What the Heck Is a PFIC – Tax Pitfalls of International Investments
If you are an international investor or have spent time living or working outside the US, this topic is essential to understand. While it is easy to avoid, the consequences of owning a PFIC can be so substantial that your returns are eaten away, and you are left with a nasty tax situation.
Background: US Tax Revenue
The United States is the largest economy in the world, representing approximately 24% of global GDP1. In order to govern the largest economy in the world, costs associated with maintaining order and trust both in and outside the borders arise. This brings to mind a three-letter word we often hear: TAX.
The US government collected over $3.5 trillion in tax revenue in 2019, of which exactly 50% ($1.75 trillion) came from personal income tax2. With the privilege of being a US citizen, one is subject to pay tax on worldwide income. There are ways to reduce US income taxes if living or working in a foreign country, such as tax treaties and foreign tax credits. However, we often see news headlines with stories about public figures convicted of federal crimes related to wire fraud or tax evasion. These situations demonstrate how serious the US government is about collecting tax dollars from its citizens.
What is a PFIC?
An IRS ruling in 1986 created the PFIC (Passive Foreign Investment Company) classification to protect tax revenue. This classification was meant to deter wealthy US citizens from evading the collection of US income taxes.
To simplify, a PFIC is any non-US company where over 75% of income is passive (interest, dividends, capital gains, etc.). The majority of PFICs are investment vehicles that own stocks, bonds, and real estate within a pooled fund structure. Mutual Funds, and more recently adopted ETFs, are investment vehicles that US investors have used over several decades to invest. The best way to describe a PFIC is an ‘international fund with custody outside the US’.
Tax Classification
The most common taxation election of a PFIC is called Mark to Market. With this election, you are required to recognize the increase in value of an investment as ordinary income at the end of the calendar year, whether you continue to own the investment or not.
For example, say you purchase a fund for $100 on January 1st of a given year. On December 31st of the same year, the fund is now worth $150. Under standard US tax laws, you would not owe any tax until this fund is sold, when at that time, you would owe tax at the long-term capital gain rate. Under PFIC rules, the $50 of appreciation ($100 to $150) would be taxed at ordinary income and applied to income for the given year, even if you continue to hold the fund into the following year.
Why do I care?
You may be wondering why you should care about a PFIC classification. Well, as access to more and more investment opportunities arise, investors get curious and may look for ‘untapped’ markets. This can cause headaches for legal and tax representation, which could have been avoided.
A quote from Andrew Fisher’s book, The Cross-Border Family Wealth Guide, sums it up well:
“A US citizen who holds shares in a PFIC investment fund is subject to difficult and lengthy reporting requirements and punitive taxation treatment on his/her share of income within the fund.”
In reality, would anyone voluntarily sign up to increase their tax complexity/reporting requirements and also voluntarily pay more to the IRS if they knew the consequences in advance? Probably not.
How to avoid this tax pitfall
Being a global investor can be a complex situation, especially if one has dual citizenship or has lived or spent significant time in a foreign country.
An easy solution is to steer clear of international domiciled investments. This may be too straightforward for investors with significant assets/interests outside the US but highlights the importance of understanding US tax laws. As this blog highlights, it is inefficient to own investment vehicles outside the US. In many circumstances, it would simplify one’s financial life by consolidating ownership to US-based investment vehicles. The US market offers a wide selection of investments in international markets that are easy to own and straight forward for tax reporting.
Footnotes:
1 Per https://www.worldometers.info/gdp/gdp-by-country/
2 https://www.taxpolicycenter.org/briefing-book/what-are-sources-revenue-federal-government
Author(s)
Kurt Wittmeyer
Kurt developed his passion for wealth management by watching his parents in the service industry and developing the desire to connect and build relationships with those around him. He identified that working in wealth management combined the perfect balance of analysis with personal connections. Kurt earned a BS in Business Administration in Finance & Accounting at Marquette University. He is a CERTIFIED FINANCIAL PLANNER™ professional.
