As a US citizen, green card holder, or US resident you are required to report your worldwide income on your US Federal tax return. For Americans living outside of the US, or non-US nationals who have moved into the US, your investment portfolio will most likely include non-US investments. Understanding the US tax treatment of these foreign investments will help you better-structure your investment choices, and limit your exposure to draconian US taxes.
So, what is a Passive Foreign Investment Company (PFIC)?
The rules that determine what is a PFIC depend upon the entities income and assets (75 % or more of its gross income is passive income; or average market value of its passive assets is at least 50% of its total assets). However, importantly it does not have to be a company or corporation. If the IRS believe that it is organised like a company then that will be sufficient to potentially bring it within the definition of a PFIC.
This has the effect of bringing most, if not all, non-US collective investment assets into the PFIC rules.
Examples of such investments are UK unit trusts, investment trusts, Funds, ETFs and similar collective investment products. These can be held either through a normal trading account or through a UK ISA, and in either situation the US tax treatment is the same.
So how bad is the tax treatment of income and gains from a PFIC?
Unlike capital gains, where assets held for more than one year will attract a maximum 20% US income tax charge, PFIC gains are taxed at ordinary income tax rates. In addition, PFIC dividends are not taxed at the lower rate that applies to qualified dividend income.
If that is not bad enough, the PFICs are subject to what I will describe as the “excess distribution regime”. This regime attributes excess distributions1 back over the holding period of the PFIC and allocates them evenly to each year in this period. Tax is calculated for each year at the HIGHEST marginal rate for that year, interest is then charged from April 15th after each relevant tax year.
Where these investments have been held for many years this can become very expensive.
1Excess distributions are as follows:
- Dividends to the extent they exceed 125% of the average distributions for the prior three years
- Gains realised from the disposal of a PFIC.
Another significant drawback for foreign nationals who have moved to the US and become US resident is that when the individual leaves the US and ceases to be considered US resident, there is a deemed disposal of all PFICs held.
So, what is the PFIC solution?
Apart from avoiding PFICs altogether…
There are two options, the suitability of each will generally depend upon the nature of the PFIC and whether it is privately owned or publicly traded.
- Make a Mark to Market (M2M) Election: where the PFIC is publicly traded it will have a readily ascertainable market price. The PFIC shareholder elects to recognise a gain or loss each year on the PFIC by M2M at the end of the year. This avoids the aforementioned “excess distribution” regime. Any gains are taxed as regular income and losses are only allowable to the extent of previously reported gains. The election must be made on or before the due date (including extensions) of the relevant tax return. Once made, the election applies to all subsequent tax years unless the election is revoked or terminated.
- If the PFIC is privately owned, you may be able to make a QEF Election: This election allows the taxpayer to include, on their tax return their current year pro-rata share of the PFIC’s ordinary income, net capital gains and any corporation tax paid. The QEF election must be made on a timely-filed tax return (including extensions) and applies to all subsequent tax years.
We would add, as usual that this is a complex subject and that this advice is very general in nature, there are always exceptions. You should seek professional advice where you want to consider these matters further.