Taxes on Foreign Mutual Funds: Common Mistakes to Avoid

Practice Areas

By: Baljeet Singh

Many taxpayers know that American tax law requires US tax residents to report their worldwide income and assets on their US taxes.  However, some taxpayers are not aware that foreign mutual funds are classified as Passive Foreign Investment Companies (PFIC) and must be taxed accordingly. Failing to apply for ownership in foreign mutual funds can result in substantial penalties.

Taxation of PFICS AND FOREIGN MUTUAL FUNDS

Foreign corporations that derive a significant amount of their investment income from passive sources are known as Passive Foreign Investment Companies (PFICs). To qualify as a PFIC, firms must have at least:

  • 75% of their gross income is passive
  • 50% of their assets are passive

Passive income, such as rental income, requires little to no effort from the owner.

A unique taxing system applies to US shareholders of PFICs. Taxation rules apply to both direct and indirect US shareholders of PFIC stock.

A US taxpayer’s ownership in a PFIC is subject to one of three taxing regimes. PFICs are taxed under the default method, unless the taxpayer elects to be taxed according to one of the other two options.

  1. Default method: If a US taxpayer receives an excess distribution or disposes of PFIC stock, gains are recognized as prorated ordinary income earned during the shareholder’s investment holding period. An excess distribution is the of the amount of money the individual has withdrawn from their PFIC (distributed) for a year, minus 125% of the average of distributions they took in the previous 3 years.
    The tax payable is the sum of:

    • The US tax on income earned during each prior year of the investment holding period, calculated using the highest US tax rate for that year
    • Interest on the deferred tax for each previous year during the holding period, and
    • Gains attributed to the year of receipt or year of disposition
  2. Qualified Electing Fund (QEF): QEF is an optional method of taxing certain PFICs, similar to how US mutual funds are taxed. When a PFIC is a QEF and agrees to provide adequate information to the IRS, US shareholders must include their share of the PFIC’s earnings and profits in their income.
    Taxpayers will need to adjust their income, known as basis adjustments, for:

    • Money not distributed, or withdrawn
    • Distribution or withdrawals previously included in taxable income
      Shareholders must pay current tax when they include this money in their income, unless the shareholders decide to defer.
  3. Market-to-Market Election: If PFIC stock is marketable, the US shareholder of the PFIC may make a mark-to-market election. The taxpayer must subtract the adjusted basis of the PFIC from its fair market value. They must include this amount as ordinary income in their gross income for the tax year. The shareholder’s taxable basis in the stock is increased by the amount included in their gross income.

Reporting PFIC Income

Each US person that directly owns stock or is an indirect shareholder in a PFIC generally must file an annual report, Form 8621. Form 8621 is required for each holding in a PFIC, including for each mutual fund. Each time a taxpayer fails to file Form 8621, they could be subject to a $10,000 penalty.

Getting Help with PFIC Tax Compliance

The good news is that certain exceptions apply to PFIC taxes, including a minimum dollar value of PFICs to be taxable. Additionally, the IRS has specific programs which enable you to comply with minimum or no penalties for previous violations. But with potential non-compliance penalties, it is essential for foreign mutual fund owners to discuss US tax compliance with an experienced tax advisor.