Mutual Funds (PFIC)
By Vernon K. Jacobs, CPA
& J. Richard Duke, J.D., LLM
One of the most confusing aspects of foreign investing is the difference in the treatment of foreign investment companies, mutual funds and unit investment trusts as compared to U.S. based mutual funds. To understand the problem, it helps to begin with a basic explanation of the tax treatment of U.S. shareholders of a mutual fund in the U.S.
Generally, a U.S. mutual fund is treated
in a manner similar to a
partnership with respect to the income and the gains of the fund. The
income is passed through to the shareholders in proportion to their
holdings and reported to the IRS on a form 1099 by the mutual fund. A
copy of the report is also sent to the shareholder to use to prepare
Foreign investment companies or mutual funds are not subject to this kind of reporting and disclosure. Nor do they want to be. So the U.S. puts the burden on the shareholder to determine their share of the income of the investment company. The tax code refers to any kind of corporate mutual fund or investment company outside the U.S. as a passive foreign investment company or a PFIC.
The US tax laws are clearly designed to deter US persons from investing in mutual funds outside the US where the income or gains of the foreign funds are not subject to current taxation, as are the gains and other income of most domestic mutual funds. In addition, the tax law clearly seeks to deter US persons from using a foreign corporation as an investment fund. For example, if 11 (or more) US persons own equal shares in a foreign corporation, it will not meet the definition of a controlled foreign corporation and none of the shareholders would be subject to current tax on the income of the foreign corporation.
But - if that corporation
is also a PFIC, the shareholders
will be subject to severe tax treatment on any distributions from the
As a general rule, a U.S. person would be in far better position to invest directly in the stock of foreign corporations that are not PFICs or to invest in a U.S. mutual fund that invests in foreign stocks or foreign mutual funds. In some cases, a U.S. person may be able to utilize a foreign variable annuity or variable life insurance contract to invest in foreign mutual funds, but the tax treatment will be based on the rules for investments in annuities or life insurance rather than for investments in the underlying stocks or mutual funds.
Tax code sections 1291 through 1297
provide the rules for US persons
who invest in “Passive Foreign Investment Companies” (PFIC). A PFIC is
defined as “ ... any foreign corporation
if 75 percent or more of its gross income is passive income or if 50
percent or more of its assets are assets that produce or are held to
produce passive income".
There are exceptions for bona fide banks, insurance companies and foreign corporations engaged in the securities business - meaning the active marketing of securities.
A PFIC that had elected to be a “foreign investment company”, before December 31, 1962, is subject to some older rules, which require that
For companies that had not made such an election before 1963, if a foreign investment company is registered with the SEC, or if it is more than 50 percent owned by US persons, any gain realized by the shareholders will be treated as ordinary income unless the corporation elects to be taxed in a manner similar to US mutual funds.
If the PFIC isn’t qualified to be an electing foreign investment company or does not choose to do so, the US shareholder may elect to have the PFIC treated as a “pass through entity” - known as a “qualified electing fund” or QEF. If this election is made by the US shareholder, the shareholder must report as income his or her pro rata share of the earnings and capital gains of the QEF for the taxable year. The investor making this election may also elect to delay payment of the tax on the shareholder’s portion of the undistributed earnings of the QEF, but that deferral will be subject to an interest charge. This election is only allowed if the PFIC complies with the IRS information disclosure requirements which will enable the IRS to determine the PFICs ordinary earnings and capital gains.
If the U.S. beneficiaries of a trust investing in a PFIC expect and agree to be taxed on the trust's income - even though they do not expect to receive any current distributions from the trust, there should be no disadvantage to electing QEF status for every PFIC in which the trust has invested, and indeed there are enormous disadvantages from failing to do so. If the PFIC is not a QEF for every year in which it is a PFIC, then the conversion from capital gain to ordinary income and the interest charge rules continue to apply to the extent of the company's earnings while it was a non-QEF. In other words, only a so-called "pedigreed" QEF which has been a QEF in every year in which it was a PFIC is excused from the interest charge and character conversion rules. For this reason, a foreign trust agreement should provide that the trustee may not acquire any equity interest in a foreign company that qualifies as a corporation for U.S. tax purposes (unless that company is engaged in the active conduct of a trade or business) without providing notice to any U.S. beneficiaries and their accountants so that the appropriate election to be a QEF can be made in a timely manner. Furthermore, the trust agreement should provide that this notification requirement must be made applicable to any investment adviser engaged by the trustee to manage any trust assets.
If a PFIC does not agree to be subject to the jurisdiction of the SEC and does not provide the IRS with the annual information the IRS requires for a QEF election, then the shareholders of the PFIC are subject to
Another “simplification rule” in
the 1997 law permits US owners of a
stock in a PFIC that is traded on a national securities exchange to
a “mark-to-market” election (IRC section 1256) based on the market
of the PFIC shares at the end of each year. However, any gains
recognized by the shareholder will be treated as ordinary income and
losses are limited to gains previously recognized. In addition, the IRS
has introduced proposed regulations that will make it very difficult
for many foreign mutual funds to qualify for the "mark-to-market"