Passive Foreign Investment Company Taxation
When it comes to international tax law, one of the most complicated aspects involves Passive Foreign Investment Companies (PFICs). What makes the PFIC so complicated (and unfair) is that many US taxpayers either accumulated assets abroad or otherwise invested in overseas assets — and may have unwittingly acquired a PFIC without even knowing it, with no intention of doing so. As a result, these taxpayers who may have simply purchased units in a foreign mutual fund or other foreign pooled fund are now subject to a more complex tax regime than they would have been subject to had they been domestic funds. While there are certain elections that can be made which may minimize the tax implications, usually taxpayers do not learn about the elections until later. By that time, the taxpayer is also required to make a purging/cleansing election as part of the process, which results in the same excess distributions that would have otherwise been required if no election was made. Here are some important tax tips about how Passive Foreign Investment Companies are taxed.
No Minimal Share Ownership
One very important aspect of the PFIC tax regime is that unlike other reporting requirements (such as reporting foreign corporations, for example) there is no minimum holding requirement or ownership percentage that a taxpayer must have in order to have to file the PFIC — presuming the reporting threshold values are met. In other words, even if a person had fractional ownership but that fractional ownership exceeded the reporting requirements, they would still have to report it (while there are some potential exceptions based on the minimal or reduced value of the PFIC).
Excess Distributions Tax Rate
For taxpayers who have ownership of a PFIC but did not make an election (see below), the PFIC tax calculation can be a bit complicated and overwhelming. From a baseline perspective, when a person has a PFIC, accrued income within the PFIC is not taxed until the distribution. But, when that income is distributed and there are excess distributions, then the tax rate is typically going to be the highest tax rate for each year that the investment was held except for the current year in which the taxpayer is taxed at their progressive tax rate. This often comes as an unwelcome surprise for many taxpayers who believed that they would only be subject to long-term capital gains or qualified dividend tax rates of 15% or 20%.
Timely Election vs Late Election
Most taxpayers are not aware that they even have a PFIC until several years after becoming a US person or otherwise holding the investment. Therefore, oftentimes the election that a Taxpayer makes will be a late election, which requires the cleansing/purging election as well. In a nutshell, this means that at the time the taxpayer makes the late QEF or MTM election, they will have to include an excess distribution calculation for the prior years the investment was held as a PFIC but no election was made.
QEF Election Requires Cooperation
The QEF election refers to a Qualified Electing Fund. This is the preferred election because the QEF election minimizes tax implications of the PFIC, so that the resulting taxation will not (usually) exceed much beyond what the tax liability could be if it was a US-based asset. The hardest part about making the QEF election is that it has to be made with the cooperation of the foreign financial institution since they have to provide certain information and many of these funds understandably do not want to expose themselves to the US government. In fact, some foreign funds might actually ask you to leave the fund as they do not want a US person included in the fund in order to avoid FATCA and by presenting the QEF election, you have made that fact known to the fund.
MTM Limits Allowable Losses
The mark-to-market election operates similarly to most mark-to-market elections in other areas of tax law. The increase in value can be taxable and some deductions are possible but losses are limited — and typically cannot go below the initial value of the asset. There are also limitations to carrying it forward or back.
Pension Treaty Exception
One thing to keep in mind is that many foreign pension plans contain funds such as mutual funds, ETFs, or SICAVs, which would otherwise be considered PFIC. There is a limited exception for PFIC that is contained within certain pension funds within a tax treaty country. It is important to note that there must be a tax treaty in place and it must be contained in a pension — and oftentimes what a person may consider a pension or retirement is merely just a foreign investment wrapped inside a life insurance policy that may be designed to supplement retirement, but may not qualify for preferred treatment.