At one time, investing in foreign mutual funds and other foreign investments was very popular with US citizens and connected individuals. The practice however created a few problems for the IRS. The first problem was that the government did not have a way to track foreign investments. Many taxpayers took advantage of this and may have neglected to report the foreign income on their tax return.
Another problem was that with every dollar that went into a foreign investment. That dollar didn’t invest in America. Mutual funds established in the U.S. included a mandatory payout schedule that generated additional tax income. Even the honest investor could defer these payments and the related tax on foreign investments, which increased the risk of the U.S. coffers coming up short.
To solve these problems, Congress enacted The Tax Reform Act of 1986. This law imposed complex record-keeping procedures for PFICs to make them less convenient and thereby less attractive. It also altered the tax rates, as we’ll discuss now.
The complicated reporting requirements imposed by the new law was designed to chase taxpayers away from PFICS, but some investors continued to invest. As such the law went further than just inconveniencing taxpayers, it started costing them, as well.
Under the new law, income from PFICs no longer enjoy the lower capital gains tax rate of other investments. Instead, income from PFICs are taxed at not just the ordinary income tax rate but at the highest rate. Income is automatically taxed at the maximum tax rate reserved for the highest earners. Currently 37%.
Just in case all of this wasn’t enough to send you running from these foreign investments, Congress added one more thing. In certain circumstances, you can elect to defer the gains you receive from PFICs. If you do, you will have to deal with a non deductible interest penalty.
When you opt to defer your gains, the IRS assesses you with a non-deductible interest penalty. This interest compounds daily for the entire period. Right about now, most investors find themselves overwhelmed. The daily interest adds up to a significant amount. As a result, PFICs remain legal but highly unattractive.
Under the passive foreign investment company rules, you can employ a strategy to reduce the tax you pay on a PFIC. However, they are complicated and difficult to follow. One such strategy is the qualified electing fund (QEF).
The QEF election, a taxpayer can pay tax on income generated by PFICS under the same rules and tax rates as domestic investments. Part of the income is taxed at the personal income
tax rate and part at the capital gains rate. This election allows you to safely defer unrealized gains without penalty while offering a slightly less daunting income tax rate.
Another common strategy is the Mark-to-Market Accounting Method. Under this rule, investments are valued at their current fair market price. Gain from FPICs gets taxed at the marginal tax rate based on your income level. This option lets you pay your marginal income tax rate on both realized and unrealized gains, again eliminating the daily interest on deferrals. It also allows for loss claims, which can help offset taxes.
Both of these strategies accelerate your tax liability but may save you interest charges and potentially higher tax rates. Understand that when using the QEF, Mark-to-Market or other investment strategies, you can generally only reduce your tax rate to reflect your current tax bracket. Depending on your bracket, your savings may prove minimal and not worth the effort.
Remember, the tax strategies you can use to minimize the tax on PFICS all affect other aspects of your bigger tax picture. Depending on your situation, they may hurt more than they help.
If you invest in PFICs, you’re going to see Form 8621. The Form 8621 is an information return filed with your taxes. You will report various information about the PFICs you hold and any income or losses generated by these investments.
This form is also where you’ll announce your choice to take the QEF or Mark-to-Market elections. Other elections are also available on Form 8621, remember that you must file this form every year and mark your elections each time or you will lose them.
This is not a simple form. The form includes things like the “CFC overlap rule” and “the portions allocated to the days in the current tax year.The point here is you will need professional help and to be honest it is the reason why most US Expats and US Connected individuals avoid PFICs. We here at Cl-Associates are versed in these complex areas and are ready to present a diversified foreign investment strategy that is US compliant and avoids the pitfalls outlined above.
Warren Ferguson, Cl-Associates