IRS Stepping Up Enforcement
If you are a U.S. citizen or resident and have investments in a foreign financial institution, including foreign mutual funds, you need to familiarize yourself with Passive Foreign Investment Companies (PFICs).
Foreign Account Tax Compliance Act is leading to much stricter enforcement of U.S. tax laws for Americans with investments abroad. As a result, it’s becoming harder to ignore filing obligations, including those related to PFICs. of passive foreign investments.
One of the things that can be confusing about investing in foreign countries is that foreign mutual funds have different rules for reporting and taxes compared to those based in the U.S.
U.S. tax laws clearly discourage U.S. residents from investing in foreign mutual funds. However, many taxpayers don’t realize its consequences until it’s too late.
Investing in a foreign mutual fund and dealing with passive investments can be a huge trap for those who aren’t careful.
Taxpayers frequently tell us at Tax Samaritan that offshore mutual funds lured them with false promises of tax-free earnings until they bring the profits back to the U.S. Unfortunately, every year, many U.S. investors fall for these pitches and invest in foreign mutual funds, usually in the form of an insurance policy or retirement account.
While no tax may be payable in the fund’s jurisdiction or foreign country of residence, that is generally not the case as it applies to U.S. taxation for the taxpayer. U.S. taxation and tax codes apply to all U.S. taxpayers.
Why You Can’t Ignore This Tax Liability
When some Americans hear the term Passive Foreign Investment Company for the first time, they often just ignore it because it sounds confusing. But for many Americans abroad, ignoring it is a mistake, and the consequences of this mistake could be significant.
PFICs refer to “pooled investments” registered outside of the United States. This covers most foreign mutual funds, hedge funds, and even some insurance products. It might also include your bank account if it’s a money-market fund, as they’re basically short-maturity fixed-income mutual funds.
The rules for pooled investments usually affect investments in foreign pension funds, unless the U.S. considers those pension plans as “qualified” under a double-taxation treaty with the host country, but this often doesn’t happen.
The IRS views pooled investments registered outside the U.S. with much more scrutiny than it does for mutual funds. It’s not uncommon for taxes and interest on these investments to wipe out any gains.
Foreign Mutual Funds Could Be Subject to U.S. Taxes
The Internal Revenue Service has been saying for years that investments made in foreign mutual funds and certain other types of entities may be subject to U.S. income taxation as investments in passive foreign investment companies.
To satisfy the income test, the foreign corporation must generate three-fourths or more of its gross income as passive income.
To satisfy the asset test, the foreign corporation must have half or more of its assets producing passive income or held for that purpose.
Generally, income earned from dividends, interest, royalties, rents, annuities, capital gains from the sale or exchange of property that produces such income, foreign currency gains, etc. is considered passive income.
The Reporting Pain of Pooled Investments
Not only is the tax treatment tough for holding a passive foreign investment company but the disclosure and reporting on Form 8621 are also complicated. When it comes to pooled investments, taxpayers have to choose one of three different methods to figure out how much income they need to report from their investment in the fund.
Two of the methods are elective options subject to strict rules and timing of election. The third is the default method absent any election. It’s worth noting that most taxpayers use the default method for reporting because they become aware of their investment holdings after it’s too late to choose how they want to pay.
Qualified Electing Fund Method
For most investors, the most favorable method of taxation will be to treat foreign mutual funds as a qualified electing fund. This option allows the taxpayer to distinguish between capital gains and ordinary income of the foreign mutual fund.
To make the qualified electing fund election work, the foreign mutual fund needs to give the taxpayer a “PFIC Annual Information Statement” that has enough details to help the taxpayer figure out their share of the investment income and capital gain for the year accurately.
So you may be asking, “Why doesn’t everyone make a qualified election fund election for foreign mutual fund shares?”
It’s simple. The reason that few investors make this election for foreign mutual fund shares is that it is impossible to do so in most cases.
Foreign mutual funds, even if they are similar to U.S. funds, typically don’t maintain American financial records or share U.S. tax details with their investors. This is necessary for choosing the qualified election fund option.
Mark-To-Market Election Method
If it’s not possible to make a qualified election fund, U.S. taxpayers holding foreign mutual funds may elect to treat the investment on a “mark-to-market” basis. In order to make the election, the units the investor owns in the foreign mutual funds must be “marketable stock.”
The Code defines the term “marketable stock” as stock that a foreign government (equivalent to the SEC in the United States) regulates and that is regularly traded on a national securities exchange.
The mark-to-market option lets the taxpayer add the difference between their pooled investment’s basis (“mark”) and its fair market value at the end of the year (“market”) to their gross income, known as the “mark-to-market gain.” This option considers the resulting gain, along with any profit earned from selling or disposing of the pooled investment, as ordinary income.
You fill out Form 8621 to make the QEF and mark-to-market options for passive foreign investments. This is usually due on the regular tax return deadline.
Section 1291 Method – The “Excess Distribution” Method
When taxpayers don’t choose this option on time, the IRS will tax them under the excess distribution method outlined in Code Section 1291.
The excess distribution method applies when you get a dividend that’s more than 125 percent of your average distributions over the past three years, or when you sell mutual fund shares. It’s as if the excess distribution was earned gradually during the time you held foreign mutual funds. When you sell, any profit is also treated the same way over your ownership period.
In the past, we calculated taxes as if they were due at the highest ordinary income rate and added interest based on the underpayment rate defined in Code Section 6621 for each holding period year. This can result in a substantial amount of taxes and interest accumulating. Additionally, calculating the excess distribution tax and interest can be very complex. To make matters worse, you can’t claim a loss on disposition as a deduction or capital loss.
Compliance Challenges of Foreign Mutual Funds
- Limited Expertise
Passive foreign investment companies have more drawbacks for American investors, besides high taxes. Complying with IRS reporting rules is also a significant challenge.
Many American expats own foreign mutual funds and often hire tax specialists for expat tax preparation. However, having an expat tax specialist doesn’t guarantee correct PFIC-related filings and tax payments. The number of experts in expat tax returns is limited, and even fewer are well-versed in PFIC reporting and taxation, including Form 8621. Tax Samaritan is one firm with substantial expertise in this area.
At Tax Samaritan, we frequently see taxpayers unintentionally overlook disclosing their pooled investment holdings, and tax professionals often don’t ask or inquire further about them.
- Cost Concerns
In some situations, if the client and tax preparer have agreed on a fixed tax preparation fee, the preparer might hesitate to inquire about potential pooled investments. This is because the IRS estimates that the record-keeping and preparation time for the complex Form 8621, required for each investment owned, is around 46 hours per mutual fund per year. In other words, it is neither a simple nor inexpensive undertaking.
You must file Form 8621 annually for each individual PFIC investment (such as each different mutual fund). In the past, the IRS required taxpayers to file this form in years with an option, distribution, or disposition. However, starting from tax year 2013 and onwards, taxpayers must file it annually for all holdings.
- Complexity Challenge
This situation becomes even more challenging because most tax professionals, and even taxpayers, struggle to correctly fill out Form 8621. It involves complex calculations that outweigh any potential savings from attempting to do it oneself. At Tax Samaritan, we have the expertise to handle Form 8621 and its calculations at a reasonable cost.
The New Tax Law Makes Pooled Investment Reporting Essential
As a U.S. taxpayer, you may be thinking about an obvious question. If passive foreign investments are such a big trap, why has there not been more discussion of the issue, and why have I never read about it before? The reason is that until now the IRS faced many obstacles to enforcing the PFIC rules and lacked the resources to go after filers on the issue. With FATCA information sharing and disclosures made by taxpayers, it won’t be long before the IRS starts to focus on these known investments and the companies that promote them.
In the past, the authority has been keen on people reporting foreign investment accounts through programs like the Offshore Voluntary Disclosure Program. We expect the IRS will keep a close eye on this, maybe even more so with the new voluntary disclosure and streamlined programs. They’ll want to make sure taxpayers fill out Form 8621 correctly and calculate the taxes they owe accurately.
Penalties For Failure To File Form 8621
Previously, failing to file Form 8621 and reporting PFICs correctly rarely led to audits or charges of tax fraud. Many Americans didn’t pay much attention to the foreign investment account issue. If you don’t report, you could face a penalty of $10,000, and your investment accounts might be disclosed when you submit the Report of Foreign Bank and Financial Accounts (with the FinCen Form 114) and Form 8938. So, there’s a real risk in not reporting now.
The new legislation makes it necessary for individuals to report their foreign financial assets, including pooled investments. It also requires that foreign financial institutions report the assets held by U.S. citizens and permanent residents directly to the IRS.
It might be surprising, but most foreign financial institutions are likely to follow these reporting rules. Experts anticipate that banks, brokerages, insurance companies, and mutual funds worldwide will comply because the law imposes harsh penalties on those who don’t. Additionally, many foreign governments, facing their own tax compliance challenges, are eager to exchange information with the U.S.
The result is that all U.S. citizens must assume that as of July 1, 2014, the IRS will have a direct and easily accessible window onto their holdings in foreign financial institutions. While it may take several years, it’s highly likely that institutions will be able to easily cross-reference a taxpayer’s direct reports with the IRS using forms like FinCen Form 114, Form 8938, and Form 8621. This will help determine if taxpayers reported their PFIC investments correctly and if they accurately calculated and paid their taxes.
Foreign Investment Account Avoidance Strategy
As a general rule, a U.S. taxpayer would be in a far better position to invest directly in the stock of foreign corporations that are not PFICs or to invest in a U.S. mutual fund that invests in foreign stocks or foreign mutual funds.
Whichever reporting method you choose, you must file an IRS Form 8621. Whatever you do, be sure you file and prepare it correctly. Failure to file the 8621 when required to do so can result in a $10,000 fine.
The Bottom Line
Don’t believe any foreign investment adviser regarding the U.S. tax consequences of any investment. Know the consequences of investing in foreign mutual funds before you invest by getting tax advice from a qualified U.S. tax practitioner, such as Tax Samaritan.
Our goal at Tax Samaritan is to provide the best counsel, advocacy, and personal service for our clients. We’re not only tax preparation and representation experts but strive to become valued business partners. Tax Samaritan commits to understanding your unique needs. Every situation is different and demands a personalized approach. Our goal is to provide practical and effective solutions tailored to your specific circumstances.
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Tax Samaritan is a team of Enrolled Agents with over 25 years of experience focusing on US tax preparation and representation. We maintain this tax blog where all articles are written by Enrolled Agents. Our main objective is to educate US taxpayers on their tax responsibilities and the selection of a tax professional. Our articles try to assist taxpayers who want to prepare their taxes themselves by offering clear tips and warnings to simplify the process.
Randall Brody is an enrolled agent, licensed by the US Department of the Treasury to represent taxpayers before the IRS for audits, collections, and appeals. To attain the enrolled agent designation, candidates must demonstrate expertise in taxation, fulfill continuing education credits, and adhere to a stringent code of ethics.
Every effort has been taken to provide the most accurate and honest analysis of the tax information provided in this blog. Please use your discretion before making any decisions based on the information provided. This blog is not intended to be a substitute for seeking professional tax advice based on your individual needs.