This Blog Post on TaxConnections is an effort to respond in a practical way to the questions that people have. Please watch my presentation at the Internet Tax Summit to learn more.

“I Really Wish I Could Do Retirement Planning Like A “Normal” Person. But, I’m an American Abroad. I hear I can’t Invest in Mutual funds in my Country of Residence.

The “Coming into U.S. Tax Compliance Book” is designed to provide an overview of how to bring some sanity to your life.

My Assumptions: This discussion assumes without deciding, that non-U.S. mutual funds are PFICs AKA “Passive Foreign Investment Corporations”. Although a clear majority of the tax compliance community considers non-U.S. mutual funds to be PFICs, it should be noted that:

1. Although the “consensus” is that non-U.S. mutual funds are PFICs, the IRS has never definitively said that non-U.S. mutual funds are PFICs; and

2. Some tax professionals take the position that only “some” non-U.S. mutual funds are PFICs.

Before we begin,  please note there are different ways that PFICs can be taxed. This post focuses on the “default method”. The “default method” applies unless another option is elected. For all practical purposes, Americans abroad, who own non-U.S. mutual funds  have NOT made another election. Hence, the “default method” will apply. Let’s begin.

First – some practical advice – Get individual counselling:

The above tweet references my comment to an article – “Why U.S. Expats Should Never Own Foreign Mutual Funds” – written by David Kuenzi of Thunfinancial. I suggest that you:

• Read David’s helpful article and
• Read all the comments to the article. The article includes a general warning about both the punitive tax and reporting aspects of owning non-U.S. mutual funds.

He writes:

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U.S. expats commit their fair share of investing mistakes. One of the most disastrous, in my view, is owning non-U.S. mutual funds.

For U.S. tax purposes, non-U.S. mutual funds qualify as Passive Foreign Investment Companies (PFICs). PFICs almost always result in a costly mess for U.S. taxpayers. Here are two main reasons why:

1) PFIC investment income is generally subject to highly punitive U.S. federal income tax rates of no less than 39.6% and potentially much higher. Losses in PFICs usually cannot be used to offset gains in non-PFIC investments, and gains are taxed annually, whether realized or not. In contrast, long-term capital gains rates for U.S.-registered mutual funds range from 15% to 23.8% and the tax is deferred indefinitely until realized through sale.

2) U.S. reporting rules require that each separate PFIC investment must be reported yearly on tax Form 8621. Completing Form 8621 requires meticulous annual record-keeping and complex reporting. The IRS estimates that each Form 8621 requires more than 30 hours of accounting time a year to prepare and file. Not surprisingly, paying a tax preparer to properly report a handful of PFICs can cost thousands of dollars.

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Some, “known unknowns”:

– If you don’t own non-U.S. mutual funds don’t buy them.

– If you DO own non-U.S. mutual funds, don’t buy any more of them.

The “known unknown” and more difficult question is:

What should you do if you already own non-U.S. mutual funds?

What follows is my comment to his article:

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David:

Thanks for alerting Americans abroad to the issue of non-U.S. mutual funds. It’s obvious that Americans abroad should neither buy (although some Canadian fund companies are now providing the information to make the QEF election) nor buy more non-U.S. mutual funds. The more difficult question is what to do with existing funds.

You comment that:

“Where PFIC reporting is required, the blunt but almost always correct advice is to sell the PFIC immediately. The punitive tax and the reporting burden only compound the longer the investment is owned.”

There are many elements that factor into the decision of whether to sell mutual funds that are PFICs. If they have been held for a long period of time (Buy and hold is NOT a good investment strategy for PFICs) the sale will almost always (assuming there is a gain) result in the payment of large amounts of tax.

The payment of the tax will result in the significant erosion of the capital. Let’s take an example. Say the fund has been held for a period long enough so that the tax will eat up most of the gain. (Yes, this is possible). The payment of the tax will necessarily be the significant erosion of the capital. The erosion of the capital means that the capital can no longer be used to generate income. The income itself (as long as it’s not an excess distribution) will still be available. After all, income is income.

In some cases, the better way to view this may be to see the mutual fund as more of an “income stream”  than as a capital asset. But, it can be an “income stream” only if the capital still exists. This is true particularly of an older person who is more concerned about keeping the income stream and less concerned with his estate.

In any case, I suggest that those who have held non-US mutual funds for the long term, should get specialized advice on whether to hold or sell.

Thanks again for taking the time to write on this important topic!

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Second – What is a PFIC and why is the “taxation” so punitive?

This references a submission that I made to the U.S. Senate Finance Committee.

If you agree that non-U.S. mutual funds are “PFICs” (“Passive Foreign Investment Corporations“) then, to the extent that distributions and the sale meet the test of being an “excess distribution”:

They will be subjected to the most punitive and confiscatory  taxation in the Internal Revenue Code. This is found in S. 1291 of the Internal Revenue Code which is titled:

“Interest on tax deferral”

The words “Interest on tax deferral” are an indicator of how punitive the tax treatment of non-U.S. mutual funds actually is.

Here is how the “Interest on tax deferral” calculation works:

(Note: This example applies to any “excess distribution” under the default method of taxation. The profit from the sale of a mutual fund is one of two kinds of excess distribution. This example focuses on the profit from the sale.)

Imagine that you invest $1000 in a non-U.S. mutual fund. Imagine that you sell it for $11,000. Imagine that you have owned it for ten years. If this were a share of a stock you would pay a capital gains tax on $10,000. Because this is a non-U.S. mutual fund your “tax” bill will be calculated differently. If you aren’t sitting down, you really need to be sitting.

Here is the progression of taxation:

1. Instead of the distributions and profits being treated as normal dividends and capital gains (and taxed at those rates) they are taxed at the highest rate of taxation in the Internal Revenue Code (currently about 39%).

This is unfair.

2. The distribution and capital gain are then reallocated over each year of the holding period. In other words, we assume that the $10,000 profit was taxed over each of the ten years at a rate of 10,000/10 = $1000 per year. Tax (at punitive rates) will be calculated on the $1000 gain for each year. In other words, you are deemed (even though you didn’t) to have received a “pro-rata share” of the gain in each year of the holding period. You are being taxed on years where you did not receive an actual gain. You are being taxed on a PRETEND gain and not on an actual gain. For each of the ten years the tax on the PRETEND gain is calculated at the highest marginal rate.

This is very unfair.

3. Once the tax is calculated at the highest possible rates on the “pretend gain”, for each of the ten years, then you are required to pay an ACTUAL interest charge on the tax owing from a “pretend gain” for each of the ten years. After all, you owed taxes to the government for a “pretend gain of $1,000 in previous years. You should therefore pay an interest charge on that tax owing. That tax is payable at prescribed rates to the U.S. Think of it! An ACTUAL interest charge on the taxation on a PRETEND gain!

This is pure confiscation.

4. The interest is compounded daily over each day of the holding period. What started out as “unfair”, which evolved to “very unfair”, and then which evolved to “pure confiscation” finally evolves to “criminal”.

This is criminal.

It is also a protectionist measure for the U.S. mutual fund industry

(Comment: Not only is this unfair, but Form 8621 (rather dishonestly) treats every distribution as having been held since the first distribution. In other words, if all the gains on the sale are in the later years of ownership, you are taxed as though those gains took place in the earlier years of ownership as well.)

Q. What is the reason for this?

A. Obviously to protect the poor U.S. mutual fund industry from competition.

You can’t make this up! If you agree with me then tweet this post with the hashtag: #YouCantMakeThisUp!

For an example (with real numbers, calculations and a Form 8621) of how this works in practice, please see the following installment of the Richardson Kish Submissions to the Senate Finance Committee in April of 2015.

Richardson Kish – Mutual Fund Comparison Canada vs United States – April 15, 2015 – International-1

Finally …

PFICs and “non-U.S. mutual funds” are NOT “do it yourself” projects. Please, please, please (did I say please?) get yourself some competent advice!

Here is an interview I did with Gordon T. Long that included a discussion of the PFIC regime.

 

Original Post By:  John Richardson

See My Next Blog Post – The Problem of #Americansabroad And Ownership of Non-U.S. Real Estate