PFIC: Why You Probably Do Not Want To Invest Funds Outside The U.S.

There are so many great companies and investment opportunities outside the U.S. If you read the article I shared on my blog before, you would know that I am a big fan of global investment. However, when it comes down to selecting investment companies and vehicles, you probably do not want to choose the ones organized outside the U.S. Without considering any potential country-specific currency risk, inflation risk, political risk, or liquidity risk, the most significant hurdle that the U.S. investors are facing is the punitive federal income tax treatment imposed by the IRS.

For those who currently have investment accounts in other countries, you could check out my previous blog here to figure out whether you need to report it and how to report it to the government.

This week, I will help you get some basic understandings of what investments are subject to the punitive income tax treatment, how bad the tax treatment is, and what you could do to make it less bad. 

First and foremost, you need to understand the concept of a Passive Foreign Investment Company (PFIC). If the foreign investment you directly or indirectly own is a PFIC, you will be subject to a special income tax treatment, which can be a lot worse than other Non-PFIC investment's tax treatment.


What is a PFIC?

Here is the definition of a PFIC directly from instructions for Form 8621:

"A foreign corporation is a PFIC if it meets either the income or asset test described below.

1. Income test. 75% or more of the corporation's gross income for its taxable year is passive income;

2. Asset test. At least 50% of the average percentage of assets held by the foreign corporation during the taxable year are assets that produce passive income or that are held for the production of passive income."

In general, most of the foreign mutual funds, exchange-traded funds, money market funds (e.g., Yu'e Bao in China), hedge funds, private equity funds, investment trusts and even some startups fall under the definition of a PFIC.


What are the tax consequences of being a shareholder of a PFIC?

It is important to make sure that you understand how a regular U.S based investment is taxed. Ordinary dividends, interests, short-term capital gains are taxed at your individual income tax rate. Qualified dividends and long-term capital gains are taxed at a favorable long-term capital gains tax rates. You don't have to pay income taxes on your capital gains until you recognize (i.e., sell) it and the capital losses from one investment can be used to offset the capital gains from other investments. The highest federal income tax rate is 39.6%, and the highest long-term capital gains tax rate is 20% for 2017 tax year. To keep it simple, I ignored the 3.8% Net Investment Income Tax (NIIT) for our purpose in this article.

How is a PFIC taxed differently? By default, any excess distributions including all the gains you recognize upon sale will be first allocated day by day over your entire holding period and then taxed at either the highest ordinary income tax rate or your individual marginal income tax rate of each tax year based on different holding periods. Also, you are subject to the interest penalty for any taxes due during the holding period, and the capital losses cannot be used to offset capital gains from your U.S. based investments.

The definition and calculation of the "Excess distribution" are so complicated that I will not cover it here. You could find all the details from instructions for Form 8621 if you are interested.

Now, let's take a look at how bad this special tax treatment really is through a quick example.

Scenario: you invested $100,000 in a mutual fund on 01/01/2015. You held it for three years and sold it for $130,000 on 12/31/2017. There were no other interests, dividends, or capital gains distributions during your holding period. Your federal income tax rate is 35%  which also means that you are subject to the 15% long-term capital gains tax rate.

If this mutual fund is a U.S. based fund (i.e., not a PFIC), the federal income tax on the $30,000 gain would be $4,500 ( $30,000 * 15%).

If this mutual fund is a PFIC, the federal income tax plus interest on the $30,000 gain would be about $11,914 in total. And here is where this number comes from:

Firstly, you have to allocate the $30,000 gain back to your entire holding period based on how many days you held it in each tax year.  For this simple case, since you had the investment for the whole 2015, 2016, and 2017 tax year, $10,000 gain will be allocated to each year. The total federal income tax on the $30,000 gain would be $11,420 ($3,500 for 2017 tax year + $3,960 for 2016 tax year + $3,960 for 2015 tax year). Secondly, assuming you paid the taxes on 04/17/2018, you still have to pay interest on the taxes due for 2015 and 2016 tax year which is about $494 ($163 for 2016 + $331 for 2015).

The payment due to the IRS would be more than doubled for this case. And your after-tax annualized rate of return would be reduced from 7.87% to 5.69%.

In general, the longer you hold a PFIC, the more interest you need to pay under the default method. And the lower your capital gains tax rate is, it will be more beneficial for you to invest in something not subject to the PFIC rule.


Is there anything you could do to get a better tax treatment on a PFIC?

Yes, there are two elections that could possibly help you to reduce the bad impact if you are eligible. Not to make this article too complicated for you,  I will only cover some basics of the two options here.

The first election is called Mark-to-Market (MTM) election. It basically gives you an option to pay income tax on any gains including unrealized gains at your individual marginal ordinary tax rate every year. In other words, even though you don't have to pay taxes at the highest ordinary income tax rate anymore, you have to pay taxes on any hypothetical gains you haven't sold and realized yet. Also, since you would not only report but also pay taxes every year, there is no interest charge anymore. The loss is treated as ordinary loss subject to certain limitations. To qualify for the MTM election, the PFIC stock you own has to meet the definition of a "marketable stock" which you could find it on Instructions for Form 8621. For example, you probably could make this election if you own shares of a publicly traded mutual fund with daily net asset value (NAV).

The second election is called Qualified Electing Fund (QEF) election. The tax treatment for a PFIC with QEF election is similar but not the same as a comparable U.S. based investment. Unlike the default method and the MTM election, QEF election allows you take advantage of the favorable long-term capital gains tax rate with certain limitations. And any ordinary earnings would be taxed at your individual marginal income tax rate which is also subject to some limitations.  The QEF election is usually the best option in most cases. The problem is that it is also the hardest one to qualify. To make the QEF election, you must have a document called PFIC Annual Information Statement provided by the PFIC you invest in. The statement must contain certain information required explicitly by the IRS and must be signed by an authorized person of the PFIC. In general, unless a PFIC is under some of those well-known global investment firms or it is targeting to attract the U.S. investors, it probably won't provide the PFIC Annual Information Statement to you automatically or even upon request.


In summary, the punitive tax treatments on a PFIC could make a foreign investment opportunity a lot less attractive than it looks to a U.S. investor. Next time when you are considering purchasing a PFIC, besides doing due diligence on the investment itself, please also consider the tax consequences at the same time. And do not forget the time you need to spend on gathering all the information and any fees you choose to pay for some professionals' help on reporting and preparing your taxes. It could easily take hours and cost you hundreds or even thousands of dollars. Is the foreign investment still worth it after all these? Due to the complexity of investment and tax implications here, I highly recommend you consult with a qualified professional based on your specific situation.


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