by Tracy Moede, AWC Hamburg, US Tax & Banking Co-Chair
A PFIC is a Passive Foreign Investment Company. It’s an investment fund or collective investment and it is taxed at a disadvantageous rate in the US. The PFIC problem is a confusing one and is a common US Expat mistake. Failure to address PFIC problems once they are identified can result in potentially catastrophic tax consequences.
Why is a PFIC a problem?
FATCA was passed in 2010 and since then has made PFICs highly visible. You can’t pretend no one is ever going to find out because your foreign financial institutions are most likely already reporting your accounts to the IRS. When reporting a PFIC on your taxes, for any capital gains, you must pay the ordinary income tax rate instead of the capital gains tax rate and you can not offset any capital gains with capital losses.
There are complex and time-consuming taxpayer reporting requirements if the following apply:
- You receive a distribution from a PFIC
- You recognize a gain on a disposition of PFIC
- You report a qualified electing fund (QEF) or mark-to-market election
- Make an election on Part II of Form 8621
- When you hold over $25,000 (aggregate total) worth of assets in PFICs
Is my investment a PFIC?
It is NOT the account in which it is held that makes the investment a PFIC; it is the investment itself. If you only hold individual stocks and bonds – like shares of HSBC or Nestle – then you likely don’t have a PFIC problem.
If it has some form of collective investment, such as a foreign mutual fund, you very well may have a PFIC problem.
Ask yourself these questions:
- Is my investment an entity organized for investment?
- Is it a foreign entity, not a US entity?
- Does it provide some kind of limitation of liability? For example, a shareholder is not liable and will not lose any more than the initial investment in this fund. If it does not offer a limitation of liability, the US will not consider it a company.
The C part of PFIC means that it is recognized as a company by the US. If you have made some sort of investment in a partnership to own real estate, for example, this is not recognized as a company. Remember, it is not the account, but rather the vehicle for investing that may make it a PFIC. There are two simple tests to determine whether your investment is a PFIC.
A foreign company is a PFIC if it meets either of these tests:
- 75% of the gross income is passive income.
- 50% of assets are held for the production of passive income. Cash can sometimes cause companies you don’t think of as collective investment vehicles to actually become PFICs. One example of this is a start-up company. A start-up company in a foreign country that raises cash and/or has large cash balances – perhaps because it hasn’t yet managed to spend the money it has raised – qualifies as a PFIC. The cash balance is considered to be held for the production of passive income.
Passive income includes interest, dividends, rent, royalties, capital gains, foreign exchange gains and gains from hedging.
Where are PFICs held?
PFICs are generally held in brokerage accounts, directly held securities, nominee accounts, unrecognized (in bilateral treaties) pension/preferred accounts such as UK ISAs or non-US insurance/investment products.
One significant problem is non-US insurance hybrid investment products. If you have term insurance in your country that does not have an investment component, it is NOT considered a PFIC. However, if your insurance has an investment component, then it IS considered a PFIC. Just because it is labeled an insurance, does not mean it is not a PFIC-defined investment.
If you think you own a PFIC, we encourage you to talk to a professional accountant to validate that it is a PFIC and if it is, to report it to the IRS.
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