Of all the confusing acronyms regarding tax issues for US-connected investors that are thrown about these days, PFIC is probably the most misunderstood.
Even once you expand the abbreviation to its full meaning, ‘Passive Foreign Investment Company’ can seem just as ambiguous. What is more, the rules regarding taxation of PFICs by the US tax authorities are punitive, to say the least, for those investors who fall foul of the regulations.
Considering that a US-connected individual* could suffer unnecessarily high tax rates for PFICs that are declared and could be prosecuted for PFICs that are not declared, this is a subject that should be cleared up. Let’s start with a few rules of thumb for US-connected investors around the world:
- Always keep your home address up to date with banks and investments. Those companies have a responsibility to tell you when regulations might affect your situation.
- Always declare all of your investments on your tax return. Penalties can be retroactive!
- If you are unsure whether an investment you already hold is PFIC, seek professional advice about it immediately to avoid nasty tax surprises.
- If you are unsure whether an investment you are considering is PFIC, avoid it until you know what the tax status will be.
With that out of the way, the best way to identify a PFIC is to break the acronym down into its three component parts. Yes, three, not four. A common mistake for investors is considering that each of the initials represents a qualifying statement.
Passive – Does the investment do (some or all of) the work for you or do you actively make the decisions and transactions that generate returns? Buying stocks directly through a stockbroker or starting your own business is active investing. Putting funds in a portfolio that invests on your behalf is not.
Foreign – Firstly, is the investment based or regulated outside the USA? Secondly, has there ever been a time when that investment did not report all details to the IRS? If the answer to either of these questions is ‘yes’ then the investment is considered foreign.
Investment Company – Have you invested your money in a company that makes its money by investing for others? This is the part that is most often mistaken. This term automatically includes almost every managed or mutual fund, and even many investment platforms.
So if part of your portfolio ticks those three boxes, what does that mean? Should you sell everything and start from scratch? Not so fast.
Because of the ‘foreign’ bit, the IRS deems that most PFICS must be hiding something. For that reason, they can be taxed aggressively. A PFIC will normally be taxed annually at short-term capital gains rates (similar to income tax), whether it is sold or not.
The temptation might be to conceal or ‘forget to mention’ any foreign investments, in the hope that the IRS will overlook your holdings or not bother to investigate little-ol’ you and your dainty little nest-egg. This is tax evasion, pure and simple. If and when you are caught, you can look forward to ruthless prosecution, hefty fines and even federal prison. Don’t risk it.
Ok. PFICs are bad, right? Well, they can be a pain, but not all PFICS are created equal.
If an investment company, fund or portfolio is outside the US and generates passive returns for its investors but it has volunteered all information to the IRS since it was first established, it may qualify for a QEF election. A Qualified Election Fund can be declared on your tax return and will be taxed in a very similar way to a US mutual fund held by a US-resident investor.
Not all QEF investments will say that on the tin. If a good financial advisor has recommended something for you on the basis that it will be efficient for US tax, you can have faith in that. If you are trying to go it alone with your portfolio, stick to platforms and investments designed and marketed specifically for Americans outside the US. The chances are you won’t be allowed to open an account that is non-compliant even if you try, but take care anyway.
Above all, simply understand that the PFIC classification makes it easier for US-connected investors to invest their money without unexpectedly losing all of their gains to higher rates of tax. By knowing in advance what will be heavily taxed and what will not, you can make sure your portfolio grows in line with your targets.
If you have questions about PFICs or any other investment or tax acronym you have seen or heard recently, contact us for help with busting the jargon and understanding suitable investments.
*If you are not American but have some financial or family connection to the US, please see our article ‘Are You an Accidental American?’