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How the OVDP Works With Passive Foreign Investment Companies (PFIC)

PFIC Tax Rules – Disclosure Options when you Have Foreign Mutual Funds

Barclays Bank
If you’re a U.S. citizen who has lived or done business outside the U.S. it may have seemed like a good idea to invest in a mutual fund over there, but you need to know the tax rules about passive foreign investment companies (PFIC). Maybe your banker recommended a fund that had had good returns recently. Maybe your employer put you in the local retirement plan there. Maybe you just wanted a fund that used the same currency as you were getting paid in.

In fact, there are plenty of perfectly legitimate reasons for owning shares in a foreign mutual fund and it is perfectly legal to do so. But we hate it to break it to you that it wasn’t actually a good idea. Why? Because while the I.R.S. has not barred U.S. citizens from holding foreign mutual funds they have set up an obstacle course of notoriously elaborate and harsh rules to discourage U.S. citizens from doing so.

A Not-So-Well Publicized Tax Obstacle Course for Foreign Mutual Funds

The I.R.S. has not broadcast the fact that the obstacle course even existed. (Well, technically they have with laws, regulations and guidance, but those are not usually designed to be understood by civilians.) And we all know that ignorance of the law is not an excuse. If you didn’t know the obstacle course was there, you’re still on the hook for not running it. If that’s news to you, though, you’re not alone. As foreign account disclosure specialists we deal with people every day who simply had not heard the story yet. And neither had their professional tax preparers.

The PFIC Tax Obstacle Course Got a “Seek-and-Destroy” Upgrade in 2014

Even if you or your tax preparer had gotten wind of the PFIC rules, up until 2014 it was a more or less reasonable approach to slide them under the rug. We’re not saying that was O.K, we’re saying that it just didn’t seem to make sense for a U.S. taxpayer to spend hours (or pay someone else to) doing complex reporting on a plain old Canadian mutual fund, for example.

That approach doesn’t really work anymore, though. The Foreign Account Tax Compliance Act (FATCA) came into force in 2014 and effectively put “wheels” on the PFIC rules. If you have a foreign mutual fund, the I.R.S. will now have this information and will drive the obstacle course over to your location so you can run it. And impose even harsher penalties for not having done so earlier.

What can you do next? We’ll come back to that in just a minute. First let’s go over whether or not you need to be worrying about the PFIC rules at all. The basic question is if you have one or not.

What’s a PFIC?

Non-U.S. registered mutual funds will almost always be PFICs. If you own shares in one, do not pass go. Skip ahead to the next section.

Other foreign investment structures that involve investment funds in some way, shape, or fashion can be very difficult to untangle and classify as a PFIC or not. The basic rule is that the investment entity (e.g. the company that owns shares is another company) is a PFIC if 75% of its gross income is classified as “passive” (e.g. dividends or interest) or at least 50% of its assets are held in order to produce this passive income. In other words if it makes a lot of passive income or supposed to make a lot of passive income it is a PFIC. (There are a few other exceptions such as for companies that you yourself own and start-ups that we’ll skip here.)

Non-U.S. “wrappers” like life insurance policies and retirement plans (i.e. foreign equivalents of IRA’s and 401k’s) that typically hold foreign mutual funds have to be evaluated together with all the facts surrounding them like double taxation agreements. Your best bet is to assume that you have a PFIC and hire a specialist to tell you that you don’t. If you don’t, be pleasantly surprised.

Is it really that complex? Well yes it is. For example, you’d think that a big name mutual fund provider like Fidelity would have this figured out, right? Especially in Canada; thousands of U.S. citizens are going back and forth all the time. Think again. They say they think they know what’s going with Canadian retirement plans, but won’t really confirm it. The Fidelity website says,

“How do these rules affect different types of accounts, such as non-registered accounts, TFSAs and RRSPs?

These rules affect investments in non-registered accounts, TFSAs and RESPs. For PFICs held in Retirement Savings Accounts such as RRSPs and RRIFs, most tax advisors suggest that as long as IRS Form 8891, “U.S. Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans”, is filed annually, the PFIC rules should not be applicable. However, Fidelity recommends speaking with a U.S. tax advisor.”

If Fidelity in Canada won’t go on the record, that tells you something. Do as they suggested and talk to a specialist. (There are special rules for Canadian retirement accounts, by the way.)

So I Have a PFIC. What Next?

You run the 2-part obstacle course. It consists of the following:

  • Reporting your share of the PFIC to the IRS every year on forms 8621 and 8938.
    • You can skip Form 8621 if your share in the foreign mutual fund is worth less than $25,000. When in doubt, go ahead and file it. One form 8621 for per PFIC. The IRS officially thinks that one form 8621 takes 22 hours to complete. Go figure.
    • Form 8938 is for reporting foreign accounts held by U.S. citizens in general. There are also exemptions available depending on the aggregate value of your foreign holdings. If you file a 8938, you need to report PFIC interests of any size on it.
  • Pay taxes on your gains from the PFIC (but not necessarily every year). You can choose to do it three different ways that are, in broad overview:
    • The “1291 Fund” way – save the worst for last with extreme prejudice.
      Here you pay U.S. tax at normal income rates on actual distributions from the PFIC every year as long as the annual distributions appear to follow a regular pattern every year. If there is a distribution that is higher than the regular pattern (e.g. when you sell your shares in the fund) then you get taxed in the highest available U.S. income tax bracket and pay interest on the amount distributed calculated pro rata over however many years you held the PFIC.

If the PFIC had mediocre gains during the time you held it, the retroactive compound interest may even put your PFIC “underwater” just like an overvalued piece of real estate whose rental income won’t cover its mortgage payments. The thing is, though, you can’t just give back the keys to the PFIC and walk away. If you want to gift it to someone else (hopefully a non-U.S. person) it has different rules than other appreciated property. You are required to pay the tax as if you had sold it before you get rid of it. Breaking up with a PFIC is hard to do.

What’s the point of all this cruel and unusual tax treatment? It is designed to encourage PFIC owners to take distributions from the PFIC (and be taxed accordingly) early and often just like they would be from a domestic U.S. mutual fund.

  • The “Qualifying Electing Fund” (QEF) way – rely on a “unicorn” mutual fund company that believes in international cooperation. Hint: they don’t really exist.
    If the German, British, or Australian (or wherever) mutual fund company is willing to play ball, you can be taxed on the PFIC every year at ordinary U.S. income tax rates on annual gains. Playing ball means doing calculations according to U.S. methods, providing you with an annual document stating the calculations, and making their books available for interested parties to verify those calculations. It’s the best option for you but the mutual fund company has to understand the situation and cooperate. Typically that just doesn’t happen in real life.
  • The “Mark-to-Market Election” (MTM) way – rely on a spreadsheet and market data.
    This option is similar to the QEF way except that you (or your tax preparers) do the calculations on annual gains or losses and are taxed annually accordingly. The information about gains or losses can be verified later if necessary using historical stock market data. The catch, therefore, is that the PFIC needs to be publicly traded on a market in order to take this route.

For practical purposes your choices come down to either the 1291 (harsh) or MTM (less harsh) routes. As you can see from the brief outline above, the basic idea of both methods is to discourage U.S. citizens from building up undistributed gains in foreign mutual funds. They should pay taxes on foreign mutual fund gains just like they do on U.S. mutual fund gains. The practical result, bearing in mind compliance costs especially, is that it is a pain for U.S. citizens to hold shares in foreign mutual funds.

What If I’ve Had a PFIC And Never Did Any Reporting on It?

Unfortunately this is not a question of choosing the best option. It is about choosing the least worst option. It will take some time, money, and effort to square up with the IRS. You have been, technically speaking, legally obliged to report and pay taxes on your PFIC holdings. If you didn’t do so, you will need to set the record straight sooner rather than later.

The first thing to consider is whether you want to hang on to the PFIC or not. Is the mutual fund doing so well that it justifies the extra hassle of reporting it and paying U.S. tax on it?

(You can, of course, just keep the PFIC, not do anything, and worry about it later. Up until last year it was more or less safe for you to fly under the radar – whether or not you knew you were doing so – but that won’t work much longer now that FATCA is in effect. We don’t recommend that as a viable option, obviously.)

Bearing that in mind, here’s what you can do:

  • Keep the PFIC and start reporting it and paying tax on it under the 1291 rules.
    This option would be a quiet disclosure and (like all quiet disclosures) puts you at risk of penalties for not being compliant earlier. The IRS does not seem to be handling quiet disclosures as quietly as they used to. Moreover if you will be staying compliant with PFIC, you should doing so with the MTM method. It is less worse than the 1291 way.
  • Keep the PFIC and start reporting it and paying tax on it using the MTM method.
    This option is another quiet disclosure (which are not ideal in general) but at least you will have least worst tax treatment going forward. You will have to treat the PFIC as if it had been sold as a 1291 Fund in the current year before using the MTM method from now until you sell in the future. In other words, you will be taxed harshly on previous gains and less harshly on future gains.
  • Sell the PFIC and bite the bullet on 1291 fund taxation.
    This is the “cold turkey” option for PFIC holders who just want to put the issue to sleep. It is still a quiet disclosure, though, with the risks that they all entail.
  • Enter the Offshore Voluntary Disclosure Program (OVDP).
    There are some specific reasons why this option is a good idea for PFIC holders which we’ll cover next. (For a general overview of the OVDP as it stands in 2015, see this this article I wrote here.)

Why the OVDP Makes Sense for PFIC Holders

As you can see from the previous section, if you take the quiet disclosure route under any PFIC scenario, you will always get hit with 1291 Fund taxation on the PFIC’s prior gains. If you keep the PFIC, you will be able to switch over to the MTM method moving forward but only after doing a fake sale of the PFIC and paying real money in 1291 Fund taxes on it to the tune of 35% plus interest, generally speaking. The story is the same if you sell the PFIC.

Really what we want, as a least worst option, is to be able to use the MTM method on the PFIC’s prior gains or, in other words, to use the MTM method retroactively. Generally speaking you just can’t do that except for a few once-in-a-blue-moon scenarios.

However, there is a “lite version” MTM that you can use as part of the “full version” OVDP that covers the last eight years worth of offshore reporting. This rule is special and is the only case, practically speaking, in which you can use the MTM method retroactively. Basically how it works is that you use the value of your PFIC eight years ago as a starting point and pay 27% tax on the gains you had accumulated up to that point. And then you use normal MTM calculations on the gains for the next 7 years and pay 20% tax on them.

Note that you cannot use “MTM lite” as part of “OVDP lite” which the IRS officially calls the Streamlined Filing Compliance Procedures. These procedures cover the last three years worth of reporting and have two subsets of rules depending on whether you are resident abroad (the Streamlined Foreign Offshore Procedures) or in the U.S. (the Streamlined Domestic Offshore Procedures). You can find more detailed outlines on how it works in both scenarios here and here.

If you do opt for the streamlined procedures you, would need to use the 1291 calculation method when calculating the tax to pay on your PFIC. That’s the same treatment as would be necessary if doing a quiet disclosure.

In conclusion, if you have an unreported PFIC your decision as to what happens next can be to:

  • Go with “MTM lite” as part of the full, 8-year OVDP. Manage the risks of penalties for not reporting in previous years and achieve the least worst tax treatment whether or not you sell the PFIC.
  • Throw yourself under the 1291 tax bus as part of the 3-year, streamlined OVDP. Manage the risks of penalties for not reporting in previous years and rip the PFIC band-aid off. It will hurt but you will live to invest another day.
  • Throw yourself under the 1291 tax bus in a quiet disclosure. Poorly manage the risks for not reporting in previous years with no real upside. You will achieve the same tax treatment with the streamlined OVDP.
  • Bury your head in the sand. If you think the 1291 tax bus looks bad, get a load of the willful violator paddy wagon. Not recommended.

Which option should you go with? If you have a substantial sum invested in PFICs it may make sense to soldier through the full version OVDP in order to take advantage of the special MTM rule. Otherwise the streamlined OVDP may mean less overall investment even if taxes due on the PFIC gains are relatively higher. We strongly recommend talking to a specialist when you’re making this decision regarding PFIC matters.

NOTE: Photo of Barclays Bank ©Elliott Brown, license at https://creativecommons.org/licenses/by/2.0/legalcode

Venar Ayar, Esq.

Venar Ayar, Esq.

Attorney-at-Law, Master of Laws in Taxation
Principal and founder, Ayar Law

Venar is an award-winning tax attorney ranked as a Top Lawyer in the field of Tax Law. Mr. Ayar has a Master of Laws in Taxation – the highest degree available in tax, held by only a small number of the country’s attorneys.