PFICs Explained for US Expats: The Costly Tax Trap in Foreign Funds
Navigate PFIC tax rules with clarity. Discover essential insights to manage your tax obligations effectively. Read the article for practical guidance.
- What Is a PFIC and Why Should US Expats Care?
- How PFICs Trigger Punitive US Tax Rules
- How to Mitigate PFIC Tax Treatment
- Common Ways Expats Accidentally Invest in PFICs
- PFIC Reporting Requirements Every US Expat Must Know
- PFICs for Returned Expats: The Hidden Risk After Moving Back
- PFIC Alternatives for US Expats
What Is a PFIC and Why Should US Expats Care?
A Passive Foreign Investment Company (PFIC), is the label the US tax system applies to certain investments that US citizens and expats may hold outside of the country. This area of tax law often catches US expats by surprise, as PFICs are often mistaken for seemingly ordinary financial vehicles like foreign mutual funds, investment trusts, or offshore funds, though other types of investments may also be classified in the same way.
An investment or foreign company is considered a PFIC if most of its income comes from passive sources such as dividends, interest, rent, royalties, or capital gains, or if at least half of its assets are held to produce passive income, such as stocks, bonds, or cash. While the technical definition may sound complicated, in practice it means that many everyday financial products available abroad fall squarely into PFIC territory.
This must be a crucial consideration for all US expats, as the IRS imposes some of its most punitive tax treatment on PFICs in order to stop US taxpayers from sheltering passive income in foreign funds. The problem is that many US expats invest in local financial products without realising the harsh tax treatment and complex reporting they will face later down the line.
How PFICs Trigger Punitive US Tax Rules
The tax treatment for PFICs are some of the most extreme in the US tax code, and US expats who hold one of these investments are automatically subjected to special tax treatment which is very different to that of US mutual funds.
Under the default system, known as the Excess Distribution Regime, any gain or distribution from a PFIC is not simply taxed in the year that it is received- instead, the IRS will spread the income backward across every year for which the investment has been held. For each of those years, the amount will be taxed at the highest rate applicable at the time, and additional interest will be added as though you had underpaid your taxes for that time period. The results can be so extreme that US expats may end up paying more in tax and interest than they received from the investment in the first place.
How to Mitigate PFIC Tax Treatment
There are some strategies to work around this harsh tax treatment, although they do come with challenges:
One option is the Qualified Electing Fund, or QEF. US expats who make this election are allowed to report their share of the PFICs income each year in a similar way to US based funds. The drawback with QEFs is that the fund must be able to provide the very detailed annual statements in the specific IRS approved format in order to be accepted, and since most foreign funds cannot provide this, the QEF election is rarely available to most expats.
The Market-to-Market election is another option, which usually applies to PFICs which are publicly traded. Each year you may calculate the change in the market value of your PFIC shares and report the unrealised gain as normal income. The advantage of this election is that it avoids the excess distribution method, although the downside is that you will be required to pay tax annually, even when you have not sold the investment or received a distribution.
For expats who do choose either of these elections, the outcome will rarely be favourable compared with simply opting for US mutual funds, which come with far less complexities. Furthermore, PFIC gains do not benefit from the lower capital gains tax rates, but are treated as ordinary income - yet another way that these rules will erode investment returns over time for US expats abroad.
Common Ways Expats Accidentally Invest in PFICs
All too often US expats fall into the trap of unknowingly investing in PFICs because these types of investments are not obscure or unusual. In fact, many of the most common financial products available overseas are structured in a way that will qualify them as PFICs.
Most foreign mutual funds, for example, are likely to qualify, as well as most ETFs registered outside of the United States, even if they are invested primarily in US or global companies.
Bank products and insurance-based investments are another way that US expats are often caught out. Savings plans, investment-linked insurance or retirement products are heavily marketed to US expats in many countries, and although these often appear to be safe investments, many of these will be classified as PFICs under US tax laws.
Even for US expats who are trying to build a diversified portfolio using familiar tools such as mutual funds, the fact that they are located outside of the US can cause problems, as the classification is dependent on where the fund itself is incorporated, rather than which assets are within the fund.
It is also common for US expats to get caught in PFIC tax traps indirectly. Holding interests in foreign trusts, partnerships or funds, may mean that the underlying holdings will trigger PFIC status. Many US expats only discover this later down the line, once they are asked for extensive details on their foreign accounts, and by this time they may have accumulated many potential penalties.
PFIC Reporting Requirements Every US Expat Must Know
Along with the hefty tax bills that investing in PFICs will lead to, the reporting obligations attached to these types of investments are some of the most burdensome in the entire tax system.
US taxpayers must file IRS Form 8621 every year for any PFICs they have invested in, and this is required not only when receiving income from a sale but also from simply holding shares above certain thresholds. It is estimated to take more than 20 hours to complete this notoriously complex form for each PFIC, and for expats who hold multiple PFICs, the amount of paperwork due can quickly become overwhelming.
US citizens are required to file Form 8621 if they receive any distribution from a PFIC, make a gain when selling PFIC shares, make an election such as QEF or Mark-to-Market, or if their holdings are more than $25,000 ($50,000 for joint filers). Even reinvested dividends will count as distributions and will require reporting. For U.S. expats who fail to file Form 8621, the consequences can be severe.
Unlike other IRS forms which carry explicit monetary penalties, the real risk in this case is that omitting the form can leave your tax return open to indefinite audits, meaning that the statute of limitations on your entire return will never close, giving the IRS unlimited time to examine your finances. Furthermore, failing to file the form may invalidate prior elections you may have made in an attempt to reduce the harsh tax treatment.
PFICs for Returned Expats: The Hidden Risk After Moving Back
One surprising aspect of the PFIC tax rules is that they do not simply cease for expats once they return to the United States. If you acquired PFIC investments whilst living abroad and still hold them after repatriation, you will remain responsible for ongoing reporting. The IRS does not care if you are no longer an expat, the classification will remain with the investment itself.
This creates an often hidden risk for expats who move back to the USA, perhaps under the illusion that their tax obligations may simplify once they live stateside again. In reality, the complexities of PFICs may follow many expats home- unfiled 8621 forms may catch up with you, and any future gains from PFIC investments will continue to fall under the punitive IRS regime.
Fortunately, there are ways to correct past filing mistakes, and the IRS has compliance programs such as the Streamlined Filing Procedures which allow taxpayers to catch up on missed filings without paying severe penalties, provided the noncompliance was not willful. This may be an effective route for many returned expats to put PFIC problems behind them.
PFIC Alternatives for US Expats
With all their complications and risks, many financial advisers may recommend US expats to avoid PFICs at all costs. The safest approach is often to invest in US registered funds or securities, even whilst living abroad.
A mutual fund or ETF which is domiciled in the United States is not a PFIC, no matter where it invests. US domiciled investments are far easier to manage from a tax perspective, although they may be slightly less convenient to access for expats using foreign bank accounts or brokers.
Another option is to focus on individual stocks and bonds, instead of pooled vehicles. This strategy eliminates any risk entirely, as individual securities are not subject to PFIC tax rules, although this may require a larger portfolio and more effort to ensure diversification.
Retirement accounts can often be a safe investment option for US expats. Depending on the country and applicable tax treaties, investments inside a qualified retirement plan may not be subject to PFIC treatment. As this may vary widely, seeking advice from a specialist adviser is essential.
Ultimately, the best protection against PFIC issues is proper financial planning, and working with advisers who are specialised in expat financial planning. Many local advisers are completely unaware of PFIC rules, and often advise US clients to invest in local funds without knowing the disaster this will cause. At The Wealth Genesis, our expert advisers work with US expats to navigate investing abroad safely and efficiently.
Key Takeaways: Protecting Your Portfolio from PFIC Problems
For US expats, getting familiar with PFIC rules is essential. These investments are everywhere, and the IRS rules surrounding them are not gentle. Accidently investing in one can lead to years of frustration, complex reporting and punitive tax treatment.
There are, fortunately, ways to navigate the challenges PFICs present. By opting for US domiciled funds, considering individual securities and retirement accounts and ensuring to seek out the best professional advice, US expats are still able to build strong investment portfolios without being crushed by PFIC rules.
For US expats living abroad, proper expat financial planning is key. The Wealth Genesis can help secure your future abroad, discover more by booking a free discovery call with one of our advisers today.
FAQs
Are ETFs PFICs?
This all depends on where the ETF is domiciled. To avoid Passive Foreign Investment Company (PFIC) treatment, US expats should always opt for ETFs domiciled and registered in the US, (such as iShares or Vanguard)These will be treated just like US mutual funds.
Foreign-domiciled ETFs are almost always classified as PFICs, even if they invest entirely in US stocks or global companies.
Do I need to File Form 8621 Every Year?
Yes, the IRS requires US expats to file this form every single year, for each separate PFIC they hold. Even if the investment did not produce any income in that year.
How Can I Avoid PFIC Investments as a US Expat?
In short, the best way is to opt for US registered investments, and to steer clear of any foreign-domiciled funds, including non-US mutual funds, ETFs, foreign corporations or investment-linked insurance products.
