- 1 Expats, Foreign Mutual Funds, and US Tax
- 2 Tax Rules in General for Funds
- 3 Growth vs Distributions (Non-Excess vs Excess)
- 4 Redemptions and Sales
- 5 MTM or QEF Election
- 6 Current Year vs Prior Year Non-Compliance
- 7 Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)
- 8 Golding & Golding: About Our International Tax Law Firm
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.
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 that 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.
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.