Imagine this: You’re living and working in Germany as a U.S expat and decide you want to diversify your investment portfolio by investing in foreign mutual funds. You discuss your intentions with a friend and fellow expat while grabbing drinks in a biergarten after work and they mention that you should take care to avoid triggering PFIC filing. What is a PFIC? You ask, bracing yourself.
They pause. I’m not sure exactly, but I think you get taxed more if you invest in foreign funds? Something like that. I do remember that "PFIC" stands for Passive Foreign Investment Company!
You grimace, because now you have research to do.
Note: Although the example refers to a U.S. expat in Germany, PFIC and foreign mutual fund reporting requirements apply to all U.S. expats!
Setting the Stage
Navigating the financial landscape as an American expat living in Europe comes with a unique set of challenges, particularly when it comes to understanding and complying with U.S. tax obligations.
For U.S. citizens and green card holders, one crucial aspect is the requirement to file a U.S. tax return regardless of where they reside. This retirement is due to the United States' citizenship-based taxation regime, which requires citizens and certain other US-connected persons to file an annual tax return regardless of where they live. This obligation significantly impacts long-term investment strategies, especially concerning Passive Foreign Investment Companies (PFICs).
Fortunately, we know a thing or two about navigating this tricky reporting requirement!
The following guide provides a detailed overview of PFICs (reported on IRS Form 8621), highlighting their implications and offering strategies for American expats to navigate these complexities efficiently.
Understanding Passive Foreign Investment Companies (PFICs)
As an investor, you’re likely familiar with the concepts of mutual funds, index funds, and exchange-traded funds (ETFs). However, the taxation and reporting rules that govern a PFIC are considerably stricter and more complex.
A Passive Foreign Investment Company (PFIC) is a non-U.S. investment entity that meets specific criteria under U.S. tax law. The PFIC rules aim to prevent U.S. taxpayers from avoiding taxes by investing in foreign entities. PFICs include various investment funds and certain types of pension investments located outside the United States.
What is a PFIC for U.S. Tax Purposes?
An investment is classified as a PFIC if it meets at least one of the following tests:
- Income Test: If 75% or more of the foreign corporation’s gross income is passive income (such as dividends, interest, royalties, annuities, and rental income), it qualifies as a PFIC.
- Asset Test: If 50% or more of the foreign corporation’s assets generate or are held for the production of passive income, the company is a PFIC.
These tests are applied annually, meaning an investment could qualify as a PFIC one year and not the next based on its income and assets.
What is a PFIC example?
Common examples of PFICs that American expats might encounter broadly speaking include:
- Foreign Mutual Funds: Investment funds registered outside the U.S.
- Foreign Exchange-Traded Funds (ETFs): ETFs listed on foreign stock exchanges.
- Foreign Real Estate Investment Trusts (REITs): Companies investing in real estate outside the U.S.
It's important to note that individual shares in foreign companies do not qualify as PFICs. Only pooled investments are classified as PFICs.
Identifying a PFIC Using ISIN
Source: www.isin.org
An International Securities Identification Number (ISIN) can help determine if an investment is a PFIC. (1) An ISIN starting with "US" indicates that the investment is U.S.-registered and not a PFIC. If it begins with other letters, the investment is classified as a PFIC.
Taxation of PFICs
The IRS offers three methods for taxing PFICs: Excess Distribution, Market-to-Market (MTM), and Qualified Electing Fund (QEF).
Each method has distinct rules and tax implications:
- Excess Distribution Method: The default and often most burdensome method, where U.S. taxes are deferred until earnings are distributed or the PFIC is sold. The excess distribution amount is calculated by spreading out the distribution over the holding period on a pro-rata basis, with interest charges potentially resulting in significant tax liabilities.
- Market-to-Market (MTM) Method: Electing the MTM method on Form 8621 allows investors to recognize annual gains based on the PFIC's value at the end of the tax year. Gains are taxed as ordinary income, while losses can offset gains in current years.
- Qualified Electing Fund (QEF) Method: This method includes the investor's pro-rata share of the PFIC’s earnings in their annual gross income, which may be classified as ordinary income or capital gains. The QEF election requires filing Form 8621 in the first investment year, with the PFIC providing an annual information statement. (2)
Reporting Requirements for PFICs
American expats must file Form 8621, "Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund," if they:
- Receive a distribution from a PFIC.
- Recognize a gain on the disposition of PFIC stock.
- Make a QEF or MTM election.
What is Not a PFIC? Exceptions to Filing Form 8621
- Foreign Pension Plans: Certain foreign pension plans may be exempt from PFIC reporting requirements until distributions are made. Adjustments or early cash-outs may nullify this exemption.
- Controlled Foreign Corporation (CFC): If the PFIC also qualifies as a CFC, only Form 5471 needs to be filed. (3) A CFC is a foreign corporation where specific U.S. shareholders own more than 50%, with shareholders owning at least 10% considered for classification.
Avoiding PFICs
U.S. taxable investors should focus on building a globally diversified investment portfolio through U.S.-registered funds to avoid PFIC reporting complications and additional tax costs. For example, a U.S.-based fund investing in emerging markets may benefit from a 15% long-term capital gains rate, whereas a similar foreign-listed fund could incur a tax rate near 50%.
The PFIC Problem with Foreign Pension Plans
Foreign pension plans, especially private pension plans, often include PFICs, especially if not qualified under a U.S. double tax treaty. The underlying PFIC investments in such plans must be reported individually, making it burdensome for U.S. taxpayers. Avoiding voluntary contribution pension plans not covered by a tax treaty can help steer clear of PFIC-related issues when filing U.S. tax returns.
"Reverse PFICs" in Other Countries
Many countries have similar rules to the U.S. PFIC regime, such as the U.K.'s "reporting funds regime" and regulations in Germany, Austria, Australia, and New Zealand. These rules discourage owning nontransparent offshore funds.
Building Cross-Border Wealth in a Tax-Efficient Manner
Understanding PFIC rules is crucial for U.S. expats, green card holders, and other U.S. taxable persons. Due to the Foreign Account Tax Compliance Act (FATCA), it's increasingly important for U.S. taxpayers to report all foreign investments accurately.
Many foreign financial advisors may not realize the tax inefficiencies of selling foreign funds classified as PFICs to U.S. taxpayers. Therefore, U.S. citizens abroad should use U.S. investment funds and work with financial advisors specializing in cross-border matters.
Also worth mentioning: Green card holders and foreign nationals should consider selling PFICs before moving to the U.S. for a cost-effective and tax-efficient way to build wealth globally.
All This to Say
For American expats in Europe, understanding and navigating PFIC rules is essential to avoid significant tax liabilities and reporting burdens. And if you intend to move to Europe from the U.S., a little proactive expat tax planning never hurts, either.
By focusing on U.S.-registered funds and seeking professional advice from cross-border financial planners, expats can ensure compliance with U.S. tax laws while continuing to optimize their investment strategies. Experienced international financial advisors can help review individual situations, ensuring all foreign investments are reported correctly and efficiently.
For personalized advice or assistance with PFIC requirements, American expats are encouraged to contact cross-border financial planners or tax advisors specializing in expat tax issues. These experts can provide tailored guidance and ensure that expats meet all regulatory obligations while minimizing their tax liabilities.