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Summing It Up

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Investing in Foreign Mutual Funds? Beware of Filing Requirements and Liability Risks

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So you decided to invest in a foreign mutual fund. At first glance, the US income tax reporting requirements for income received from this investment appear simple: Just report dividends, interest income, and any capital gains on your form 1040 as if the income was received from a US mutual fund, right?

Unfortunately, the answer is not that simple.

Because the IRS classifies foreign mutual funds as passive foreign investment corporations, aka “PFICs,” there not only is additional reporting requirements for you the taxpayer, but any income received from these investments could be subject to a much higher tax rate and increase your overall tax liability significantly.

What is a Passive Foreign Investment Corporation?

The IRS defines a PFIC as any foreign corporation that meets either of the two requirements below:

  • At least 75 percent of the gross income from the corporation for the taxable year is passive income (e.g., dividends, interest, capital gains, etc.), or
  • The average percentage of assets held by the corporation that generates passive income is greater or equal to 50 percent.

Therefore, pooled investments registered outside the United States, such as foreign mutual funds and foreign hedge funds, will qualify as PFICs under the Internal Revenue Code.

PFIC Tax Implications

So now that we know a foreign mutual fund qualifies as a PFIC under US tax law, why is this significant?

For starters, your investment in the mutual fund must be reported separately on Form 8621 each year, regardless of whether or not you received income from the fund, provided that the value of the PFIC stock owned both directly and indirectly exceeds $25,000. While failure to file Form 8621 in this situation would not result in any penalties, it would leave the statute of limitations on all tax matters on the return open indefinitely, leaving you the taxpayer more vulnerable to potential IRS audits and additional tax assessments.

The biggest implication, however, is the additional tax and interest that might be owed on any passive income received from the fund during the year. While there are various elections you can make with regard to the recognition of income from the PFIC, let's assume that you did not know that the investment had to be specially reported and never made an election.

Instead of just picking up the income in the current year, income is subject to the “excess distribution” regime. As a result, any distributions classified as excess must be allocated among all tax years in your holding period and will then be taxed at the highest rate enacted by law in that year. In addition, since that tax was technically owed in prior years, you must also calculate interest owed. This amount of interest can add up quickly especially if you have held the investment for a long period of time and are now just reporting the income properly on Form 8621.

The IRS defines “excess distributions” that are subject to this additional tax as the following:

  • Any gain from the sale of the PFIC, or
  • Any distribution from the PFIC that exceeds 125% of the prior three year average of distributions previously received from this investment.

Takeaways

Suffice it to say, when it comes to reporting your foreign mutual fund investment on your tax return, the IRS requirements can be very confusing. Not only do you need to determine if you are required to file Form 8621, but you must also consider the various elections available to you (mark to market, qualified electing fund), what (if any) election to make, and how to properly report the income received and tax owed from these investments.

Stay tuned—another post on other types of PFIC investments is coming soon. If you have any investments in foreign mutual funds or are thinking about investing in some, please contact us for advice and potential planning opportunities.

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Passive Foreign Investment Companies Can Lead to Aggressive U.S. Tax Issues

Many people who receive income from passive foreign investment companies, or “PFICs,” have no idea that they hold an interest in an investment that may trigger additional filing requirements and tax payments on their U.S. returns.

Most Americans work hard to file accurate tax returns and pay the correct amount owed to the government. They may not be happy about taxes, they may complain about them, but some combination of patriotism and fear of consequences keeps most taxpayers in line.

One of the most serious tax problems that can arise for people who make an honest effort to comply with U.S. tax obligations is a tax that they didn’t know existed. Passive foreign investment companies, or “PFICs,” are an excellent example of this problem, and there are steps you can take to protect yourself against it.

What Is a PFIC?

A PFIC is a business or fund based outside of the United States that generates passive investment income to its owners/shareholders. If the business or investment meets either of 2 tests, it should be treated as a PFIC for U.S. tax purposes.

  • The first test is an “income test.” The investment meets the income test if 75% or more of the income it generates in a given year is passive income, such as dividends, interest, rents and royalties.
  • The second test is an “asset test.” The investment meets the asset test if more than 50% of the business’ average asset value consists of assets held to produce passive income.

The most common type of PFIC that causes problems for U.S. taxpayers is a foreign, or non-U.S., mutual fund. When a mutual fund is based in the U.S., the government requires it to report information about what it pays to its investors in order to match that against the tax returns those investors file. The government also maintains certain requirements on what the funds must distribute annually. Non-U.S. mutual funds aren’t subject to these reporting and distribution requirements. So, in an effort to avoid income deferral, these foreign mutual funds are treated as PFICs for U.S. tax purposes. Therefore, taxpayers who own foreign mutual funds may be subject to additional taxation and reporting under the PFIC regime.

Who Has to File?

The first requirement is that the taxpayer needs to be a “U.S. tax person,” as discussed in a previous post, Know Before You Go—The 3 Ways That Nonresidents Incur U.S. Tax Obligations. An individual or business that qualifies as a U.S. person then needs to determine if they have ownership of any companies or investments that meet either of the two tests discussed above. If yes, the taxpayer may be subject to additional reporting requirements and taxation.

There are some exceptions to PFIC reporting. For example, in some circumstances there may be an exception to the annual reporting requirements if the total value of all PFICs owned is $25,000 or less ($50,000 or less for married filing jointly) at the end of the year. Other exceptions exist, including an exemption for the first year of a corporation that might otherwise be treated as a PFIC, if certain conditions are met. This exception helps certain start-up businesses that begin operations with a significant investment but have yet to spend as much capital on operating assets as planned by the end of the tax year. Without this exception, these businesses might be PFICs under the asset test because cash is considered to be a passive asset under the test.

What Has to Be Filed?

State Tax Structuring - Rochester CPA Firm The short answer to this question is, if you think that you might have a filing requirement based on the discussion above, you should probably consult a tax professional with experience in the area before trying to figure out this part of your tax return. The information you report and the calculation of any tax you might owe can be very complicated. There are several different ways a PFIC may be taxed depending on elections that can be made for treatment of the PFIC.

If you believe that you may have an obligation related to a PFIC, you should contact our International Tax Team at Freed Maxick for additional information about these rules.

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