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Expat Tax Essentials
Most American investors are familiar with the basic mechanics of a mutual fund. But many American expats will need to navigate the reporting requirements that come from investing in a passive foreign investment company (PFIC).
The reporting requirements for a PFIC can be a bit intimidating if you’re not familiar with how they work, and U.S. taxpayers may be required to pay additional costs.
If you’re an American expat, you may want to bookmark this page before tax season, as it explains everything you need to know about PFICs and how they work.
A passive foreign investment company, or PFIC, is a pooled investment that is registered outside the borders of the United States. PFICs are defined by U.S. tax law, and they include a variety of investment funds and certain types of pension investments.
If you’re an investor, you may already be familiar with mutual funds, index funds, or exchange-traded funds (ETFs). But the taxation and reporting rules that govern a PFIC are considerably stricter and more complicated than the rules that govern these other investment vehicles.
Only U.S. citizens or residents are impacted by PFIC rules. If you’re an American expat, you are still required to pay U.S. taxes, which means that you’ll be responsible for abiding by PFIC rules.
These rules apply regardless of how long you have been living abroad; even if you become a resident of a foreign country, you will still need to file a U.S. tax return each year.
If an investment fund contains international investments, is it automatically classified as a PFIC?
Not necessarily. Most mutual funds, index funds, or ETFs based in the U.S. are not considered to be PFICs, even if they include foreign investments. An asset can be classified as a passive foreign investment company if and only if it meets at least one of the following criteria:
These tests must be applied every taxable year, so it is possible that a particular investment would not qualify as a PFIC one year but would the next.
For the purpose of these tests, what counts as passive income? Common sources of passive income can include:
Additionally, certain types of contracts or asset exchanges can generate passive income. These include:
Again, if 75% or more of an entity’s income comes from these sources — or if 50% or more of its assets produce passive income — it’s classified as a PFIC.
The income and asset tests are the primary criteria by which a PFIC can be identified. Here are some common examples of PFICs that you may encounter:
But keep in mind that the passive component of PFICs can be to your advantage. A foreign company entity that carries on active business would not be classified as a PFIC; therefore, it would not be subject to the same type of PFIC tax requirements.
A PFIC can be taxed in one of three ways.
Excess distribution is the default taxation method. It’s classified as a Section 1291 Fund. This method allows for a deferral of U.S. taxes until either (1) the earnings are distributed or (2) the PFIC is sold. Earnings are taxed as ordinary income, and the excess distribution is spread out over your investment period on a pro rata basis.
To calculate the excess distribution amount, you’ll need to include both the sale amount of the PFIC and any distributions in which the total annual distributions exceed 125% of the preceding three-year average.
To elect the market-to-market (MTM) approach, you must use the option on Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. While this alternate tax plan will allow you to avoid interest charges and a higher tax, it will also cause you to face an earlier tax obligation.
When you use the MTM approach, you must recognize an annual gain or loss based on the PFIC’s value at the end of the tax year. This gain or loss is taxed as ordinary income or treated as ordinary income loss.
Like the MTM approach, you can opt for the qualified electing fund (QEF) by selecting the appropriate option on Form 8621. The QEF will also accelerate your tax liability, though it will lower your potential interest and tax obligation.
To use the QEF election, you’ll need to file Form 8621 in the first year that you invest in the PFIC. However, if the PFIC’s annual information statement isn’t available, you may be prevented from exercising this PFIC taxation method.
In the QEF approach, you must list a pro rata portion of the PFIC’s earnings as part of your annual gross income. Depending on the nature of the income, this may be classified as ordinary income or capital gains.
Note that the QEF method can only be selected during the first year that you own the PFIC. You can make your selection on Form 8621.
Since 2013, American expats have been generally required to file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, to report income earned from a foreign mutual fund. This form is required when you:
You must also file a separate Form 8621 for each PFIC held. So if your investment portfolio consists of a foreign mutual fund and an EFT, you’ll need to file two forms each tax year.
There are two primary reasons why an American expat would not file Form 8621.
If the total value of all of your PFIC holdings falls below $25,000, you are exempt from filing Form 8621. However, this exemption only applies if you have not made any QEF or MTM elections.
Additionally, the rules regarding direct and indirect PFIC holdings can be hard to determine, which makes this a difficult exemption to qualify for. Ask a tax advisor to help you evaluate your eligibility.
Certain types of foreign pension plans may also be exempt. For example, any retirement plan where income is deferred is exempt from PFIC tax reporting requirements until distributions are made. However, if you make adjustments to your retirement plan or cash out early, it may prevent you from using this exemption.
PFIC taxation requirements can be complex, and some of the rules and exemptions are subject to competing interpretations. A tax advisor can help you fill out Form 8621 and help you make decisions regarding your reporting options (i.e., excess distribution, QEF, or MTM). The advisor will also look for any exemptions that may apply.
For that matter, American expats might also consider using a professional tax advisor to help reduce their overall tax burdens. A tax preparer can highlight key areas where you may qualify for deductions and save money on your yearly taxes, which may help you maximize the earnings you receive from a PFIC.
Living abroad yet paying U.S. taxes can be a complex process. PFIC tax requirements only add to the confusion. Greenback Expat Tax Services can help. We will guide you through the requirements and options relating to your PFIC investments and ensure that you comply with all regulations.