The Tax Implications of Offshore Mutual Funds for U.S. Expats

Do Expats Investing in Foreign Mutual Funds Pay US Tax?

Expats, Foreign Mutual Funds, and US Tax

One of the most common types of investments that US Taxpayers across the globe make is investments into ‘pooled funds.’  The idea behind pooled funds such as mutual funds or ETFs is that instead of investing in just a single company, a person invests in a fund that owns portions of several other companies. As a result, it allows the taxpayer to invest broadly into the market without having to worry about putting all of their eggs in one basket. Unfortunately, from a US tax and reporting perspective, foreign pooled funds such as mutual funds have serious negative tax and reporting implications because they are considered to be PFIC (Passive Foreign Investment Companies). Unlike other international reporting forms such as Form 5471 or Form 8865, there is no 10% ownership requirement for having to file this form. In other words, a Taxpayer can have fractional or incremental ownership of a foreign fund and still be required to fill this form if they meet the threshold value filing requirements. Let’s go through some of the basics of why investing in foreign mutual funds can be taxing from a US tax perspective and what taxpayers can do to minimize taxes – as well as what you can to get into compliance for prior non-filing.

Tax Rules in General for Funds

In general, the US taxes individuals on their worldwide income. The taxation rules surrounding foreign mutual funds are a bit different. In general, income is not taxable until it is distributed, but even though it may be distributed as a dividend or capital gain — it does not enjoy reduced tax treatment. In fact, if the distributions are considered excess distributions, the taxpayers are taxed at the highest tax rate available – even if they do not fall into the tax rate. There is usually interest as well and the overall payments can oftentimes exceed 50%.

Growth vs Distributions (Non-Excess vs Excess)

When the value of the mutual fund grows, that growth is usually not taxable. Generally, this includes accumulated, but non-distributed income. The problem becomes when the foreign mutual fund distributes income. The rules involving the taxation of distributed income vary based on whether it is a distribution or an excess distribution.

Redemptions and Sales

When a foreign mutual fund is sold, it is (unfortunately) not treated as capital gain with a 15% or 20% Long-Term Capital Gain Tax Rate (or OI tax rate for short-term gains). Instead, the income is calculated over the value of the investment, with most years (excluding the current year) being taxed at the highest tax rate available, in addition to interest.

MTM or QEF Election

In order to reduce taxes, the Taxpayer may be able to make an election. The two most common types of elections are Mark-to-Market (MTM) and Qualified Electing Fund (QEF). In general, the QEF election results in a better tax outcome but requires additional reporting from foreign institutions — which may not be feasible. In addition, late elections require a ‘purging election’ that results in an excess distribution at least up to the point of the election.

Examples of Reporting Foreign Pooled Funds to the IRS

While the reporting and tax complexities of PFIC of IRS Form 8621 can seem daunting, overall, they are usually manageable once the Taxpayer better understands how these types of investments are taxed and reported. Let’s look at some common examples for Taxpayers who have PFIC. *For all examples, please note that the Taxpayers are U.S. persons for tax purposes who have not made any treaty elections to be treated as a Non-Resident Alien (NRA). Also, these examples are for illustrative purposes only and Taxpayers should consult with a Board-Certified Tax Law Specialist if they have specific questions about their reporting requirements and not rely on this article for legal advice.

Foreign Mutual Fund and ETF Reporting

One of the most common types of situations that require PFIC reporting is when a Taxpayer owns foreign mutual funds and/or foreign ETFs. Depending on whether the funds are held within an account or individually may impact the extent of their reporting, but pooled funds are reportable.

• • • Example: David invested in various foreign mutual funds that are all contained within one single account at a Foreign Financial Institution. The only assets in the investment account are mutual funds and the total value of the funds are $170,000. For FBAR purposes, David will report the single account, but for PFIC/Form 8621 purposes David will report each fund individually.

    • Example: Michelle invests in different ETFs but does not hold the funds in a single account – rather, she owns each fund individually. The total value of the funds is $650,000. Michelle will have to file the FBAR to report each fund individually as well as having to report each fund separately on Form 8621.

    • Example: Peter owns two mutual funds (not in an account) with a combined value of $19,000 and no distributions from the funds. Peter must file the FBAR to report the mutual funds, but is only required to do very limited reporting on Form 8621 because he files as ‘Single’ and is below the $25,000 exception. Noting, there is contradiction between what the regulation requires and what the instructions require for this Form 8621 exception — with many Taxpayers choosing to err on the side of caution by filing the Form 8621 just to complete the very top portion of the form for each fund.

Foreign Mutual Fund and ETF Tax

When it comes to PFIC, one component of filing with the IRS is to report the existence of the account while the other aspect is dealing with the tax implications. Various issues regarding PFIC will help determine what the tax implications may be.

• • • Example: Scott has $700,000 in foreign mutual funds that have grown significantly in value but have not distributed any income — so that there are no distributions. There have also been no sales of the funds. While Scott must report these foreign mutual funds, he may not have any tax implication.

    • Example: Danielle has been holding multiple mutual funds for several years and they never issued dividends in prior years. In the current year, one of Danielle’s mutual funds issued a very large dividend. Since the current year distribution is not in the first year of the fund and it is more than 125% of the average of the three prior years, Danielle will presumably have an excess distribution which she will have to calculate — as well as provide the additional reporting forms to supplement her Form 8621.

    • Example: Brenda has been holding a few mutual funds for several years and has never sold any of the funds or received any dividend distributions. In the current year, Brenda decides to sell one of her funds for a gain. As a result, Brenda will have an excess distribution calculation and will also have to provide the additional reporting forms to supplement her Form 8621.

Foreign Pension/Treaty Exception

If a Taxpayer has a pension-type investment in a foreign country that contains funds that are PFIC, but the country is a treaty country, then the Taxpayer may be able to avoid having to file form 8621 for these investments. PFIC Exception Under Section 1.1298-1 Section 1298(f)(c)(4)

• Exception for PFIC stock held through certain foreign pension funds.

  • “A shareholder who is a member or beneficiary of, or participant in, a plan, trust, scheme, or other arrangement that is treated as a foreign pension fund (or equivalent) under an income tax treaty to which the United States is a party and that owns, directly or indirectly, an interest in a PFIC is not required under section 1298(f) and these regulations to file Form 8621 (or successor form) with respect to the PFIC interest if, pursuant to the applicable income tax treaty, the income earned by the foreign pension fund may be taxed as the income of the shareholder only when and to the extent the income is paid to, or for the benefit of, the shareholder.”

    • Example: Sam has a pension fund in a treaty country that has several types of investments including foreign ETFs and Mutual Funds. Even though Sam will have to report the pension for FBAR and Form 8938 purposes, he may be able to avoid having to file form 8621 for the PFIC investments.

    • Example: Shelly has a pension fund in a non-treaty country that also contains several types of investments including foreign ETFs and mutual funds. Unfortunately, because Shelly’s pension is in a non-treaty country she would have to file IRS Form 8621 to parse out the separate investment funds that are PFIC.

Foreign Corporations Used to Hold Passive Investments

In some countries, it is common for Taxpayers to have a foreign holding company such as a corporation that they use specifically for passive investments. In this type of situation, the company itself may be considered a PFIC, along with individual PFICs for the different types of investments. For example, a Taxpayer may have a foreign holding company that has foreign rental properties but also contains foreign mutual funds. This type of reporting can be very complicated and there may be CFC/Subpart F income crossover.

PFIC Elections

Some Taxpayers may qualify to make an election to reduce the tax implications of the excess distribution PFIC tax regime — such as the QEF election or the MTM election. It is important to note that the Taxpayer should make the election in the first year — or else when they make a late election it will require a purging election and an excess distribution calculation at that time. The Taxpayer may qualify to make a reasonable cause late submission, but unlike other types of reasonable cause submissions a late PFIC reasonable cause submission requires very specific requirements that most Taxpayers cannot satisfy.

*Crossover with Subpart F Income

Taxpayers who have foreign-holding corporations that would qualify as PFIC but also qualify as Controlled Foreign Corporations (CFC) generally will fall under the Subpart F tax regime for CFC and not the PFIC reporting for Form 8621. A key issue will be whether the foreign corporation is a CFC or not and Taxpayers should review the requirements in detail if they believe they may fall into this category. One common example would be a corporation in a foreign country that is owned primarily by family members who are considered U.S. persons and the corporation is used for passive investments.

The Tip of the Iceberg

The goal of this article is to help clarify some of the basics of Form 8621/PFIC. Reporting foreign assets to the U.S. tax authorities can be very complicated, especially when it involves additional items such as foreign life insurance policies, foreign corporations, foreign partnerships, and transactions between U.S. persons and foreign companies. Taxpayers should try to stay in compliance if they are already in compliance or should consider getting into compliance if they have not properly filed the necessary reporting forms if for no other reason than the fact that the IRS has made offshore compliance a key enforcement priority and has been issuing fines and penalties for non-compliance. 

Late Filing Penalties May be Reduced or Avoided

For Taxpayers who did not timely file their FBAR and/or other international information-related reporting forms, the IRS has developed many different offshore amnesty programs to assist Taxpayers with safely getting into compliance. These programs may reduce or even eliminate international reporting penalties.

Current Year vs. Prior Year Non-Compliance

Once a Taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, Taxpayers should consider speaking with a Board-Certified Tax Law Specialist who specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to Streamlined Procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead. But, if a willful Taxpayer submits an intentionally false narrative under the Streamlined Procedures (and gets caught), they may become subject to significant fines and penalties. 

Need Help Finding an Experienced Offshore Tax Attorney?

When it comes to hiring an experienced international tax attorney to represent you for unreported foreign and offshore account reporting, it can become overwhelming for Taxpayers trying to trek through all the false information and nonsense they will find in their online research. There are only a handful of attorneys worldwide who are Board-Certified Tax Specialists and who specialize exclusively in offshore disclosure and international tax amnesty reporting.  *This resource may help Taxpayers seeking to hire offshore tax counsel: How to Hire an Offshore Disclosure Lawyer.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, specifically IRS offshore disclosure.  Contact our firm today for assistance.