Americans living abroad often consider investing in non-US investments offered by their local banks or employers. But before investing in non-US opportunities like foreign mutual funds, it is important to understand the tax implications. It could result in a much higher US tax bill for passive foreign investments (PFICs) that can wipe out any higher investment returns.
The US discourages investments outside the US in PFICs (Passive Foreign Investment Companies) by punitive tax treatment. And a foreign mutual fund held through a foreign broker is a PFIC.
What is a PFIC?
A PFIC, as defined by the IRS, is a Passive Foreign Investment Company that meets either the asset or income test:
- Income Test – 75% or more of the foreign company’s gross income for its tax year is passive.
- Asset Test – 50% or more of the assets held by the foreign company during the year produce passive income or are held to produce passive income.
This typically occurs with foreign mutual funds not held by a US investment firm. Mutual funds with non-US investments held by a US broker are not a PFIC. For example, a Europe-focused fund or ETF held with Vanguard is not a PFIC. However, any fund or ETF held with a UK bank or broker is a PFIC.
There are other non-US investments besides mutual funds that are treated as a PFIC. Foreign life insurance for example might meet the IRS PFIC definition. In this article we focus on non-US mutual funds.
The PFIC designation is made on the investment level, not for the foreign account as a whole.
In most cases, the foreign account(s) are wrappers that hold various types of investments, funds, bonds, etc. Each investment must be reviewed individually. This is because not all investments are considered PFICs, e.g., active companies don’t meet either PFIC test.
For each PFIC, you must file a separate Form 8621. We discuss the filing requirements in more detail later.
How are PFICs taxed?
There are three types of tax treatments for PFICs:
- Excess Distribution (section 1291 Fund) – default treatment
- Mark-to-Market Election (MTM)
- Qualified Electing Fund (QEF)
The taxpayer can elect the tax treatment that makes the most sense for them. They do this on Form 8621, which we explain in a moment. But note that you can make the election only during the first year that you own the PFIC or the year the PFIC holding period begins. Otherwise, the default treatment typically applies.
If this sounds overwhelming, consult with an experienced expat tax accountant.
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Excess Distribution (Section 1291 Fund)
Under this default tax treatment of PFICs, US taxes can be deferred until earnings are distributed or the PFIC is sold. The IRS taxes these earnings as ordinary income.
The excess distribution tax is calculated based on the increase in tax each year during your holding period. The highest tax rate for each applicable year applies to the excess distribution. The amount calculated per year is based on the total taxable amount prorated based on the total number of days each year over the total number of days during the holding periods.
You also pay interest based on the net increase in tax.
This means that you could face a high tax bill plus interest charges later.
The calculation can get complex since covers multiple years, tax rates, interest rates, etc. It’s best to use an accounting firm that can compute on your behalf.
Mark-to-Market (MTM)
When you elect the mark-to-market tax treatment, the annual gain or the allowed loss in the PFIC’s fair market value at the end of the tax year is taxed as ordinary gain or loss. This is not a realized gain or loss but the change in value. It is treated as if you sold the funds at the end of the year and repurchased them the next day.
Of course, if you sell PFICs during the year, then you pay tax on the actual gain or loss.
The advantage of the mark-to-market tax treatment of PFICs over the default method is that you avoid interest payments, potentially the highest income tax rate, and spread out your tax bill. The calculation is also easier as it only covers one year.
Qualified Electing Fund (QEF)
With the QEF election, the PFIC is taxed on its pro-rata share of undistributed earnings for both ordinary income and long-term capital gain. This requires a QEF investor statement that complies with US GAAP financials.
Many foreign brokerages don’t comply with this documentation requirement. Therefore, not many taxpayers use the QEF election for PFICs.
How to select the best PFIC tax treatment?
A number of factors affect which tax treatment is more beneficial.
- Are you a U.S. Citizen/GC holder? How long do you plan on living in the US if you are neither? Are you planning on applying for citizenship or permanent residency?
- What amount(s) are you planning on investing and what is the expected growth of all foreign funds held?
- Does the fund pay dividends or offer dividend reinvestments?
- Do you anticipate holding the investments for short or long-term periods?
An experienced tax accountant can guide you through the scenarios and help you decide if the Section 1291 default method or the mark-to-market method is better for you.
Form 8621 PFIC reporting
You must report foreign mutual funds on Form 8621 as part of your individual tax return. Form 8621 is called Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.
You must file Form 8621 if you:
- Hold more than $25,000 in all PFICs combined, or
- Receive a distribution from a PFIC, or
- Have a gain from your PFIC, or
- Make a QEF or MTM election.
You must typically file a Form 8621 for each investment separately, not one for the entire foreign account(s).
So, if you hold three mutual funds and two ETFs in your Spanish brokerage account, you’d have to file five Forms 8621 each tax year. Some accounts in a brokerage account are not PFICs, for example individual stock. This is why you may not have to report the brokerage account as a whole.
And don’t forget to report your foreign accounts on FinCEN 114 (FBAR) and on Form 8938 if you meet the reporting thresholds.
Exceptions to filing Form 8621
You don’t have to report your foreign mutual funds to the IRS if the total value of all your PFICs combined is:
- less than $25,000 ($50,000 if filing a joint return) on the last day of the year, and
- there are no excess distributions or gains on the sale or dispositions of stock sales.
However, remember that you can make the MTM election only in the first year of owning the PFIC. If your PFICs are below the filing requirement in the first year but exceed the threshold in the second year, you can’t take the election retroactively.
If you don’t want to use the default tax treatment down the road, you should file Form 8621 even if your PFICs are below the threshold.
Filing deadlines and penalties
Form 8621 is filed together with your individual tax return, so the due date is the same. For an overview of tax deadlines for expats, check out our tax calendar.
Not filing or filing late can result in numerous penalties (late filing, late payment, interest).
Should expats invest in foreign mutual funds and ETFs?
As you can see, holding mutual funds or ETFs through a foreign bank or broker can have significant US tax implications. Before you make such an investment abroad, consult with a knowledgeable expat tax accountant.
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