If you are a US expat, investing in foreign mutual funds might seem like a straightforward and attractive option. However, significant US tax complications are associated with non-US registered pooled investments such as mutual funds, which the IRS classifies as Passive Foreign Investment Companies (PFICs), and investing in PFICs can negatively impact your US tax reporting. In this article, we explain what PFICs are, why US expats should avoid foreign mutual funds, and offer some strategies to mitigate potential tax liabilities.
- What are PFICs?
- Why PFICs are problematic for US expats
- Example scenario and the costly consequences
- Tax structures to beware of before moving abroad
- Strategies for US expats
- How to identify PFICs in your portfolio
What are PFICs?
PFIC stands for Passive Foreign Investment Company. In US tax law, a PFIC is any foreign (non-US) corporation or trust that meets one of the following tests:
- Income test: At least 75% of the entity’s gross income is passive income, such as income from dividends, rent, interest, or capital gains.
- Asset test: At least 50% of the corporation’s assets produce or are held to produce passive income.
Common examples of PFICs include foreign mutual funds, non-US registered exchange-traded funds (ETFs), foreign investment trusts (including real estate investment trusts), and some pooled foreign pension plans. These types of investments typically generate passive income, making them susceptible to PFIC classification.
Why PFICs are problematic for US expats
Complex tax reporting
The IRS introduced harsh treatment of PFICs in the 1980s to encourage investment in domestic funds. Investing in PFICs adds a significant layer of complexity to your tax reporting obligations. The IRS requires detailed reporting for each PFIC you own, primarily through Form 8621, which requests information on your income, distributions, and the PFIC’s annual earnings. Failure to file Form 8621 accurately and on time can result in substantial penalties. Form 8621 is a complex form that the IRS estimates takes 40 hours to file, so seek assistance if you need to file it.
Punitive taxation
The US tax treatment of PFICs is particularly harsh. There are two primary taxation methods for PFICs:
- Excess distribution method: If you receive a distribution from a PFIC that exceeds 125% of the average distribution received over the past three years, the excess is taxed at the highest marginal income tax rate Moreover, the IRS applies an interest charge for the deferral of taxes over every year of ownership
- Mark-to-market election: Alternatively, you can elect to mark your PFIC to market annually, recognizing gains or losses as if you sold the PFIC shares at the end of each tax year. Gains are taxed as ordinary income, and losses can offset current year gains.
Double taxation
Even if you pay foreign taxes on your PFIC income, claiming the Foreign Tax Credit to offset foreign taxes you’ve paid, as you would with normal income, can be challenging. The mismatch in income classification between US and foreign tax systems often results in double taxation of PFIC income.
Retroactive taxation
Sometimes, the IRS attempts to tax any years during which you held the investment prior to moving abroad, applying interest charges on the annual capital gains and income from those years.
Example scenario and the costly consequences
As an example, let’s assume a US expat moves to Europe and invests in $100,000 in a foreign mutual fund (a PFIC). Over five years, the fund appreciates to $150,000. If the expat sells the investment, the $50,000 gain is subject to PFIC rules. If the excess distribution method applies by default, the effective tax rate could be 37% plus some interest. In contrast, investing in a US-based mutual fund might only incur a long-term capital gains tax rate of 15% or 20%.
Tax structures to beware of before moving abroad
Many expats establish tax optimization structures, such as corporations or family trusts, to spread income among family members and reduce overall tax liability. However, if these entities are registered offshore or abroad, the IRS may classify them as a PFIC if they hold passive income-generating assets such as investment properties and blue-chip shares. This classification can lead to substantial tax liabilities.
Strategies for US expats
To avoid the pitfalls of PFICs, consider these strategies:
Invest in US-based mutual funds: Choose US mutual funds or exchange-traded funds (ETFs) that are not subject to PFIC rules. These investments are typically more tax-efficient and easier to report. However, investing in US mutual funds for non-US residents is often problematic since funds need to be “registered where offered”, as the phrase goes, and therefore you may not be able to access US mutual funds from your country of residence. There may also be limitations on accessing US ETFs from certain parts of the world, such as the EU.
Use retirement accounts: Investing through tax-advantaged US retirement accounts like IRAs or 401(k)s can help defer taxes and reduce the complexity of PFIC rules, as these accounts have different reporting requirements.
Individual stocks and bonds: Directly investing in individual stocks and bonds can also help you avoid PFIC complications. By building a diversified portfolio of individual securities, you can achieve your investment goals without the punitive tax treatment associated with PFICs.
Real estate investments: Real estate can be a viable investment option for US expats looking to avoid PFIC issues. Whether investing in rental properties, US real estate investment trusts (REITs), or real estate crowdfunding platforms, real estate offers a tangible asset class that is not subject to PFIC rules.
Consult an expat financial planning expert professional: Given the complexity of PFIC regulations, working with a financial advisor who specializes in working with expat Americans is essential. They can help you navigate the rules, make informed investment choices, while ensure compliance with US and foreign tax and compliance rules.
How to identify PFICs in your portfolio
With your expat financial advisor, carefully review your investment portfolio to identify any foreign mutual funds, ETFs, or other investments that might qualify as PFICs. Look at the income and asset composition of these investments to determine if they meet the PFIC criteria.
Final thoughts
Before moving abroad, restructure your investment portfolio to minimize PFIC exposure by selling or divesting from foreign mutual funds and any other PFICs, and reinvesting the proceeds in US-based investments or other non-PFIC options. Seeking the guidance of a financial planning professional who is experienced working with expats is essential when investing as an American living abroad, to ensure compliance with both US and foreign regulations, and to develop a tax-optimized investment strategy. With careful planning and proactive management however, you can avoid the pitfalls of PFICs and achieve your financial goals as a US expat.
If you have any questions about financial planning or investing as an American living abroad, get in touch.
This article is for informational purposes only; it is not intended to offer advice or guidance on legal, tax, or investment matters. Such advice can be given only with full understanding of a person’s specific situation.