Passive Foreign Investment Companies - Form 8621
Important issues relating to the investment in foreign mutual funds
The literal definition of a Passive Foreign Investment Company is a foreign corporation of which at least 75 per cent of the income earned is "passive" i.e. dividends, interest etc., or 50 per cent of the assets held by the corporation generate passive income.
In practice, a PFIC is an investment in a foreign (non-US) mutual fund, OEIC, ETF, unit trust or other investment vehicle incorporated as a non-US company (or trust, which the IRS deems to be an investment company). Virtually every foreign mutual fund is a PFIC, and doubtless many US taxpayers living abroad will have invested their assets into mutual funds in the country they are living without any idea of the PFIC rules. Furthermore, their financial advisers may have invested them into PFICs as they have been historically unaware of the issues regarding investments for their US-linked clients.
Originally enacted in 1986, PFIC legislation was designed by Congress to discourage the use of foreign corporations to delay or reduce tax on financial assets, which can provide a significant tax advantage to investing in foreign mutual funds over domestic ones.
PFICs are often referred to as "toxic" assets because of the following issues for individual US taxpayers:
Thankfully, the Treasury have issued regulations specifying an aggregate de minimis value of a shareholder’s PFIC reporting requirement on Part 1 of Form 8621 of $25,000 for single taxpayers (or married filing separate) and $50,000 for married filing joint. If the total value of your PFICs are below the applicable amount you do not need to declare them on Part 1 of the Form 8621. However, Form 8621 will still need to be filed if the asset was sold during the year, or if you received what is referred to as an "excess distribution".
See our FAQs below for more details:
Q: How do I know if I have a PFIC in my portfolio?
You should perform a comprehensive review of your portfolio to see what types of assets it contains. Any of the following types of mutual funds and collective investment schemes are most likely a PFIC unless they are incorporated in the US:
Q: None of my PFIC assets are worth more than $25,000/$50,000. Am I under the Form 8621 filing threshold?
The filing threshold relates to the total value of all PFICs that you may hold, not the individual assets. If you held PFICs which in aggregate exceeded $25,000/$50,000 in value on the last day of the tax year then you are required to file a Form 8621 for each PFIC, reporting the relevant information on Part 1 of the form.
Q: I am sure that my PFICs, in aggregate value, do not exceed the filing threshold, should I still be concerned with Form 8621?
The above filing threshold relates to the filing of Form 8621 to report the holding on Part 1 of the form. If you sell the asset or receive an "excess distribution" from the asset, you will still have to report this on Form 8621 and will be subject to the PFIC tax and interest regime.
Q: What is an "excess distribution"?
You receive an excess distribution when you earn income from the PFIC (interest/dividends/etc.) during the year which exceeds 125% of the average distribution of the last three years in which you held the asset, or if the fund was sold (wholly or in part) for a USD gain in the tax year.
Q: What is the PFIC tax and interest regime? How can the tax rate end up exceeding 100%?
Simply: the asset gains are allocated pro-rata to each day in your holding period and aggregated within each tax year. Tax is then calculated at the highest marginal rate for that tax year, and interest calculated upon that. Generally, no foreign tax credit is allowed against the "prior year" tax and interest charge. It is the lack of foreign tax credit and interest charges that can push the effective tax rate on the gain to—in theory—above 100%. A more detailed explanation of the tax calculation can be found within the downloads in the Client Area of our website.
Q: So I should just open a US brokerage account and invest in US mutual funds?
Unfortunately, HMRC have a similar regime called Offshore Income Gains, which is designed specifically for almost exactly the same reason as the PFIC regime: to avoid the use of offshore funds/companies to defer tax on investment income and/or convert income generated into capital gains. The OIG regime charges tax at the taxpayer’s marginal income rate rather than the capital gains rate. To avoid the pitfalls of the OIG regime you should take care to only purchase "Reporting Funds", which are those non-UK funds that are registered and reported to HMRC. For more information, see Offshore Income Gains.
The literal definition of a Passive Foreign Investment Company is a foreign corporation of which at least 75 per cent of the income earned is "passive" i.e. dividends, interest etc., or 50 per cent of the assets held by the corporation generate passive income.
In practice, a PFIC is an investment in a foreign (non-US) mutual fund, OEIC, ETF, unit trust or other investment vehicle incorporated as a non-US company (or trust, which the IRS deems to be an investment company). Virtually every foreign mutual fund is a PFIC, and doubtless many US taxpayers living abroad will have invested their assets into mutual funds in the country they are living without any idea of the PFIC rules. Furthermore, their financial advisers may have invested them into PFICs as they have been historically unaware of the issues regarding investments for their US-linked clients.
Originally enacted in 1986, PFIC legislation was designed by Congress to discourage the use of foreign corporations to delay or reduce tax on financial assets, which can provide a significant tax advantage to investing in foreign mutual funds over domestic ones.
PFICs are often referred to as "toxic" assets because of the following issues for individual US taxpayers:
- The PFIC legislation includes punitive tax and interest treatment relating to both the income and the sale of the funds which—in theory—can result in an effective tax rate of over 100 per cent on the gains from the funds. The treatment essentially spreads out any gains made in the fund to the entire period you have held it; tax is then calculated at the highest marginal tax rate in each year of holding and then interest calculated on the tax due; and
- Since Tax Year 2013, all US taxpayers are required to report detailed information pertaining to the taxpayer’s holdings in the year of PFIC assets on the newly instituted Part 1 of Form 8621. This means that the taxpayer is required to file a separate Form 8621 for each separate fund you held during the year even if there was no income generated by the fund or you did not sell it.
Thankfully, the Treasury have issued regulations specifying an aggregate de minimis value of a shareholder’s PFIC reporting requirement on Part 1 of Form 8621 of $25,000 for single taxpayers (or married filing separate) and $50,000 for married filing joint. If the total value of your PFICs are below the applicable amount you do not need to declare them on Part 1 of the Form 8621. However, Form 8621 will still need to be filed if the asset was sold during the year, or if you received what is referred to as an "excess distribution".
See our FAQs below for more details:
Q: How do I know if I have a PFIC in my portfolio?
You should perform a comprehensive review of your portfolio to see what types of assets it contains. Any of the following types of mutual funds and collective investment schemes are most likely a PFIC unless they are incorporated in the US:
- Exchange traded fund (ETF)
- Open ended investment company (OEIC) and foreign unit trusts
- SICAV ("société d'investissement à capital variable") or SICAF ("société d'investissement à capital fix")
Q: None of my PFIC assets are worth more than $25,000/$50,000. Am I under the Form 8621 filing threshold?
The filing threshold relates to the total value of all PFICs that you may hold, not the individual assets. If you held PFICs which in aggregate exceeded $25,000/$50,000 in value on the last day of the tax year then you are required to file a Form 8621 for each PFIC, reporting the relevant information on Part 1 of the form.
Q: I am sure that my PFICs, in aggregate value, do not exceed the filing threshold, should I still be concerned with Form 8621?
The above filing threshold relates to the filing of Form 8621 to report the holding on Part 1 of the form. If you sell the asset or receive an "excess distribution" from the asset, you will still have to report this on Form 8621 and will be subject to the PFIC tax and interest regime.
Q: What is an "excess distribution"?
You receive an excess distribution when you earn income from the PFIC (interest/dividends/etc.) during the year which exceeds 125% of the average distribution of the last three years in which you held the asset, or if the fund was sold (wholly or in part) for a USD gain in the tax year.
Q: What is the PFIC tax and interest regime? How can the tax rate end up exceeding 100%?
Simply: the asset gains are allocated pro-rata to each day in your holding period and aggregated within each tax year. Tax is then calculated at the highest marginal rate for that tax year, and interest calculated upon that. Generally, no foreign tax credit is allowed against the "prior year" tax and interest charge. It is the lack of foreign tax credit and interest charges that can push the effective tax rate on the gain to—in theory—above 100%. A more detailed explanation of the tax calculation can be found within the downloads in the Client Area of our website.
Q: So I should just open a US brokerage account and invest in US mutual funds?
Unfortunately, HMRC have a similar regime called Offshore Income Gains, which is designed specifically for almost exactly the same reason as the PFIC regime: to avoid the use of offshore funds/companies to defer tax on investment income and/or convert income generated into capital gains. The OIG regime charges tax at the taxpayer’s marginal income rate rather than the capital gains rate. To avoid the pitfalls of the OIG regime you should take care to only purchase "Reporting Funds", which are those non-UK funds that are registered and reported to HMRC. For more information, see Offshore Income Gains.
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