One of the more complicated tax issues that apply to people living outside the U.S. is what is referred to as “PFIC”s. This applies when somebody owns foreign mutual funds. Mutual funds include ETF’s or other types of index funds.  PFIC stands for passive foreign investment company.

 

Here is just a short summary of the rules when one owns PFIC’s.

 

First let’s define what a PFIC is. A stock is a PFIC if it either meets the income or asset test.

Income test – 75% or more of the gross income of the company is passive.

Asset test – 50% or more of the assets of the company produce passive income.

When owning a PFIC there are 2 requirements. One is to file the form 8621 that reports this PFIC and second to calculate the amount of income and tax due because of the PFIC.

 

These rules apply to a person whether he owns a PFIC directly or indirectly.

 

Indirect owner includes the following cases:

1. At least a 50% owner of a foreign corporation that owns a PFIC.

2. At least a 50% owner of a US corporation that owns a 1291 fund.

3. Owns a PFIC that owns another PFIC.

4. Owner of a pass-through entity that this entity owns a PFIC.

 

Owning a PFIC through a 501(c) organization or in an IRA account is not subject to the PFIC rules.

 

If owned by a US pass-through entity (pte) – the owner must file the Form 8621 only if the U.S. entity does not file the form or you have 1291 income.

 

If you don’t need to file a tax return, you still need to file the 8621.

 

 

There are three different ways of calculating the PFIC tax. It can be done through the 1291 rules, QEF rules and the mark-to-market rules. We will now briefly explain each one.

 

1291 Fund –

When one gets a distribution (dividend) from the fund the distribution has to be determined if it is an “excess distribution” or not. If it is an “excess distribution” he is subject to special rules. Additionally if one sells the PFIC stock it is automatically considered an “excess distribution”.

An excess distribution is a dividend that is more than 125% of the average distributions received during the 3 preceding tax years.

 

The excess distribution is determined on a per-share basis and is allocated to each day in the shareholder's holding period of the stock. This means that you divide up the distribution or gain over the entire time you owned the stock, starting on the day you bought it and ending on the day you sold the stock or received the dividend. You then have an income allocated to each day you owned the stock.  This will calculate the amount of income is to be allocated to each year. You then multiply this income by the highest tax rate that applied to that tax year. This is not just your highest tax rate but the highest tax rate possible for that year.

Any PFIC loss is not taken into account when calculating the PFIC tax, instead, it is reported on Schedule D as a regular loss.

 

There are three portions of this income: current tax year, pre-PFIC years, and PFIC years.

Any income that is allocated to the current tax year or years before the stock was a PFIC is reported as ordinary income on the tax return.

Any income that is allocated to the PFIC years is not reported as income on the tax return, but instead is subject to a special tax (as explained before) and interest calculation.

 

However, regarding distributions (as opposed to gains) from a PFIC there are 2 other time periods to take into account.

One is if the holding period of the PFIC started in the current year and the other is in the case of a non-excess distribution. Both of these distributions are treated as ordinary dividends reported on Schedule B of the tax return.

Any foreign taxes paid on the excess distribution is claimed as a credit against the PFIC tax.

In addition to the PFIC tax, there is also an interest charged against this tax as well.

 

Part V of the 8621 form needs to be filled out separately for a distribution or sale of even the same stock, if the stock has different holding periods.

 

 

 

QEF Election -

If one makes the QEF election he is taxed in the following manner: The ordinary earnings of the PFIC is reported as ordinary income and the net capital gains is reported as a long-term capital gain (LTCG).

 

One needs to make a QEF election in the first year the stock is owned, otherwise the owner will have to make a special election called a Deemed Sale Election in Connection With a QEF. A shareholder making this election is deemed to have sold the PFIC stock as of the first day of the year for its fair market value. The deemed gain of this sale is then subject to the 1291 rules as explained above.

 

One can only make the QEF election if the fund will issue the stockholder an Annual Information Statement. This statement provides information about the ordinary earnings and net capital gains of the PFIC.

If the fund is owned through another U.S. pass-through entity, only the first US owner in the chain can make this election.

 

 

The basis of the QEF is increased by the amount of income reported and reduced by the amount of distributions received from the QEF up the amount of the reported income.

This means that if you receive dividends from the QEF you don’t need to pay taxes on it, up to the amount of income you already reported from the QEF. Beyond that amount the dividends are taxable.

Similarly, if you sell the QEF the cost basis is calculated based on the basis adjustment.

 

Mark to Market Election -

If one makes the Mark to Market election he is taxed in the following manner:  The taxpayer reports as ordinary income the excess of the fair market value (FMV) of the stock at the end of the year over the adjusted “cost basis” of the stock. Initially, the amount of the “cost basis” of the stock is the amount you bought the stock for. It is then increased by the amount of income reported due to this election.

If however, the adjusted cost basis of the stock is more than the FMV, (meaning the value of the stock decreased) then this excess is reported as an ordinary loss but only up to the amount of income that was reported from this stock in previous tax returns.

 

One can only make this election if the stock is publicly traded.

 

The basis of this stock is increased by any income reported and reduced by any loss reported. This will have an effect when you sell the stock.

 

When you actually sell the stock you can have either a gain or a loss. If the proceeds are more than the adjusted cost basis, the gain is reported as ordinary gain. If however, the proceeds are less than the adjusted cost basis then the loss is reported as an ordinary loss, up to the amount of the previously reported income. Beyond this amount, the loss is reported as a regular capital loss.

 

If the election is not made in the first year of owning the stock, the election will create a deemed sale of this stock based on the FMV of the stock as of the end of the year. This deemed sale will be subject to the 1291 rules as explained above.

 

The 8621 form needs to be filled out by every owner of the PFIC even if there is no income to report.

However, if the total amounts of all the PFIC’s are less than $50,000 if Married Filing Jointly, or $25,000 if not Married Filing Jointly you don’t need to file the form 8621.

Alternatively, if the value of a specific PFIC is less than $5,000 it does not have to be reported.

The values are based on the last day of the year.

 

Similarly, even if you do have to report QEF or mark-to-market income but you own the PFIC through another US entity, and that entity does file the 8621 form, you are not required to file the 8621 form.

However, you do have to report on your tax return the QEF or mark-to-market income.