One of the major economic fallouts of last year’s Brexit referendum was the sudden and significant depreciation of the British pound. Over the past week, the pound fell sharply again following the unexpected results of the most recent U.K. election.
What does this mean from a tax perspective for U.S. expats living in the U.K.?
Aside from the general exchange gain or loss implications for U.S. citizens transacting in non-U.S. currency, the weaker British pound actually provides an important opportunity for U.S. expats who have investments treated as passive foreign investment companies (PFICs) for U.S. tax purposes.
PFICs – An Overview
The PFIC rules, while complex, are important to understand because they affect many U.K. investments made by expats after moving abroad, both from a tax and reporting perspective. Unbeknownst to many expats, most non-U.S. mutual funds, for instance, fall within the definition of a PFIC. This can be the case even if such funds are held through a tax-deferred savings account (e.g., U.K. individual savings accounts (“ISAs”) or a U.K. pension that is not covered by the U.S.-U.K. tax treaty.
Technically, a PFIC is a foreign corporation that has one of the following attributes: (i) At least 75% of its income is considered “passive” (e.g., interest, dividends, royalties), or (ii) At least 50% of its assets are passive-income producing assets. A U.S. person that holds any interest in a PFIC, directly or indirectly, is subject to the PFIC rules.
Under the PFIC default rules under Section 1291 of the Internal Revenue Code, investment income resulting from certain distributions from a PFIC or gain from the sale of a PFIC interest is generally subject to highly punitive U.S. federal tax rates, namely the highest marginal tax rate that can be imposed on an individual taxpayer (regardless of whether capital gains tax rates would normally apply). A significant (and non-deductible) penalty interest charge, which compounds regularly while holding an interest in a PFIC, is also triggered upon certain distributions from a PFIC or gain from the sale of a PFIC interest.
The PFIC Elections
There are two elections generally available to mitigate the more onerous aspects of PFIC taxation under the default Section 1291 rules.
If a Qualified Electing Fund (“QEF”) election is made, then in contrast to the default rules, PFIC shareholders include each year in gross income the pro rata share of earnings of the QEF and include as long-term capital gain the pro rata share of net capital gain of the QEF. In order to make a QEF election, a shareholder must have received a PFIC Annual Information Statement from the PFIC. Often times, investors are not provided such a statement from the PFIC, so the QEF election is not available.
If a Mark-to-Market (“MTM”) election is made, then in contrast to the default and QEF rules, PFIC shareholders include each year as ordinary income, the excess of the fair market value of their PFIC stock as of the close of the tax year over its adjusted basis in the shareholder’s books (normally the purchase price). The MTM election is generally available only with respect to marketable (i.e., traded) securities. However, since many PFIC investments consist of marketable securities, the MTM election is the far more accessible election for the typical U.S. expat investor.
Making The MTM Election
In the ideal scenario, a PFIC shareholder would timely make a MTM election for the first year of PFIC ownership in order to completely avoid the onerous default Section 1291 regime. A number of our new clients, however, only realize they have a PFIC problem several years into their investments.
In such case, a taxpayer can transition from the default regime to the MTM regime by making a MTM election starting with the current year, but with one important catch: The default Section 1291 rules apply in the first year of the MTM election (and only thereafter, do the friendlier MTM rules apply), and in such first year, the excess of the year-end fair market value over the basis in the PFIC is treated as gain from a deemed (not actual) sale of the PFIC subject to the default rules. As such, the excess is taxed at highly punitive rates in addition to the onerous penalty interest charge.
A Practical Scenario
We realize that’s quite a lot to absorb, so to give a practical scenario:
Mr. Expat purchased a U.K. mutual fund in 2013. While the fund has performed well over the years, Mr. Expat discovers only this year that the fund is considered a PFIC for U.S. tax purposes. The fund does not provide a PFIC Annual Information Statement. In order to avoid the onerous Section 1291 default regime, Mr. Expat files a MTM election (on the IRS Form 8621) on his 2016 tax return, transitioning him to the preferable MTM regime moving forward.
In such case, Mr. Expat would be deemed for tax purposes to have sold the fund on December 31, 2016. Any appreciation in the fund would be taxed at the highest marginal tax rate in addition to a penalty interest charge that has been compounding since 2013. Moving forward, Mr. Expat’s basis in the fund would be increased by the taxed amount – but that is small consolation for the PFIC tax hit taken by Mr. Expat for the 2016 tax year.
The Relevance Of The British Pound Currency
In order to understand the relevance of the weakened British pound, we need to start with a fundamental rule of U.S. expat taxation – U.S. citizens, even those residing abroad, are viewed for U.S. tax purposes as using the U.S. dollar as their “functional currency” for monetary transactions, including the purchase and sale of foreign investments.
As such, in the case of Mr. Expat, even if his mutual fund appreciated over the years, due to the sharp decrease in the value of the British pound, the U.S. dollar value of his investment may have actually decreased (or only increased insignificantly) as of December 31, 2016.
If this is the case, then the deemed PFIC sale resulting from the MTM election should seemingly have little to no adverse tax consequences, because there should be no excess of fair market value of the PFIC over its adjusted basis, and therefore there should be no PFIC taxation of the investment under the onerous Section 1291 rules.
Thus, expats with a U.K. source investment would be wise to do two things: First, consult with a tax advisor regarding the potential PFIC status of your investment and, second, consider making a MTM election while the British pound remains weak. This may put you in a much better position from a U.S. tax perspective moving forward as compared to dealing with the default PFIC regime. That being said, each taxpayer scenario involving a PFIC interest is unique and should be analyzed on a case-by-case basis.