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.
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.