Most of American expats find the issues of FBAR and FATCA to be confusing. However, many of them do not realize the complexity of tax rules covering Passive Foreign Investment Companies (PFICs).
If you believe that this situation is not applicable to you, then read the following story.
“Mark who has been living in London since 2007 contacted us and expected that his 2011 return would be simple and straightforward. He has had several investments that generated a $50 dividend per year. After a careful review of his holdings we found that one of the investments was considered “tax free” in the UK. However, this investment was classified as PFICs or Foreign Investment Company in the USA. The failure to correctly report this investment to the IRS could result in a $10,000 penalty. We advised Mark about consequences of having PFICs in his portfolio and determined the next steps.”
We come across this type of issue on a regular basis. The problem is that most of American expats do not choose to acquire an interest in PFICs. Many US expatriates seek help of a foreign advisor who may be completely unaware of potential adverse US tax consequences. These small investors end up being penalized for this “unexpected” investment in foreign investment companies because a US taxpayer even with a 0.1% interest in PFICs has to be fully compliant per the PFIC rules.
Another important issue is that many US tax preparers have never heard about foreign investment companies. US-based mutual funds issue a 1099 form at the end of the year. However, foreign mutual funds or PFICs do not comply and they are not expected to comply with the IRS requirements. So many American expatriates are at a loss about the required steps to become compliant with the PFICs rules.
Why were PFICs (Passive Foreign Investment Companies) introduced in the first place?
The history goes back to 1986 when Congress enacted the PFICs rules. The main idea behind this tax rule was to prevent a US person who invests in passive assets through foreign investment companies from obtaining a substantial tax advantage by avoiding current taxation and converting income that would be considered ordinary income at that time into capital gain income. Today, however, the tax rate on qualified dividends and long-term capital gains is the same so there is no tax disparity between distributions taxed as qualified dividends and long-term capital gains. The PFICs rules do not serve its primary goal anymore but they definitely penalize a US person by limiting his/her investment choices.
If you need help with PFICs requirements and want to know how to avoid IRS penalties, please contact a tax professional that provides international tax services.