It is common knowledge that citizens and permanent residents of the United States who earn money elsewhere in the world must report and pay taxes on that money. The FATCA agreement between the United States and other countries made information about US taxpayers' overseas bank accounts, investments, etc., readily available to the Internal Revenue Service.
A new era of significantly improved cross-border tax openness began in 2010 with the implementation of the Foreign Account Tax Compliance Act (FATCA). U.S. citizens and other U.S. taxable persons who have accounts at foreign financial institutions must now disclose the existence of those accounts.
You must file tax returns in both the United States and the country where the overseas mutual fund is located. Foreign Investment Passive Entities are one such necessity (PFICs).
Hence, U.S. taxpayers run the possibility of having their return audited and having to pay tax, interest, and penalty costs equal to or greater than their return if they fail to correctly record PFICs on their U.S. tax return.
1. PFICs.
To be considered a PFIC, a foreign company must either have more than 50% of its assets "kept for the production of passive income" or have 75% or more of its income originate from passive sources (interest, dividends, capital gains, rent, and certain royalties). This includes holding cash as well as any investment that isn't a stake in a company.
The vast majority of PFICs are merely "pooled investments" based in a country other than the United States. Certain investments held by non-U.S. pension plans and some foreign mutual funds, ETFs, closed-end funds, hedge funds, insurance products, and so on fall under this category. Even if they are kept in a bank, money market funds can be considered PFICs because they are essentially short-term fixed-income mutual funds.
Unless the foreign pension plan is "qualified" by the United States under the terms of a double-taxation treaty between the United States and the host nation, the PFIC rules apply to investments held within the foreign pension fund. The chances of the IRS discovering hidden PFICs have increased considerably as a result of FATCA. Last but not least, PFIC laws are equally applicable to U.S. citizens living overseas and U.S. citizens living in the U.S., yet the problem is still far more prevalent among U.S. taxpayers residing abroad.
2. Tax Treatment
When compared to similarly structured U.S. corporations, the tax treatment of PFICs is exceptionally harsh. If an American invests in a U.S.-incorporated mutual fund that invests in European companies and holds the fund for more than a year, he or she will pay the low long-term U.S. capital gains tax rate of 0%, 15%, or 20%. All revenue (including capital gains) is treated as regular income under the PFIC taxation regime, which applies to the same American investor holding a nearly similar fund listed in Singapore, the UK, or anywhere else outside the U.S.
This gain is taxed over the period of time beginning with the year the PFIC was purchased. During the current year, it is taxed at the shareholder's marginal rate, but for each prior year it was taxed at the highest marginal rate in effect for that year.
All taxes also accrue daily compounded interest beginning on the date of purchase. Distributions from PFICs may be nullified if the overall tax on the underlying investment is high enough. Capital losses from one PFIC can only be used to offset gains from another PFIC, and only under specific conditions.
3. Tax Filing Requirement
As a result of the Foreign Account Tax Compliance Act of 2010, a new Form 8621 must be submitted annually for each PFIC. In the past, Form 8621 was submitted only in years in which distributions were made to fund shareholders. No matter how much (or how little) the underlying investments are worth or how they perform over time, it doesn't take long to recognize that submitting Form 8621 for many PFIC investments may quickly build up a tax preparation cost to many thousands of dollars.
All "foreign financial institutions" are now obligated to report immediately to the IRS any and all assets held by U.S. citizens and permanent residents that are located outside the United States, including Passive Foreign Investment Companies (PFICs). It may be difficult to assume that foreign financial institutions would voluntarily comply with such reporting obligations; nonetheless, the severe consequences imposed by the IRS on non-compliant financial institutions have led to practically universal compliance with FATCA-induced laws.
4. PFIC compliant investments
It's safe to suppose that the Internal Revenue Service has complete access to the accounts of all U.S. individuals held at overseas banks. The IRS will have little trouble connecting the taxpayer's Forms 8938 and 8621 to the information reported by these financial institutions. The IRS needs this data to verify whether or not you accurately disclosed your PFIC investments and paid the appropriate tax.
All Americans living abroad must be aware that the numerous tax systems impacting cross-border or international investors add significant complexity to international financial planning. Even if investing internationally, American investors must retain their money in U.S. accounts due to PFIC restrictions.
Contact Surya Padhi at Sure Financials for any question and clarification. Surya Padhi is an expert who keeps current on tax law changes as well as a member of the National Association of Tax Professionals National Association of Tax Professionals (NATP) and New Homepage - National Association of Enrolled Agents (naea.org). Visit Welcome | Sure Financials & Tax Services, LLC (surefintaxsvs.com) for more information and contact us by calling +1908.300.9193.
