Passive Foreign Investment Companies (PFICs): Why They Are a Tax Trap for U.S. Expats
What is a PFIC?
A Passive Foreign Investment Company (PFIC) is a foreign corporation that meets either of two tests: at least 75% of its gross income is passive income (the income test), or at least 50% of its assets produce or are held to produce passive income (the asset test). In practice, virtually every foreign mutual fund, foreign exchange-traded fund (ETF), and many foreign holding companies qualify as PFICs.
For U.S. taxpayers — citizens, residents, and others subject to U.S. income tax — owning an interest in a PFIC triggers one of the most punishing tax regimes in the Internal Revenue Code. The rules are designed to eliminate the tax deferral advantage that might otherwise result from holding passive investments offshore in low- or no-tax jurisdictions. The result is a system that is complicated, expensive to administer, and easy to stumble into inadvertently.
The default PFIC tax regime: excess distributions
Under the default "excess distribution" rules, income from a PFIC is not taxed currently as it accrues. Instead, when a U.S. shareholder receives a distribution from a PFIC or disposes of PFIC shares at a gain, the excess distribution or gain is allocated ratably back over the shareholder's entire holding period. The portion allocated to prior years is taxed at the highest applicable ordinary income rate for each prior year — not the current preferential capital gains rate — and an interest charge is imposed on each prior year's allocated amount as if the tax had been due back then.
The result is that gains on PFIC investments are taxed far more harshly than gains on comparable U.S. investments. Long-term capital gains rates do not apply. The interest charge compounds the cost further. And because the tax is computed year by year over the entire holding period, the longer the investment is held without a QEF or mark-to-market election, the worse the outcome.
The QEF and mark-to-market elections
Two elections can mitigate the harshness of the default PFIC regime. A Qualifying Electing Fund (QEF) election allows the U.S. shareholder to include their pro-rata share of the PFIC's ordinary income and net capital gain in gross income currently each year — similar to how a U.S. partnership interest is taxed. This eliminates the punitive interest charge, but it requires the PFIC to provide annual financial information (a PFIC Annual Information Statement) that many foreign funds simply do not produce.
A mark-to-market election is available for PFIC shares that are traded on a qualified exchange. Under this election, the shareholder includes any unrealized appreciation in income each year as ordinary income, and deductions for losses are allowed to the extent of prior inclusions. This avoids the interest charge but means paying tax on paper gains annually, and all income is treated as ordinary — no preferential capital gains treatment.
Where U.S. expats most commonly encounter PFICs
The most common PFIC trap for U.S. expats is the foreign mutual fund or locally-domiciled ETF. These are the standard investment vehicles in most countries outside the United States, and expats often hold them in local retirement or investment accounts without realizing they are PFICs under U.S. tax law. Some foreign life insurance and pension products can also contain PFIC interests. Even small investments can generate disproportionate compliance burdens and tax costs.
Form 8621 — the PFIC reporting form — must be filed for each PFIC in which the taxpayer holds shares, in each year a reportable event occurs. Failure to file Form 8621 can suspend the statute of limitations on the entire tax return.
PFIC compliance is one of the most technically demanding areas of U.S. international tax law. If you are a U.S. expat or investor holding foreign funds, our cross-border tax attorneys can help you understand your exposure and implement the most favorable available election. Contact us to discuss your situation.
