American Expats: PFICs—Don’t Get Caught Out by U.S. Tax Rules on Foreign Investments
With the introduction of the U.S. Foreign Account Tax Compliance Act (FATCA), most expat Americans have found that trying to avoid U.S. tax by investing offshore doesn’t work. American citizens and green card holders are subject to U.S. tax on all of their global income, even when they live outside of the United States.
The complications can be considerable: An American expat’s current country of tax residence, their source and type of income, and any other tax jurisdictions that may be relevant—for example, if they happen to be dual-nationality Americans or live in a multi-nationality household—can all affect the way the U.S. Internal Revenue Service (IRS) views these individuals, their income, and their wealth.
Below, we outline some of the offshore investing problems that Americans living overseas should be aware of.
Investment Scheme Tax Problems
Where Americans invest their savings matters—a lot. Unfortunately, as an increasing number of Americans are living and working overseas, many have unwittingly subjected themselves to the IRS’s punitive Passive Foreign Investment Company (PFIC) rules.
A PFIC could be any kind of mutual fund, hedge fund, or other similar type of pooled investment product originating and domiciled outside of the U.S.
Less obviously, even investing in domestic local mutual funds or local tax-deferred vehicles in the country in which the American currently lives may subject him or her to the IRS’s punitive PFIC consequences.
Additionally, investing in offshore investment schemes that involve an insurance wrapper usually doesn’t help. That’s because these types of financial products normally include an insurance structure that’s defined under the laws of an offshore jurisdiction only. And while such insurance wrappers may offer tax benefits in some tax jurisdictions, they almost never qualify for U.S. tax-deferral benefits from the IRS.
What Is a PFIC?
The rules surrounding PFICs are complicated, but essentially, any non-U.S. incorporated investment fund that derives 75% or more of its income from passive activities is classified as a PFIC. This covers virtually all mutual funds, exchange-traded funds (ETFs), and hedge funds that have been incorporated outside the United States and distributed by foreign financial institutions.
The intent of the PFIC rule is to discourage Americans from investing in financial products and through financial institutions that cannot easily be monitored by the IRS. In theory, a foreign fund manager could structure payouts and reporting on his fund to qualify for U.S. tax treatment similar to U.S. domestic funds—and a few do. The reality, though, is that most offshore funds have relatively few U.S. investors. Their managers may be unaware of the U.S. tax consequences to their American clients. Or it may simply not be economical for an offshore fund to be structured in the specific way needed to meet U.S. rules.
Many Americans who’ve invested in PFICs have been unaware of their different treatment and have tended to report and pay tax on their foreign investments in the same manner as they would an investment in a U.S. domestic fund. Since this is not the correct way to handle PFICs for U.S. tax purposes, they could, and often do, end up facing significant penalties, back taxes, and interest when they try to rectify the situation later.
U.S.-Domiciled Is Usually Better for Americans
While the intent of the PFIC rules may be to discourage Americans from investing in products and through institutions that cannot easily be monitored by the IRS, the result is that they effectively deter American citizens from investing in funds that are not U.S. domiciled.
Why, after all, buy a non-U.S. mutual fund that charges an expense ratio of 2% per year or more, and a 5% to 7% front-end load; offers no tax deferral; and sees any gains taxed at the investor’s marginal tax rate in the best case, and in the worst case, sees them subject to the top marginal tax rate, as well as a penalty interest rate?
While investing in PFICs can still make sense in specific, limited cases, it's important to compare the after-tax, after-fee return with comparable investment options first. In most cases, Americans will find that they can gain the same economic exposure using a U.S. investment vehicle—with far lower fees and commissions, lower overall taxes, few tax-filing issues, and stronger regulatory consumer protections.
When Offshore Investing Makes Sense
There are some cases in which owning an offshore fund or PFIC can, however, make sense. Here are three examples:
1. Foreign pension plans
U.S. citizens may find it beneficial to sign up for a foreign pension plan such as a Thai Provident Fund, even if it involves PFICs, in cases where an employer is making matching pension contributions.
They should seek professional tax advice before doing so—in some cases, tax treaties may allow for preferential tax treatment and filing; in other cases, a foreign pension plan may be considered an “employee benefit trust,” with different filing and tax requirements.
They should also be careful of tax residency implications—for example, a U.S. citizen with a U.K. pension plan may not be able to claim U.S.-U.K. treaty benefits if the American is a tax resident of a third country, for example, Singapore.
If Form 8621 and PFIC rules do apply, they should consider the “mark-to-market” election to minimize the U.S. tax and filing impact.
2. Funds that provide local tax benefits
Some countries have incentive programs that provide local tax deductions for fund contributions—for example, Thailand’s Retirement Mutual Funds (RMFs) and, previously, Long Term Equity Funds (LTFs).
Even though the IRS will not recognize the local tax deduction for U.S. tax purposes, and the fund is a PFIC, contributing to such funds still can make sense in some cases.
For example, for Americans who can exclude from U.S. taxes all foreign-earned income under the Foreign Earned Income Exclusion (FEIE, equal to $105,900 in 2019 and $107,600 in 2020) and housing deduction, making locally tax-deductible contributions from salary income to a foreign fund may cut local taxes and save on their total annual tax burden.
Even though the investment earnings may be reported annually under PFIC rules, the overall tax savings could still make this a worthwhile trade-off—especially if the mark-to-market election is made. Each case is different, however, so American expats or their tax advisors would need to do the math to make sure there is a net tax savings.
3. For Americans in Europe: Inside IRAs, Roth IRAs or other U.S. tax-advantaged accounts
Purchasing investments such as offshore ETFs generally does not make sense for American expats, both due to the complicated and expensive U.S. PFIC tax rules and the otherwise excellent selection of U.S.-domiciled ETFs that make investing in offshore ETFs unnecessary.
An exception may be in the case of American expatriates living in Europe. European legislation enacted in 2018—MiFID II—was intended to protect investors. Unfortunately, MiFID II also prohibits European residents—including American expats—from investing in U.S.-domiciled ETFs.
In this case, one option for Americans living in Europe could be to use a U.S. tax-deferred or tax-exempt account such as an IRA, Roth IRA, 401(k), or 403(b) to purchase European ETFs. In this case, PFIC rules do not apply—IRS Notice 2014-28 announced the exemption of U.S. taxpayers who own PFICs in these types of accounts from having to file Form 8621.
Conclusion: U.S. Expats Need Qualified Advice
One thing American expatriates need to understand from the outset is that they cannot expect an insurance or asset management company that is seeking to offer them their latest offshore investment scheme to be relied upon to inform them of the U.S. tax consequences of the proposed investment. These product providers may be unaware or uninformed about the rules.
Additionally, expatriate Americans should not expect that TurboTax or a hometown tax preparer back in the U.S. will be up to speed on such matters either. The parts of the U.S. tax code that apply to American expats are obscure and, until recently, were rarely enforced. With the arrival of FATCA, though, and certain other relatively new regulations, the days of benign neglect by the U.S. tax authorities have come to an end.
Luckily, American expats have many ways to minimize their U.S. taxes while diversifying their investments globally. But before they buy any type of investment or insurance product from a foreign financial institution or offshore broker, a tax advisor who is experienced in working with American expats must always be consulted. The tax penalties that may result from failing to do so are not worth it.
This article is a revised and updated version of one that had appeared previously on www.crevelingandcreveling.com.
For American Expats: A U.S. Tax Form Checklist
Five Things to Consider Before Buying Offshore Investment Schemes
Tips for Thai Expats: Use RMFs and LTFs to Save on Thai Taxes
The New and Improved Thai Provident Fund
About Creveling & Creveling Private Wealth Advisory
Creveling & Creveling is a private wealth advisory firm specializing in helping expatriates living in Thailand and throughout Southeast Asia build and preserve their wealth. The firm is a Registered Investment Adviser with the U.S. SEC and is licensed and regulated by the Thai SEC. Through a unique, integrated consulting approach, Creveling & Creveling is dedicated to helping clients cut through the financial intricacies of expat life, make better decisions with their money, and take the steps necessary to provide a more secure future.
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