US citizens used to be able to take advantage of a tax loophole by investing in foreign mutual funds. These offshore investments were able to defer the US imposition of mandatory distributions, which resulted in the deferral of underlying income and paying tax. In order to combat the issue and encourage investments back into US-based mutual funds, the Tax Reform Act of 1986 introduced additional reporting requirements on any company or investment that was a Passive Foreign Investment Company (PFIC).
The IRS requires that US persons holding shares in PFICs must report them on Form 8621 – though there are some exceptions: broadly in years there are no distributions or sales and then only if the value is below $25,000.
Absent any election, these PFIC’s will be taxed under IRC s.1291 (default) which is generally a penal regime and involves apportioning any excess distributions of dividends over the entire holding period of the shares, taxable at the highest rate of income tax and including an interest charge based upon your holding period
What is a Passive Foreign Investment Company (PFIC)?
A passive foreign investment company is an entity treated as a corporation for federal tax purposes, which is located outside the US and meets at least one of the following tests:
- Income Test – 75% of the corporation’s gross income for its tax year is considered passive income (derived from investments or other sources not related to regular business operations).
- Asset Test – At least 50% of the company’s assets during the tax year are investments which produce passive income or are held for the production of passive income.
These conditions apply to the majority of foreign corproate investment vehicles including:
- Mutual Funds, Hedge Funds, Private Equity Funds
- Investment Trusts
- Private family holding companies and property holding companies
- Certain public shares
They can also apply to private companies operating a business and this would most commonly happen at start up, if there is a large amount of invested cash on the balance sheet or later in a businesses life if it rolls up cash from profits and invests.
It is important to note that generally mutual funds in qualifying pensions are excepted from PFIC reporting.
How is the PFIC taxed by the IRS?
The IRS Form 8621 is used to report income from passive foreign investment companies (PFICs). There are three methods of PFIC taxation:
The default method of taxation of PFIC investments, is set out in IRC s.1291 and is the method used assuming no other timely elections are made. This method involves taxing realised gains and distributions (e.g. dividends).
In summary, if a distribution (e.g. a dividend) from the PFIC significantly exceeds the average distribution of the preceding 3 years this will be an ‘excess distribution’ and any gain on disposal of a PFIC will also be an ‘excess distribution’. So, in the case of a one off dividend, if no dividends have been paid in the preceding three years the whole amount would be an ‘excess distribution’.
The mechanism of taxing excess distributions under the default basis is complicated and involves the following:
- The excess distribution is apportioned pro rata to each year of the holding period of the PFIC
- The amount apportioned to the current year (the year of disposal or distribution) is taxed at ordinary income rates, up to 37%
- The amounts of gain apportioned to earlier tax years in the holding period are taxed at the highest rate of US tax in application in that year e.g. 37% for 2018 or 39.6% for 2017.
- A form of throwback interest charge is added to the tax due determined based on your holding period. E.g. a holding period of five years would bring a rate up to 45% with s.1291 interest added
The computations are complicated and invariably the taxes exceed the 37% top rate of tax. Additionally, foreign tax credits cannot be utilised in relation to dispositions and losses cannot be offset against the gains. Overall, it is a penal regime.
Qualified Electing Fund (QEF)
Essentially a Qualified Electing Fund (QEF) is PFIC where the US shareholder has made a special election. The result is that QEF’s have similar taxation rules to partnerships, where the income/gains the QEF receives, retains its nature in the hands of its shareholders i.e. Capital Gains realised by the company will be treated as gains proportionately realised by the shareholders and reported on their tax returns. The entity is said to be transparent in nature.
The election must be made during the first tax year in which one of the following occurs:
- Acquisition of the shares
- The QEF designation of the first U.S. taxpayer in the ownership chain.
How do you make a QEF Election?
A QEF election is only available if the PFIC provides US taxpayers with an annual information statement describing their share of ordinary income, capital gains, and distributions made within the first year of share ownership.
To elect a QEF, the US taxpayer must make the election on Form 8621. The company must provide the individual with a QEF investor statement for each tax year in which the election is in effect and the company must comply with IRS requirements for QEF’s under IRC S.1295(a).
The election looks to be far less penal than taxing PFIC’s under s.1291 and is a preferable method of taxation as long as the election is possible.
It’s also important to consider the timing of the QEF election because if it’s not done correctly, the shareowner is subject to both QEF income inclusions throughout the holding period and the excess distribution taxation method upon selling the shares (unless a purging election is made).
US Taxpayers are able to make a MTM election on their holdings in a PFIC, this would have the effect of treating any distributions and dispositions of the PFIC as ordinary income or gains.
Under a mark to market election we effectively treat the PFIC as being sold at the end of each year, with the proceeds equalling the market value at 31 December.
This has the effect of rebasing the asset each year so that when the PFIC’s are eventually sold, the gain has been substantially reduced. A deemed disposal may be required to get onto this regime.
To elect to have your PFIC taxed the Mark-to-Market rules, the taxpayer will need to do the following:
- Make the MTM election on Form 8621
- Submit the information for Passive Foreign Investment Company including US expat tax return
It’s also important to consider that these steps are not taken once. The US taxpayer is required to repeat these steps every year in order to have this treatment on their PFIC.
Who must file Form 8621?
In most cases, the following people are required to file in Form 8621:
- A US person that has a direct or indirect ownership interest in a PFIC
- A US person who has shares in a PFIC by gift, death and most types of otherwise tax-free exchanges or redemptions.
How can Ingleton help?
Filing Form 8621 is a lengthy and complicated process so it’s vitally important to make sure that the filing is done correctly. If PFICs are not properly identified, this could result in penalties and unexpected tax costs.
Here at Ingleton, we can help guide you through the process with our highly skilled and diligent tax professionals. If you require any assistance regarding the filing of Form 8621, please contact us on +44 (0) 207 183 2251 or email firstname.lastname@example.org.