Toxic Foreign Investments U.S. Expats Should Avoid

By:  Joel Barretto, CFP®
Oct.26, 2021

Buying a foreign mutual fund is perhaps the most prevalent financial mistake made by Americans abroad (including ETFs or other types of non-U.S.-based funds). Non-U.S. registered mutual funds are classified as Passive Foreign Investment Companies (PFIC) under the U.S. tax code.

The United States taxes PFICs quite aggressively. Furthermore, each PFIC is required to file an annual report on U.S. tax form 8621, which involves complicated accounting and requires a lot of time to accomplish.

Over several years after the inaugural PFIC law was passed in 1986, US expats were free to flout the PFIC regulations because the absence of cross-border financial transparency caused enforcement problems for the IRS.  

All of this changed in 2010, with the adoption of the Foreign Account Tax Compliance Act (FATCA).  FATCA heralded a new era of substantially greater cross-border tax transparency and intelligence gathering on non-U.S. accounts owned by U.S. citizens and other taxable individuals.

As a result, persisting to fail to adequately declare PFICs on a US tax return implicates US taxpayers to a significant risk that the IRS may eventually discover the lack of disclosure and levy tax, interest, and penalties that could devour most (if not all) of the returns on your investments.

Understanding Passive Foreign Investment Companies (PFIC)

A foreign company is a PFIC if it passes one of two criteria under the income or an asset test. A foreign firm is a PFIC if 75% or more of its gross revenue is passive income, according to the income test. As for the asset test, a foreign business is a PFIC if 50% or more of the average value of its assets are assets that generate passive income. Several look-through rules apply for the purposes of both assessments.

The term conjures up images of esoteric and sophisticated investments, and as a corollary, numerous Americans think they do not own any. This conclusion is erroneous for many unwary Americans living overseas, because PFICs are essentially “pooled investments” established outside of the United States that include mutual funds, exchange-traded funds (EFTs), closed-end funds, hedge funds, insurance products, and non-U.S. pension schemes.

Because money market accounts are essentially short-maturity fixed-income mutual funds, a bank account may also be a PFIC if it is a money-market fund rather than just a deposit account. Moreover, PFIC regulations apply to investments held within foreign pension funds unless such pension schemes are regarded as “qualified” by the US under the provisions of a double-taxation treaty between the US and the host nation.

The probability that the IRS will eventually uncover undeclared PFICs has grown substantially as a result of FATCA. Finally, PFIC laws apply equally to Americans living abroad and Americans residing in the United States, even though the problem is considerably more prevalent among American taxpayers living overseas.

The Internal Revenue Service has rigorous and highly intricate tax requirements for PFIC investments, which are outlined in Sections 1291 through 1298 of the United States income tax code. The PFIC, as well as its shareholders, must keep accurate records and documentation concerning the PFIC, such as share cost basis, dividends received, and any undistributed revenue that the PFIC may generate.

The cost basis standards are an example of the stringent tax treatment that is imposed to shares in a PFIC. The IRS allows a person who inherits shares of almost any other marketable security or asset to ramp up the cost basis to the fair market value at the time of the bequest. However, in the case of PFIC shares, the step up in cost base is not usually allowed. Furthermore, identifying the permissible cost basis for PFIC shares is frequently a tough and perplexing procedure.

PFIC Compliance for Foreign Mutual Funds

For American investors, high tax rates are not the sole drawback of PFICs. The arduous process of just complying with IRS reporting regulations for PFICs is the second main PFIC issue. Expat Americans are the most likely to own a business, and many of them use accountants that specialize in tax preparation for Americans living overseas. Hiring an expatriate tax specialist, on the other hand, does not ensure that the appropriate PFIC-related files are completed, and taxes are paid.

 As a result of the FATCA law, investors in the United States who possess PFIC shares must submit IRS Form 8621. This form is used to report real distributions and gains in Qualified Electing Funds (QEF) elections, as well as income and growth. The tax form 8621 is a lengthy, complex paperwork that, according to the IRS, may take more than 40 hours to complete. As a result, PFIC investors are typically encouraged to have a tax specialist complete the form.

 This terrifying scene begs the obvious question. If this is such a huge trap, why hasn’t there been more debate about it, and why have I never heard of it before? The reason for this is because, up until recently, the IRS encountered several challenges in implementing the PFIC regulations and lacked the resources to pursue filers on the matter.

Failure to submit Form 8621 and correctly disclose PFICs has almost never resulted in an audit or a tax fraud conviction. Until now, the PFIC issue has been safely disregarded, even by experienced tax preparers. However, as a byproduct of FATCA, times have changed.

PFIC Compliant Investments

This case highlights an essential fact that all American expats should be aware of the complexities of foreign financial planning are exacerbated by the numerous tax regimes that the cross-border or international investor encounters through their assets. The PFIC laws are only one of the myriad reasons why American investors should retain their investment assets in US accounts, particularly if they are investing worldwide. When it comes to sensible and efficient investing, clever American investors retain their wealth invested internationally, but through U.S. financial institutions to manage the umpteen tax and regulatory concerns.