Foreign Mutual Funds: BEWARE

Feb 11 2016

As a U.S. citizen residing abroad you have to be particularly careful with respect to your investments and assets.  One particular “thorny” issue is that of foreign mutual funds. 

The problem with foreign mutual funds is they are Passive Foreign Investment Companies, or PFICs.  The tax treatment of PFICs is extremely punitive compared to similar investments that are incorporated in the U.S.  Combining the high tax rate with the cost of complying with IRS reporting rules on PFICs and the investment may quickly lose any appeal it once had. 


History

The PFIC tax regime was passed in 1986 as part of the Tax Reform Act.  The PFIC tax regime sought to level the playing field for U.S. mutual funds.  U.S. mutual funds are required to pass-through all virtually all of the income to the investors, resulting in taxable income.  In contrast, foreign mutual funds often do not have this requirement and therefore U.S. investors were able to shelter the income from taxation until it was distributed.  With the passage of the PFIC regime, the advantage of the deferral of foreign funds was effectively nullified. 

What is a PFIC?

Defined in Internal Revenue Code §1297, a Passive Foreign Investment Company is any foreign corporation that has either:

·         75% or more of its gross income classified as passive income (i.e., interest, dividends, capital gains, etc.), or

·         50% or more of its assets are held for the production of passive income.

Most foreign mutual funds, pension funds, and money market accounts are PFICs. 

Taxation

A PFIC is taxed under one of three taxation regimes.  To read further about PFIC taxation, click here.  To over-simplify the analysis, under the most onerous taxation regime, a Section 1291 Fund:

·         Distributions (i.e., dividends, interest, etc.) in excess of 125% of the prior 3-year average distribution, are treated as “excess distributions” and subject to throwback to the previous three years and taxed at the highest marginal rates and interest calculated upon the tax.

·         Dividends not deemed excess distributions do not receive qualified treatment,

·         Capital gains are taxed at ordinary tax rates, instead of preferred capital gains rates, and

·         Capital losses are only deductible on Schedule D (i.e., they cannot fully offset other capital gains from PFICs). 

Reporting

PFICs are “specified foreign financial assets” and are therefore reportable on Form 8938.  In addition, if the funds are held in an investment account, they are reportable on FinCen Form 114 (FBAR).  Lastly, and most costly, PFICs are required to be reported on Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. 

What’s the big deal?

The passing of Foreign Account Tax Compliance Act (FATCA) in 2010, requires foreign financial institutions to report to the IRS on accounts owned by U.S. persons.  Failing to file any of the required forms mentioned above can result in a $10,000 per year, per form penalty.  In addition, the statute of limitations on your tax return does not begin until all required information returns are filed.  So, to summarize, the IRS may soon have details regarding your assets, failing to properly report PFICs can be costly, and you could be subject to an IRS audit indefinitely.

What do I do now?

Have foreign mutual funds that have not been properly reported? Making a “silent” filing by amending or filing previous returns may subject you to additional penalties. Contact us today for a free consultation. 

©2017 SDC, LLC    www.sdcglobalcpa.com
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult tax, legal and accounting advisors before engaging in any transaction.

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