Passive foreign investment company
Passive Foreign Investment Companies (PFICs) are investment vehicles classified under U.S. Code: Title 26 - Internal Revenue Code, such as mutual funds, exchange-traded funds (ETFs), and Real Estate Investment Trusts (REITs), which are not registered with the US Securities Exchange Commission (SEC). Under the U.S. Code, the term “passive foreign investment company” means any foreign corporation if—
- 75 percent or more of the gross income of such corporation for the taxable year is passive income, or
- the average percentage of assets (as determined in accordance with subsection (e)) held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50 percent.
Although the taxation on these under US law can be extremely unfavorable, and are generally described as “to be avoided at all costs,” there is flexibility in the taxation method that may prove beneficial in some circumstances.
IRS filing overview
PFICs require the submission of IRS Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund) with one's tax return, which can be an extremely time consuming task, particularly if many investments are involved (as each investment requires its own 8621 submission).
Form 8621 filing options
On form 8621 PFICs may be treated in one of three ways:
- section 1291 taxation (default);
- Mark to market election;[note 1] and
- Qualified Electing Fund (QEF) election.
If no choice is made on a timely filed (including extensions) tax return for the year that the investment is made, 1291 is valid for this and all future years. The only way to change this is to “purge” the PFIC.[note 2]
Section 1291 of the U.S. Code is the tax rule which gives the particularly unfavorable treatment. "Ordinary" distributions are taxed as dividends. Any distribution which is more than 125% of the average for the previous three years is considered an "excess" distribution, as is any gain received on the sale. Excess distributions are treated as if they were prorated over the entire holding period, and for previous years it is taxed at the maximum personal tax rate for that year, not the taxpayer's personal rate, plus interest at the normal rate on tax underpayments. Losses cannot be deducted against the excess distributions on sales with gains; they would be deducted only as regular capital losses. With the interest, more than half the gain on the sale of a long-term holding could be lost to taxes.
Mark to market
For mark to market, the investment needs to be marketable and on a qualified exchange (one that “the IRS determines has rules sufficient to ensure that the market price represents legitimate and sound fair market value.”). Presumably all major exchanges qualify. Each year the gains - whether realized or unrealized - are treated as ordinary income; losses up to the value of accumulated gains are also ordinary income (losses). Losses greater than the gains are not claimed in that tax year, but will reduce gains in future years.[note 3]
Therefore, the PFIC fundholder, in contrast to the typical mutual fund holder in SEC-registered funds held outside a tax-advantaged account, suffers two major tax disadvantages:
- ordinary vs capital gains treatment; and
- taxation each year on unrealized capital gains within the underlying fund
Each block of shares purchased at a different time needs to be accounted for and reported separately – “This becomes tedious and overwhelming when the fund reinvests dividends monthly to purchase more shares,” but for many buy and hold strategies this would not involve significant record keeping. Mark to market therefore taxes at your rate of ordinary income, rather than at the rates of capital gains and dividends (which are often, but not always, lower).
For a US citizen working and living in a high tax country (e.g., a large part of Western Europe), the higher rate of local income tax can provide sufficient tax credits to cover a large investment gain without any US taxes. This brings an additional advantage that, upon eventual return to the United States, the investment can immediately be sold with no capital gain, as the gains have already been marked to market.
Qualified Electing Fund
In many cases, a Qualified Electing Fund is the best option. From the IRS:
- A shareholder of a QEF must annually include in gross income as ordinary income its pro rata share of the ordinary earnings and as long-term capital gain its pro rata share of the net capital gain of the QEF.
- The shareholder may elect to extend the time for payment of tax on its share of the undistributed earnings of the QEF (Election B) until the QEF election is terminated.
However, you must pay interest to the IRS if you elect to extend the time for payment.
The QEF approach is basically the same as how the IRS taxes US mutual funds. In order to follow the QEF method, information similar to a mutual fund 1099 form is required. The best way is for the foreign fund to provide this information (typically in what is called a “PFIC Annual Information Statement”). Many Canadian funds do this, but so far we have not found an example of a European based fund providing the information. If the investor can gather the proper information, this would be acceptable, but perhaps difficult to accomplish in practice.
Until European funds provide these PFIC statements, Mark to Market might often be preferable for US persons resident in Europe -- especially given the differential on tax rates in many European countries.
Due to tax constraints, US citizens living abroad cannot simply invest in local funds as they would in the US, and need to find the best solution for their personal situation.
One option is to invest in local funds while electing the Mark to Market or QEF option. If this is not preferred, PFIC issues can be avoided only by investing through SEC-registered investment vehicles (which may in turn incur tax problems with the local tax authorities), or else through individual stocks and bonds.
For a discussion of how to invest using individual stocks, see the Wiki page on passively managing individual stocks.
- Taxation as a US person living abroad
- Nonresident alien taxation
- Nonresident alien with no US tax treaty & Irish ETFs
- "Mark to Market" means that a security is based on its current market value. See: Mark-to-Market accounting, from NASDAQ.com.
- A purging election is filed with IRS Form 8621-A, Return by a Shareholder Making Certain Late Elections to End Treatment as a Passive Foreign Investment Company.
- A comprehensive example is here: Form 8621 Unreserved Inclusions, Serbinski Accounting Firms Forum, Mar 08, 2014, viewed December 30, 2016.
- An unrealized gain is an increase in value of a security. It is not "real" because the security has not been sold. When the security is sold, the gain becomes "real" and is known as a realized gain. See: Unrealized capital gain/loss, from NASDAQ.com
- "U.S. Code: Title 26 - INTERNAL REVENUE CODE". Cornell University Law School. https://www.law.cornell.edu/uscode/text/26. Retrieved January 1, 2017.
- "26 U.S. Code § 1297 - Passive foreign investment company". Cornell University Law School. https://www.law.cornell.edu/uscode/text/26/1297. Retrieved January 1, 2017.
- Kuenzi, David (2016). "Why Americans Should Never Own Shares in a Non-US Mutual Fund (PFIC)". Thun Financial Advisors. https://thunfinancial.com/why-americans-should-never-ever-own-shares-in-a-non-us-incorporated-mutual-fund/., viewed 30 December 2016.
- Instructions for Form 8621 - Notices, from the IRS.
- "26 U.S. Code § 1291 - Interest on tax deferral". https://www.law.cornell.edu/uscode/text/26/1291. Retrieved January 1, 2017.
- "Instructions for Form 8621, Section 1291 Fund". IRS. https://www.irs.gov/instructions/i8621/ch01.html#d0e230. Retrieved January 1, 2017.
- "Instructions for Form 8621, Mark-to-Market Election". IRS. https://www.irs.gov/instructions/i8621/ch01.html#d0e269. Retrieved January 1, 2017.
- "Instructions for Form 8621, Qualified Electing Fund (QEF) Election". IRS. https://www.irs.gov/instructions/i8621/ch01.html#d0e199. Retrieved January 1, 2017.
- Instructions for IRS Form 8621, Distributions From and Dispositions of Stock of a Section 1291 Fund viewed January 1, 2017
- Mark-to-Market Election for PFIC Stock, wininvest.com, May 22, 2007, viewed December 30, 2016.
- Form 8621 Calculator - PFIC Mark to Market Taxation, by Form 8621 Calculator, viewed December 30, 2016.
- Instructions for Form 8621 (12/2016), Tax Consequences for Shareholders of a QEF, viewed December 30, 2016.
- Bogleheads® forum topic:
- Bogleheads® forum topic:
- Passive foreign investment company, on Wikipedia.