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.
In practice, this definition captures nearly all funds and ETFs commonly used by investors in countries other than the US.[note 1] This makes these funds a potential tax trap for US citizens living abroad, and also for non-US citizens living temporarily in the US and other US residents.[note 2]
Although the taxation on these funds under US law can be extremely unfavorable, and is described as having the ability to "potentially consume most of the return on investment," there is flexibility in the taxation method that may be useful in some circumstances.
IRS filing overview
If you hold any PFICs you have to file IRS Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund) with your tax return. This can be an extremely time consuming task, particularly if many investments are involved, because each holding needs a separately completed copy of Form 8621.
Form 8621 filing options
Form 8621 gives you a choice of three different ways to treat PFICs:
- Section 1291 taxation or
- A mark to market election;[note 3] or
- A Qualified Electing Fund (QEF) election.
If you do not make a choice on a timely filed (including extensions) tax return for the year that you make the investment, the default treatment is Section 1291 taxation, and it is valid for this and all future years. The only way to change this is to "purge" the PFIC.[note 4]
Section 1291 taxation
Section 1291 of the US Code is the tax rule which generates particularly unfavorable treatment. It taxes "ordinary" distributions 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 your personal rate, plus interest at the normal rate on tax underpayments. You cannot deduct losses against the excess distributions on sales with gains; they would be deducted only as regular capital losses.
Because of the interest, your effective tax rate on the gain from a long-term holding could reach or even exceed 100%.
Mark to market
For mark to market, the investment needs to be marketable and on a qualified exchange.[note 5] (Presumably this includes all major stock exchanges.) Each year your gains - whether realized or unrealized - are treated as ordinary income; losses up to the value of accumulated gains are also ordinary income (losses). You cannot claim losses greater than the gains in that tax year, but they will reduce gains in future years.[note 6]
To say this another way, the value of the fund at the end of the year determines your taxable gain or loss. By simply holding the fund, you are taxed on the unrealized gain.[note 7]
Therefore, if you hold a PFIC, you suffer two major tax disadvantages in comparison with the typical mutual fund holder in SEC-registered funds held outside a tax-advantaged account:
- Ordinary income tax treatment, rather than capital gains tax treatment; and
- Tax each year on unrealized capital gains inside the fund
You need to account for and report each block of shares purchased at a different time 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 you at your rate of ordinary income, rather than at the rates of capital gains and dividends (which are often, but not always, lower).
If you live and work in a high tax country (for example, a large part of Western Europe), the higher rate of local income tax may provide enough tax credits to cover a large investment gain without any US taxes. This can sometimes give you an additional advantage: if you leave this country and return to the US, you can immediately sell this investment 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.— IRS Form 8621 Instructions
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, you need to provide information similar to a mutual fund 1099 form. The best way is for the foreign fund to produce this information (typically in what is called a "PFIC Annual Information Statement"). Many Canadian funds do this, but as of 2022 there appear to be no examples of European based funds providing this information. If you 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 if you live in in Europe -- especially given the differential on tax rates in many European countries.
Mark to market will usually also be preferable for non-US citizens living in the US, perhaps temporarily, and who still hold non-US domiciled funds from before they became US residents.
Exceptions for certain types of account
The PFIC tax rules do not apply to PFIC stocks held in a few US tax-deferred account types, primarily IRAs and 401ks. From IRS Notice 2014-28:
For example, applying the PFIC rules to a U.S. person that is treated as a shareholder of a PFIC through the U.S. person’s ownership of an individual retirement account (IRA) described in section 408(a) that owns stock of a PFIC would be inconsistent with the principle of deferred taxation provided by IRAs. Accordingly, the Treasury Department and the IRS will amend the definition of shareholder in the section 1291 regulations to provide that a U.S. person that owns stock of a PFIC through a tax exempt organization or account (as described in § 1.1298–1T(c)(1)) is not treated as a shareholder of the PFIC.— IRS Notice 2014–28
And from Form 8621 instructions:
However, a U.S. person that owns stock of a PFIC through a tax-exempt organization or account described in the list below is not treated as a shareholder of the PFIC.
- An organization or an account that is exempt from tax under section 501(a) because it is described in section 501(c), 501(d), or 401(a).
- A state college or university described in section 511(a)(2)(B).
- A plan described in section 403(b) or 457(b).
- An individual retirement plan or annuity as defined in section 7701(a)(37).
- A qualified tuition program described in section 529 or 530.
- A qualified ABLE program described in section 529A.— IRS Form 8621 Instructions
Non-US pensions covered by treaty
Additionally, PFIC tax rules do not apply to PFIC stocks held inside certain non-US pension funds, where these pension funds are covered by a US income tax treaty.[note 8][note 9] From the Federal Register:
In general, § 1.1298-1T(b)(3)(ii) exempts a United States person from section 1298(f) reporting with respect to PFIC stock that is owned by the United States person through a foreign trust that is a foreign pension fund operated principally to provide pension or retirement benefits, when, pursuant to the provisions of a U.S. income tax treaty, the income earned by the pension fund may be taxed as the income of the United States person only when, and to the extent, the income is paid to, or for the benefit of, the United States person.
The Treasury Department and the IRS have concluded that the treaty-based exception in § 1.1298-1T(b)(3)(ii) should be expanded to apply to PFICs held by United States persons through all applicable foreign pension funds (or equivalents, such as exempt pension trusts or pension schemes referred to in certain U.S. income tax treaties), regardless of their entity classification for U.S. income tax purposes.— Federal Register, 81 FR 95459
This exception is narrow. It only includes non-US pensions that are covered by treaty, but many treaties do not cover pensions. In addition, although you might be able to use some non-US accounts as effectively a retirement savings account, any non-US accounts that are not explicitly pension funds under the treaty definition are not exempt from PFIC reporting. Examples include UK Individual Savings Accounts (ISA), Canadian Tax-Free Savings Accounts (TFSA), and French Assurance-vie and Plan d'Épargne en Actions accounts.
For US citizens living abroad
Because of obstructive US tax rules, you cannot simply invest in local funds as you would in the US. You need to find the best solution for your personal situation.
One option is to invest in local funds while electing the mark to market or QEF option. Otherwise, you can only avoid PFIC problems 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.
For US residents
People who immigrate or relocate to the US often still hold funds in their previous country of residence. They may make investments into funds in those countries even after becoming US residents. Or, they may inherit or be gifted funds by friends or relatives still living in those countries. These will almost certainly be PFICs, making them subject to all of the US tax difficulties outlined above.
If this is you, your usual best course of action is to sell these holdings as soon as possible. Ideally, you should sell them well before you move to the US, or before you inherit them or receive them as a gift, to avoid all interactions with the PFIC tax rules. Otherwise, or if selling is not an option, the mark to market rules will generally be your least bad choice, because few if any funds will provide the information required for QEF.
- Taxation as a US person living abroad
- US tax pitfalls for a US person living abroad
- US tax pitfalls for a non-US person moving to the US
- Passively managing individual stocks
- Nonresident alien taxation
- Nonresident alien investors and Ireland domiciled ETFs
- ↑ Practically every non-US domiciled fund and ETF will be a US PFIC. As a quick way to tell, if it has 'UCITS' somewhere in its name, it is European domiciled and so a PFIC. Aside from reading its prospectus, KID, or fund documents, the other unambiguous way you can tell is to find its ISIN. If the first two letters are not 'US', it is almost certainly a US PFIC for tax purposes. Most UCITS funds are domiciled in either Ireland, with ISIN code 'IE', or Luxembourg, with ISIN code 'LU'.
- ↑ For example, all European UCITS funds and ETFs, issued by Vanguard, BlackRock and others and traded on major European exchanges will be US PFICs.
- ↑ "Mark to market" means that a security is based on its current market value. See: Mark-to-Market accounting, from NASDAQ.com.
- ↑ You file a purging election with IRS Form 8621-A, Return by a Shareholder Making Certain Late Elections to End Treatment as a Passive Foreign Investment Company.
- ↑ A qualified exchange is: "... (i) a national securities exchange which is registered with the Securities and Exchange Commission or the national market system established pursuant to section 11A of the Securities and Exchange Act of 1934, or (ii) any exchange or other market which the Secretary determines has rules adequate to carry out the purposes of this part." See: "26 U.S. Code § 1296 - Election of mark to market for marketable stock". Cornell Law School. Retrieved July 25, 2020.
- ↑ For a comprehensive example, see: "Form 8621 Unreversed Inclusions". Serbinski Accounting Firms Forum. March 8, 2014. Retrieved 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.
- ↑ At the time of writing, the US maintains income tax treaties with Australia, Austria, Bangladesh, Barbados, Belgium, Bulgaria, Canada, China, Cyprus, Czech Republic, Denmark, Egypt, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, India, Indonesia, Ireland, Israel, Italy, Jamaica, Japan, Kazakhstan, Latvia, Lithuania, Luxembourg, Malta, Mexico, Morocco, Netherlands, New Zealand, Norway, Pakistan, Philippines, Poland, Portugal, Romania, Russia, Slovak Republic, Slovenia, South Africa, South Korea, Spain, Sri Lanka, Sweden, Switzerland, Thailand, Trinidad & Tobago, Tunisia, Turkey, Ukraine, United Kingdom, and Venezuela.
- ↑ The US has announced its intention to terminate the tax treaty with Hungary, effective 1st Jan 2024 for dividend withholding tax. For more, see: "United States' Notification of Termination of 1979 Tax Convention with Hungary". US Treasury. July 15, 2022. Retrieved September 12, 2022..
- ↑ "U.S. Code: Title 26 - Internal Revenue Code". Cornell University Law School. Retrieved January 1, 2017.
- ↑ "26 U.S. Code § 1297 - Passive foreign investment company". Cornell University Law School. Retrieved January 1, 2017.
- ↑ "What is a PFIC?". Hodgen Law PC. Retrieved August 19, 2019.
- ↑ Healy, Roger (2022). "Americans Should Avoid Owning Shares in a Non-U.S. Mutual Fund". Creative Planning. Retrieved July 27, 2022.
- ↑ 5.0 5.1 5.2 5.3 "Instructions for Form 8621". IRS. Retrieved July 25, 2020.
- ↑ 6.0 6.1 ;"26 U.S. Code § 1291 - Interest on tax deferral". Cornell University Law School. Retrieved August 14, 2020.
- ↑ "Passive foreign investment company § Effect of PFIC status". Wikipedia. Retrieved April 8, 2019.
- ↑ "Form 8621 Calculator - PFIC Mark to Market Taxation". Form 8621 Calculator. Retrieved December 30, 2016.
- ↑ "Internal Revenue Bulletin: 2014-18". IRS. Retrieved November 26, 2020.
- ↑ "United States Income Tax Treaties - A to Z". IRS. Retrieved November 26, 2020.
- ↑ "Definitions and Reporting Requirements for Shareholders of Passive Foreign Investment Companies". US Treasury. Retrieved November 26, 2020.
- ↑ "What is the heir's basis in a PFIC inherited from a NRA?". Hodgen Law PC. Retrieved October 1, 2022.
- Bogleheads forum topic: "Wiki (?) - Investing as an expat (US citizen living abroad)"
- Passive foreign investment company, on Wikipedia.