By Bethany Bouw
Many with foreign investments have ownership of foreign mutual funds. This can cause a world of problems from a US tax perspective. There are significant differences between the US tax treatment of domestic mutual funds and foreign mutual funds. Foreign mutual funds are almost always considered to be passive foreign investment companies (PFICs). PFICs are a serious matter and require great consideration with reporting and elections. There are serious disadvantages to each method of treatment so it is vital to contact a tax professional who can assist.
The IRS defines a PFIC as: A foreign corporation that meets either the income or asset test described below.
- Income test. 75% or more of the corporation’s gross income for its taxable year is passive income (as defined in section 1297(b)).
- Asset test. At least 50% of the average percentage of assets (determined under section 1297(e)) held by the foreign corporation during the taxable year are assets that produce passive income or that are held for the production of passive income.
Almost all foreign mutual funds are considered PFICs as they are:
- generally organized outside of the country as corporations or a foreign entity that defaults to corporation classification and
- generally fit either the income or asset test.
Difference between foreign & domestic mutual funds
Domestic mutual funds are required to distribute to investors capital gains and dividends each year. Those tax items would be reported each year on the taxpayer’s income tax return and taxed accordingly.
Foreign mutual funds face no such requirement. Therefore, investor’s income can build and build without any distribution. Without a distribution, there would be no taxable event. This would allow a taxpayer to hold off on taking the distribution of the earnings until a year when it was more advantageous from a tax rate perspective.
Obviously, the IRS doesn’t want to lose out on tax dollars. Many taxpayers lament the method put in place to stop this tax workaround as being unfair. It is important to note, the IRS is primarily trying to even the playing field between domestic and foreign. This is accomplished by enforcing a tax and interest on those taking advantage of the ability to hold their income offshore in foreign mutual funds without distribution.
There are three methods of treatment for PFICs. One is a default method that is automatically required if no action occurs. There are two other methods which a taxpayer elects into based on their qualifications – level of information available and location fund is traded mainly. The decision as to which method is best suited to your fund, assets, and needs is crucial and should be discussed with a tax professional.
The do-nothing, make no election method AKA Section 1291 Funds
If you make no election for the fund to be a Qualified Electing Fund or Mark to Market, the fund is treated as a Section 1291 Fund. You must consider the average of the prior three years distributions when you receive a distribution from a Section 1291 fund. Generally, there is an excess distribution to the extent that your distribution is in excess of that average. The excess distribution gets allocated over the period that the PFIC has been held. Each allocated amount of excess distribution is taxed in each year at the maximum individual rate. The tax on the excess distribution allocations is then assessed interest as if the tax had been due in each tax year. It is a complicated calculation and holding the PFIC for decades can lead to huge number of those calculations. Generally, disposal of a Section 1291 fund shares creates excess distributions as well.
For many, this method has adverse tax consequences. This method requires good records to be kept over the period of ownership and can end up being costly once you consider maximum tax rates and interest. It is also important to note that this method impacts the ability to take losses when the fund is disposed. This method treats dividend and sales as ordinary income. This method may be less painful for those who take regular and consistent distributions each year. Section 1291 treatment may also suit those who do not have cash at the ready to pay tax on undistributed earnings.
Qualified Electing Fund (QEF)
QEF treatment requires an election . This method requires that you have access to information on your individual portion of the fund’s earnings. This information is needed by income type. This information is reported so you can pay tax on your earnings for the year regardless of receiving a distribution. When you receive a distribution, there is consideration for the distribution of previously taxed income.
This fund does generally eliminate the massive calculations and penalty tax/interest that can accompany Section 1291 funds. However, it does require a great deal of transparency and information from the fund which may be unavailable to you as an investor. It is important to understand that this treatment taxes undistributed earnings. It should also be noted that this method allows income to retain the character as either ordinary income or capital gain.
Mark-to-market Funds (M2M)
This treatment requires an election as well and that the fund be “regularly traded” (as defined in Regulations section 1.1296-2(b)) on:
- A national securities exchange that is registered with the Securities and Exchange Commission (SEC),
- The national market system established under section 11A of the Securities Exchange Act of 1934, or
- A foreign securities exchange that is regulated or supervised by a governmental authority of the country in which the market is located and has the characteristics described in Regulations section 1.1296-2(c)(1)(ii). Stock in certain PFICs described in Regulations section 1.1296-2(d).” per the IRS
Mark to market treatment may generally be the simplest method to use as long as the PFIC qualifies. It involves picking up in income the unrealized gains on the fund. The unrealized gains are taxed as ordinary income. Generally, to the extent that you have paid tax on unrealized gains, you can take future losses. When the fund is sold, you can pick up losses on disposition. Mark to market treatment generally leads to paying tax on unrealized gains. This could cause issues if the fund value increases substantially without providing the assets to pay the tax on the increase in value.
All in all, you should take time to carefully consider the treatment and plan with your tax preparer. There are tremendous complexities to each method of treatment and even a method that sounds simple can have hidden issues. It is incredibly important to involve your tax professional when you buy, hold, receive distributions from, and sell a PFIC. You will want to consider the options and methods of addressing older PFICs too. The main takeaway is to contact your tax professional to discuss your foreign mutual funds. It is much better to be proactive with PFICS than reactive.
Ryan & Wetmore has assisted clients with their PFICs (QEF, mark-to-market, and default treatment) over the years. We would be happy to assist you with questions or concerns regarding your PFIC ownership.
The International Tax Team at Ryan & Wetmore is well-versed in foreign informational filings. For questions or concerns regarding your international accounts and assets, click here to email our foreign tax team. Please be aware that tax issues are complicated and may vary based on the details of your situation. For this reason, an initial phone call is generally required to obtain the facts and address the questions.
Bethany Bouw CPA, is a manager at Ryan & Wetmore and has been with the firm for over eight years. She has experience with offshore voluntary compliance and assisting taxpayers with foreign asset and entity reporting requirements.
Traci Getz CPA, is a partner with Ryan & Wetmore, P.C. Traci has over fifteen years of experience providing accounting, tax, and consulting services to small and medium-sized business owners. She works with clients to understand their accounting and tax issues while specializing in international tax, healthcare, and construction.
Our firm provides the information in this e-newsletter for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this e-newsletter are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.
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