The Pitfalls of Passive Foreign Investment Companies (PFIC)
Many foreign investments and some foreign pension plans are considered PFICs under US tax law. PFIC taxes prevent U.S. taxpayers from transferring profits to foreign investment corporations and later claiming the income as a capital gain (while paying the lower capital gains rates) by taxing gains on foreign passive investments at ordinary income tax rates and charging punitive interest for the time the money was invested.
A PFIC is any foreign corporation meeting one of two conditions: 1) 75% or more of its gross income for the taxable year consists of passive income, or 2) 50% or more of the average value of its assets consist of assets that produce, or are held for the production of, passive income.2 Passive income includes dividends, royalties, rents, annuities, capital gains, foreign currency gains, and the like.3 Income derived from active banking activities, insurance, rents from relatives, and export trade is excluded from the definition of passive income for PFICs.4
For the first year, income generated by a PFIC is taxed as ordinary income at the highest marginal rate.5 In subsequent years, increases in distributions from PFICs are penalized as “excess distributions” if the increase exceeds 125% of the average income of the previous three years, or the holding period if less than three years.6 The penalty is the same as the underpayment rate7, which is the Federal short-term rate plus 3 percentage points.8
Taxpayers can avoid PFIC treatment if the company is a qualified electing fund or if the stock is marked to market.9 For the former, the taxpayer must establish fair market value as of the day the company becomes a qualified electing fund and pay the appropriate taxes.10 If a taxpayer does not make this election, the taxpayer remains subject to PFIC rates. A taxpayer may make the qualified electing fund election only if the holding company meets the requirement to determine the ordinary earnings of its net capital gain.11 Mark to market election requires the taxpayer to determine the fair market value of the taxpayer’s holdings annually and pay tax on the gains, with some adjustments for past gains and losses.12
Obviously, investing in Passive Foreign Investment Companies has consequences for the US citizen living overseas. In addition to paying the fees, the taxpayer must fill out Form 8621 to calculate and report those fees, which the IRS itself estimates will take more than 48 hours.13 US citizens living abroad are more likely than those who do not to own foreign accounts. And, they may not even know whether that account qualifies as a PFIC under IRS rules.
Consider an American taxpayer living in Taiwan. If the taxpayer is at all familiar with U.S. tax law, he knows to report income to the IRS. But what about the pension fund set up by his employer, a common event in Taiwan? It is likely the taxpayer knows the balance of the pension account, and just as likely that the taxpayer doesn’t know whether the account qualifies as a passive foreign investment company or, perhaps, a foreign trust. Mutual funds available to owners of foreign accounts face the same problem. As noted earlier, there is a penalty for failure to properly calculate earnings in a PFIC, and the same applies to foreign trusts. In fact, failure to report foreign trust earnings on time results in a penalty of $10,000, or 35% of dividends, whichever is higher, and an additional $10,000 for every 30 days the payment is late after the first 90 days.14
US citizens generally assume that accumulating funds in a retirement account or a mutual fund is a good idea. For taxpayers living overseas, however, that proposition is not a sure thing given the possible tax consequences. At the least, earnings can be reduced by the time spent calculating taxes and by penalties. At worst, the entire fund could be lost to the IRS.15 The complexities, and penalties, presented by tax rules on foreign accounts present special problems for US citizens living abroad, problems that their U.S.-resident counterparts are unlikely to ever confront, especially by accident.
[2] 26 U.S.C.S. § 1297(a).
[3] 26 U.S.C.S. §§ 1297(b), 954(c).
[4] 26 U.S.C.S. § 1297(b).<
[5] 26 U.S.C.S. §§ 1291(a)(1), 1 et. seq.
[6] 26 U.S.C.S. § 1291(b).
[7] 26 U.S.C.S. § 1291(c)(A).
[8] 26 U.S.C.S. §6621.<<
[9] 26 U.S.C.S. § 1291(d).
[10] 26 U.S.C.S. § 1291(d)(2).
[11] 26 U.S.C.S. § 1295(a).
[12] 26 U.S.C.S. § 475.
[13] https://www.irs.gov/instructions/i8621
[14] 26 U.S.C. § 6677(a).
[15] Id.