There's no easy way to say this – PFICs are incredibly confusing. Because of that, I'm going to apologize before we even get started. Bear with me and we'll all make it through to the other side relatively unscathed. Alright, here we go!
A PFIC (Passive Foreign Investment Company) is any foreign corporation that meets one of the two qualifications put in place by the IRS: the income test or the asset test. According to the IRS, the income test is met when "75% or more of the corporation's gross income for its taxable year is passive income." Therefore, any company (with at least one U.S. shareholder) making a strong majority of their annual income from passive income are likely to be labeled as a PFIC. The asset test, which differs slightly from the income test, states that a foreign company is a PFIC if 50% or more of its assets in a given year are used or held for passive income streams.
That's a PFIC for you. It might take another glance at that paragraph, but you should be able to have a pretty good grasp on it after the second (or third) read through. If we want to try to simplify things as much as possible, we can say that a PFIC is usually just a foreign version of a mutual fund. For those needing a refresher, a mutual fund is where multiple people pool their assets together and have them invested in stocks, bonds, etc. In the past, PFICs were actually better than domestic mutual funds as they had higher returns and lower costs.
Only the IRS could take the word "fun" out of funds.
Wall Street didn't like that
In order to keeps taxpayer funds stateside, Wall Street decided to do some lobbying. Using their incredible lobbying power to influence Congress, they were able to make PFICs less attractive to the average taxpayer. By making the accounting for a PFIC mind-numbingly time consuming, they were able to ensure that the cost of staying in compliance overwhelms the returns that these funds would have otherwise brought to the taxpayers investing in them.
- If you hold a US incorporated fund, you’ll pay the long-term capital gains rate of 20% if held for more than a year. If you bought a virtually identical fund listed outside of the US, it would result in both income and capital gains being classified as earned income and would be taxed at 39.6% (potentially over 50%);
- Losses on a PFIC investment can’t be used to offset gains in non-PFIC investments;
- Gains are taxed annually – however, on US mutual funds, the tax may be deferred until distribution; and
- PFICs are generally a poor investment and can be a tax nightmare; you can usually find a US equivalent mutual fund that doesn't have to deal with the the many downsides of a PFIC.
Can't I just hide my PFICs?
Thanks to FATCA, probably not. FATCA (Foreign Account Tax Compliance Act) requires taxpayers to remain in compliance with listed reporting guidelines (chiefly, the annual filing of Form 8938 alongside one's tax returns) and also requires certain foreign businesses and financial institutions to report on any accounts "held by U.S. taxpayers or foreign entities in which U.S. taxpayers hold a substantial ownership interest." You can be assured that this is a heavy weight to hand to taxpayers and makes disclosing one's foreign accounts even more difficult.
FATCA isn't just another IRS acronym — it's a law created to ensure no one hides anything anymore. Finally, adding insult to injury, the department in charge of receiving these reports is the Financial Crimes Enforcement Network (FinCEN). It sure seems like the immediate implication is that anyone with a foreign account is suspected of being a criminal. Here are some FATCA facts:
- Reporting your investments requires a separate Form 8621 for each PFIC that you own;
- The calculations are extremely complicated. We've previously written a few more technical articles that can help to understand the rules and calculations of PFICs (those will be linked at the end of this article); and
- Failure to file in a year where no income is properly reported doesn’t carry specific penalties, but could make the return technically incomplete and subject the taxpayer to tolling of the statute of limitations.
We're experts until we aren't
Here's a necessary disclaimer: we're tax experts, not investment experts. That being said, we have seen a lot of tax problems and can tell you that PFICs are not the investment you want to make if you're looking for great tax treatment. Before investing in a PFIC, you should do your due diligence to decide if this is the best strategy for investing your hard-earned money. When you look into your options, it might become readily clear that there are better opportunities for you.
*A PFIC doesn't necessarily have to be a foreign mutual fund. Whenever you hear of an investment opportunity that has the following aspects, be careful: a (1) foreign account, (2) that is managed by someone other other than the taxpayer, and (3) generates passive income. For instance, sometimes the IRS will claim that a foreign life insurance policy isn't really a life insurance policy, but is actually an investment. Depending on the circumstances, that foreign life insurance policy might be considered a PFIC in the eyes of the IRS.
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