex, but yet nothing when compared the disclosure and reporting requirements found on Form 8621.

With a PFIC, the taxpayer will be subject to one of three different methods in order to determine the income amount that will be recognized as a result of investing in the fund. Two of these methods include elective options which are subject to strict rules and timing for when they can be elected. The third is the default method used if an election is not chosen. This is the most common reporting method since the majority of taxpayers are unaware of their holding of a PFIC until after the time to make an election has passed.

Qualified Electing Fund Method

The method in which most investors will find the best benefit is to treat the PFIC as a qualified electing fund (QEF). The QEF will allow the taxpayer to make a distinction between capital gain and ordinary income of the PFIC.

In order to qualify for the QEF, the PFIC must provide the taxpayer with a PFIC Annual Information Statement which makes it easy to determine the taxpayer’s pro ratio share of the PFIC’s regular income and their capital gain for the tax year.

However, it is very rare to see this election. Most foreign mutual funds even the ones that are similar to US accounts do not keep US standard accounting and tax records nor do they provide US tax information to any shareholders. This is an important requirement if you want to make the QEF election, making it nearly impossible for most investors to do so.

Mark-To-Market Election Method

If it is impossible to make the election for a QEF, a US taxpayer holding a PFIC can choose to annually treat the investment on a mark-to-market basis. The only way that this is possible is if the units owned by the investor are known as marketable stock.

The IRS code defines marketable stock as being stock which is regularly traded in a national securities exchange which is being regulated by a foreign government, such as the SEC in the United States.

Using the mark-to-market option allows a US taxpayer to include in the gross income the difference between their basis for the investment in the PFIC (the mark) and the fair market value of the investment (the market) at the end of the tax year. This is what is known as a mark-to-market gain, and can be treated as ordinary income, even when involving a gain on the sale or distribution of the investment in a PFIC.

Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, is the form required by the IRs to make both the QEF or mark-to-market elections when filing a tax return.

Excess Distribution Method or Section 1291

If no elective is chosen in the timeframe specified, the taxpayer is automatically taxed under the default method. Described in Code Section 1291, the excess distribution method is the one most commonly seen by the IRS.

The excess distribution will be deemed to have been earned ratably over the time period in which the taxpayer had an investment in the PFIC. In the event of a sale of mutual funds (disposition) any gain will be treated as having been earned ratably over the investment period also.

Unbelievably, the tax which would have been paid in those prior years will be calculated at the highest ordinary income rate and interest at the underpayment rate as determined by Code Section 6621 which deems the tax due at the conclusion of each holding year. This will result in a significantly high amount of taxes and interest. Equally troubling is the complexity involved in calculating the excess distribution tax and interest. Moreover, a US taxpayer cannot claim a loss on a disposition as a deduction or capital loss.

Compliance Issues of PFICs

Although hard to believe, the high tax rates imposed on PFICs is not the only disadvantage to an American investor. The other factor that makes PFICs undesirable is trying to comply with the IRS reporting rules that were stated above.

The ownership of a PFIC is most commonly found with US expats living abroad. Many of these special circumstance taxpayers will employ a tax professional who specializes in preparing tax documents for individuals living overseas. This does not guarantee that the correct PFIC related filings are being made or that the taxes are being paid. There are a limited number of tax professionals who specialize in expat tax returns, and even fewer that have experience in the reporting and taxation of PFICs and Form 8621.

FATCA Reporting and PFICs

It was not until recently that the complexities revolving around PFICs and proper filing became an issue for US taxpayers who lived abroad. In the past the IRS faced a number of obstacles in enforcing their PFIC rules and regulations, and did not have the resources needed to go after filers who were not in compliance. With the passage of FATCA, information sharing and disclosing of US taxpayer holdings became mandatory, making it easier for the IRS to track these types of investments and the companies that are promoting them.

In the past, the IRS was attempting to use the Offshore Voluntary Disclosure Program to disclose PFICs that was a steep learning curve not only for US taxpayers but also for the IRS agents.

The failure to file Form 8621 or properly report a PFIC investment has hardly ever resulted in an audit or charge of tax fraud in the past. The PFIC issue was ignored for the most part, even by tax preparers. But FATCA has changed that attitude about PFICs.

As a part of the FATCA legislation, it is required that a US taxpayer report their PFICs and any other foreign held assets. Additionally, all foreign financial institutions are mandated to report on any assets held by US taxpayers to the IRS.

Some US expats may want to believe that foreign financial institutions would hedge at the idea of having to willingly comply with these reporting requirements, but industry observers predict that there is going to be a near universe compliance with these new rules by; banks, brokerages, insurance companies, mutual funds, and anything else related to the finances of American tax payers. This can be blamed on the sanctions that FATCA has put into place to compel non-compliant financial institutions to abide by the rules. Most foreign governments are actually happy to oblige the IRS, especially those with similar laws in place, in exchange for a trade of information.

As of July 1, 2014 the IRS has had a direct and easily accessible window into the various holdings of US tax payers who invest abroad. Of course the transition will take time before it is fully felt, but at some point in the near future it will become easy for the IRS to cross reference reports from these institutions with their own records to see if the FinCen Form 114, Form 8938 and Form 8621 have been filed by the taxpayer. This will then allow them to see whether or not PFIC investments have been reported and if any necessary tax has been calculated correctly and paid.

PFIC Filing Requirements

Do you meet an exception to the PFIC filing requirements?

A professional tax preparer with experience in PFICs may be able to determine that you qualify for an exception to the reporting requirement for some or even all of your investments. This determination will take some time to make, especially when there are numerous investments to consider. For example, you could qualify for exemption if:

Your holding is through a US based partnership that did not assign any portion of the PFIC excess distribution or gain to you;

The PFIC investment is held indirectly through a foreign partnership and you meet the $25,000 minimum exception for reporting;

Your holding is an indirect interest in a Section 1291 Fund and the value of that interest is no more than $5,000.

In summary, a taxpayer does not have to file Form 8621 if all of the following is true:

  • The value of all of PFICs combined is less than $25,000 on the last day of 2015,
  • A taxpayer does not have any excess distribution income to report – from sales or distributions – for 2014, and
  • A taxpayer has not made a QEF election for the PFIC.

Time to Prepare a PFIC Form

The expected time needed to complete and file a PFIC form varies depending on each individual circumstance. The estimated burden for an individual taxpayer filing this form is approved under OMB control number 1545-0074 and is included in the estimates that are shown in the instructions for their individual income tax return. The estimated burden for all other taxpayers who must file this form is as follows:

  • Recordkeeping: 13 hours and 37 minutes
  • Learning about the law and/or the form: 8 hours and 38 minutes
  • Preparing and sending the form to the IRS: 9 hours and 14 minutes
  • Grand total: 31 hours and 29 minutes

It is not uncommon for us to find that the taxpayer inadvertently fails to let their tax preparer know about, and the professional fails to ask about, any possible PFIC holdings they may have.

In other situations, the taxpayer and the preparer may have negotiated a fixed fee for preparing the tax documents. In this case, a tax preparation specialist may not want to ask about any possible PFICs because of the intense work involved.

Form 8621 must be filed each year for each separate PFIC investment or mutual fund if you meet the PFIC filing requirements. This rule went into effect for tax year 2013, where before that Form 8621 only needed to be filed in the years where there was an election, distribution or disposition.

This leads to a high cost just in the filling in and filing the requisite Form 8621, especially when there are multiple PFIC investments. Plus, these high costs will incur regardless of what the investments are actually worth or how well they have performed for the taxpayer.

There are numerous complexities and necessary calculations that far outweigh any savings you might get from self-preparing.

What to do if you own PFICs?

The best advice we have to offer on the subject is to sell your foreign mutual funds. US taxpayers are in a better position if they directly invest in stock of foreign corporations that are not PFICs or to simply invest their money in US based mutual funds that also invest in foreign stocks and mutual funds. If you need help with Form 8621, expat tax professionals at Artio Partners will be happy to help.