What is a PFIC (Passive Foreign Investment Company)
When US Taxpayers have ownership over foreign passive investments, they may become subject to the Internal Revenue Service Passive Foreign Income Company Taxation Rules — which are very complicated. Taxpayers with foreign assets may have to file one or more international information reporting forms, such as the FBAR (FinCEN Form 114), Form 8938 (FATCA) and Form 8621. A PFIC comes in many different flavors — and oftentimes it can be as simple and basic as a Taxpayer who owns foreign mutual funds. And, the Taxpayer may have held these funds even before they became a US person. The tax regime for PFIC is punitive in nature, unless the Taxpayer can make a QEF or (to a lesser extent) an MTM election. The tax rate for PFIC excess distributions — which is especially common at the time the fund is redeemed — is equivalent to the highest tax rate allowable for income, and not the preferred Long-Term Capital Gain or Qualified Dividend rate. More often than other CPAs and Attorney want nothing to do with PFIC, which is why oftentimes our team is retained to handle both the legal analysis and tax preparation of the PFIC (passive foreign investment company) regime for Streamlined and other offshore disclosure cases. In addition, with the Internal Revenue Service taking an aggressive approach to foreign accounts compliance and unreported foreign income, offshore compliance is crucial to avoid international tax penalties.
Example of Passive Foreign Investment Company Tax & Reporting
PFIC is the passive foreign investment company regime. The purpose of the rule is to ensure the IRS get its proper piece of the tax pie. When it comes to individual investors, one of the most common types of PFIC is ownership of a foreign mutual fund.
We have worked with clients in over 80 different countries, but with India especially — it is a big problem.
This is twofold:
The dividend and capital gain treatment rules are different India; and
It is very common for the Indian Mutual Funds to be distributed out to an attached bank account such as ICICI or SBI — if even momentarily — resulting in an (unintended) excess distribution
Typical Example of an Indian Mutual PFIC Dilemma
Peter is originally from India. He now resides in the United States as a Legal Permanent Resident (Green-Card Holder). He is well-to-do and has investments overseas in various foreign mutual funds such HDFC and Kotak. He has had these investments for close two decades.
While the income has not been distributed throughout the life of the PFIC, it is now time for Peter to redeem his mutual fund and reap the benefits of its growth. The problem is Peter will not receive long-term capital gains treatment at the time of redemption. Rather, Peter will be taxed at the highest tax rate available in that year.
*Non-excess distributions and excess distributions attributed to the current year are taxed differently from prior year excess distributions.
In addition, Peter will have to pay interest for the time the money sat in the fund throughout the life of the investment.
Foreign Mutual Fund PFIC
There are many different types of passive foreign investment companies. For example, many of our clients have one or more Hong Kong Pvt. Limiteds which are used to hold stock and other funds (aka ‘holding companies). We also have many clients throughout the British Virgin Islands and Australia who have similar types of businesses which are used primarily as a holding companies for different investments.
For most people, the above-referenced examples are what you would imagine or envision when you think of the term passive foreign investment company. Unfortunately, the IRS does not share in your vision. To the IRS, even fractional ownership in a foreign mutual fund may result in a potential PFIC dilemma.
Since the foreign mutual fund example is the most common for individual investors, let’s focus on that issue for our analysis.
Foreign Mutual Fund PFIC Taxation Basics
Let’s review the basics:
Growth – Non-Distributed Income
During the fund’s growth phase in which the person has a foreign mutual fund that is generating/accumulating income or earnings but is not being distributed out of fund – the fund is not taxed in the U.S. on the growth.
This is in sharp contrast to other types of investments such as a stock account, which may be accumulating dividends within the account (assuming it is not a PFIC) and is being taxed on the accrued income each year. Thus, when the stock account is drained, the basis should be close to the distribution amount, resulting in no tax.
Growth – Distributed Income
Once the income is distributed, even to a linked bank account, the excess distribution rules come into play. Generally, there are distributions (aka non-excess distributions) and excess distributions — and they are taxed differently.
For reference, there are no excess distributions in the first year of the ownership of the PFIC.
Because there is nothing for it to be in excess of.
In other words, the first year will be considered the PFIC benchmark (per fund). Conversely, if there are no distributions in the first year then any subsequent year will have significant excess distributions (at least in the first year of distribution outside of the first year of on Amy investment). This is because if zero income was distributed in the first year, then money distributed subsequent will be in excess.
The excess distribution calculation is incredibly complex.
Our team has performed several hundred calculations for clients on their tax returns and developed an excess distribution calculation example for reference to help illustrate the analysis.
MTM and QEF Elections
There are certain “elections” a taxpayer can make to try to limit the excess distribution tax. There is the Mark-to-Market (MTM) election and the Qualified Elective Fund (QEF) election. These elections are not easy to make, and if the filer does not make the election in the initial year, they will generally lose the opportunity.
To make this election, it requires at least some cooperation from the foreign financial institution (FFI) or other foreign investment company, which (presumably) wants absolutely nothing to do with the Internal Revenue Service and U.S. government.
Without their cooperation the elections may not be available.
The PFIC forms are not included with most software programs. Unless TurboTax or TaxAct changed the forms they offer, the form 8621 was never offered as part of the program.
Moreover, the IRS does not provide much in the way of instructions when it comes to preparing the form, or how to prepare the PFIC tax calculation.
Form 8621 & Reporting the PFIC
The form 8621 is the form used to report both the tax in the ownership of a PFIC. There are some exceptions, exclusions, and limitations, but generally unless you are below the threshold value you have to report the form each year. Commencing after tax year 2012, Taxpayers have to report the form even if they have no excess distributions.
In prior years, the form was primarily required only in years in which an excess distribution calculation was required.
Preparing the Form 8621
If a person does not have any excess distributions, then the form’s difficulty is average. As long as a person can get a general idea of the number shares, the NAV value, it is not too treacherous.
But, when a person has excess distributions, switch-outs, redemptions, and/or multiple funds (which must be reported separately in order to preserve the accurate basis for each fund) it can get very complicated.
What if the Form is Not Filed?
If the form was not filed there is no immediate monetary penalty up-front. Rather, the tax return remains open indefinitely.
The Internal Revenue Service has significantly increased the issuance of offshore penalties. Therefore, bu not timely filing the form or submitting to voluntary disclosure, a Taxpayer may be subjecting to significant fines and penalties.
We Specialize in Streamlined & Offshore Voluntary Disclosure
Our firm specializes exclusively in international tax, and specifically IRS offshore disclosure.
Contact our firm today for assistance.