Last updated April 13, 2023.
Picture this: You’re an expat, living abroad and diligently implementing financial strategies that served you well in the US. Suddenly, you learn: there may negative tax implications associated with your foreign investments.
As a US taxpayer investing abroad, chances are you’ve never heard of passive Foreign Investment Companies (PFICs) and Form 8621, nor how they should be considered in your investment strategy.
Whether you’re juggling foreign retirement accounts, mutual funds, or just seeking a better understanding of your overseas financial landscape, it’s important to have a solid baseline understanding of PFICs and Form 8621 and what it means for your US taxes. Below, we shine a light on this lesser-known tax topic and unveil why every US expat should be aware of PFICs and Form 8621. To begin, we’ll cover passive income.
What is passive income?
Passive income is the income you earn with zero or minimal operational effort. It is sometimes also referred to as “unearned” income. There is no difference between passive income and unearned income. These two terms are often used interchangeably to describe earnings that don’t come from your job. Throughout this article, we will use “passive income” for the sake of clarity and consistency.
Examples of passive income include interest, dividends, and distributions related to capital gains. Other examples include:
- Rental income
- Income from foreign currency exchanges
What is a Passive Foreign Investment Company (PFIC)?
A Passive Foreign Investment Company is a corporation that is registered outside the US and meets the following income or asset criteria.
- Income test: At least 75% of gross income for a Passive Foreign Investment Company is passive income.
Note: Passive income is earned while not engaged in day-to-day business operations.
- Asset test: At least 50% of the assets a Passive Foreign Investment Company holds produce passive income or are purposefully kept to create passive income.
Two common examples of PFICs
- Foreign mutual funds: Mutual funds that invest primarily in passive assets, such as stocks, may be considered PFICs.
- Foreign pension plans: Some foreign pension plans may also be considered PFICs if they invest in passive assets that meet the PFIC criteria.
How to understand if your foreign retirement account qualifies as a PFIC
Foreign retirement accounts that utilize collective investment schemes such as mutual funds are often categorized as Passive Foreign Investment Companies. In order to understand whether or not your foreign retirement account qualifies as a PFIC, you need to know what investment strategy is being used. Many retirement accounts channel the pension into mutual funds or other pooled funds as an investment strategy and therefore attract US PFIC tax treatment.
What is a mutual fund?
Mutual funds are investment vehicles that pool money from multiple investors to purchase a portfolio of securities, such as stocks and bonds. If a foreign retirement account holds mutual funds that are classified as PFICs, the account itself may also be considered a PFIC.
How does my money end up in a mutual fund that the IRS classifies as a PFIC?
Retirement brokerages and financial planners tend to rely on mutual funds as an investment strategy. These strategies vary and may be influenced by factors such as the designated retirement date and the aggressiveness (or conservatism) of the investor.
Investing in mutual funds may seem a great investment strategy for your pension account custodian to take. However, if a foreign retirement account holds mutual funds that are classified as PFICs, the account holder may be subject to additional taxes and reporting requirements. For this reason, it is important for US expats to establish relationships with expat tax professionals and financial planners with cross-border expertise and clientele.
“The PFIC mistake is amongst the most common made by U.S. expats. Unfortunately, it’s not something anyone would imagine as an issue when they move abroad. Without the right investment and tax advice most Americans that move overseas will make this avoidable mistake.”– Roger Healy, Creative Planning International
What should I do if I invest in a PFIC?
Generally, Americans with holdings in a PFIC must file Form 8621 every year. There are limited exceptions depending on the value of your PFIC holding on the last day of the year and your ownership type. Investing in the expertise of an expat tax professional here will likely save you time, energy, and potentially even money.
Form 8621 requires more complex record-keeping and delicate accounting.
For perspective, according to the Paperwork Reduction Act, filing Form 8621 for a Passive Foreign Investment Company (PFIC) may take up to 49 hours.
For comparison, the IRS estimates it takes about 13 hours to file Form 1040, a standard tax reporting form.
How the IRS taxes PFICs
Form 8621 not only discloses the PFIC itself, but it also allows the taxpayer to elect how the PFIC will be taxed by the IRS, as long as the form is submitted in a timely manner. Part 2 of Form 8621 permits PFIC-holders to select how the IRS taxes the PFIC. In the absence of a timely election, the IRS default selection is to impose tax based on excess distribution, which we describe below.
Excess distribution is the default treatment. If you choose this method, you’re informing the IRS to tax your PFIC’s distributions only.
Due to its unique taxation treatment, excess distributions can create a postponement of tax liability. The IRS will eventually tax your distributions at the highest ordinary income tax rate. For 2023, that rate is 37%.
Additionally, interest will be calculated and charged on any of the deferred tax liabilities.
This method is intended to deter expats from deferring paying their tax liability on passive income by charging higher ordinary income tax rates and interest.
If you choose Mark-to-market treatment, you’re informing the IRS to tax the growth of your investment in your PFIC every year, even growth that is unrealized. Unrealized growth is an investment term that refers to the increase in the value of an asset that has not yet been sold or realized. It is the difference between the current market value of an asset and its original cost basis.
Take, for example, a situation where your PFIC shares had a market value of $55,000 on December 31, 2022, and increased to $75,000 on December 31, 2023. In this scenario, you would be taxed on the $20,000 increase in value, even though you didn’t sell the shares.
This method is only available for marketable shares (i.e., actively traded on a qualified exchange).
Under this method, you accelerate your tax obligations and pay tax each year on the change in the fair market value of the investment. If the asset decreases in value, your tax deduction is subject to limitations, based on what you’ve already recognized as income.
Your ordinary income tax rates apply to any taxable gains or losses.
Qualified Electing Fund (QEF)
Choosing a Qualified Electing Fund involves extremely complex conditions and provisions.
Essentially, under QEF taxation, you must report your share of the PFIC’s earnings. In turn, these earnings will be treated as long-term capital gains for tax purposes.
QEF comes with rigid rules. Once you make a QEF choice, it’s binding for all subsequent years unless the IRS approves a change.
Also, QEF requires a mountain of information you need to provide that you can only get from the PFIC. From a practical standpoint, QEF treatment almost never occurs in practice.
Reporting Form 8621 as a US expat
The first thing to do before filing Form 8621 is to figure out whether you have a PFIC.
A PFIC can often be confused with a CFC (Controlled Foreign Corporation). They are not the same thing.
US expats generally must file Form 8621 if they hold a direct or indirect interest in a PFIC. There is no de minimis dollar amount that you must meet to file Form 8621.
While you can file Form 8621 on your own, be prepared to do some heavy lifting. Form 8621 requires you to figure out complex calculations and navigate a maze of accounting and tax jargon.
Need to catch up on US expat tax filing? Bright!Tax are expat tax experts
It’s always advisable to work with a tax professional to catch up if you’ve fallen behind. With Bright!Tax, you can catch up on expat tax filing via a process called the Streamlined Filing Procedures. More often than not, non-compliance was not willful. If non-compliance was not willful, you will not be assessed penalties once you initiate the procedure. The Bright!Tax team have helped hundreds of US taxpayers utilize the Streamlined Procedures to catch up on their tax filing obligations — without paying a dime in penalty.
Invest in reducing your tax-season stress today by getting in touch with a Bright!Tax team member today.
IRS Form 8621 for reporting PFICs – FAQ
What if I’m late filing Form 8621?
Form 8621 should be filed as an attachment to your annual tax return. Assuming no extensions, this is usually by June 15 for expats.
Failing to file Form 8621 on time can result in penalties if you end up owing tax on your PFIC distributions or market-to-market adjustments. But more importantly, it will extend the statute of limitations for the IRS to audit your return.
What are some other examples of PFICs?
- Foreign hedge funds: Hedge funds that are based in foreign countries and meet the income or asset tests for PFICs may be subject to PFIC taxation.
- Foreign unit trusts: Unit trusts are investment vehicles that pool money from multiple investors to purchase a portfolio of securities. If a foreign unit trust meets the PFIC criteria, it may be subject to PFIC taxation.
- Foreign insurance policies: Certain foreign insurance policies, such as variable annuities, may be classified as PFICs if they meet the income or asset tests.
How do I report foreign pension withdrawals?
Reporting requirements for foreign pensions can often be complex and confusing. In some cases, they will involve using more than one form.
Additionally, your reporting requirements will depend on the kind of foreign retirement plan, where and how those assets are invested, and the specific provisions of existing tax treaties.
The following are some of the forms you may use for filing foreign pension withdrawals.
- Form 8621, if your retirement is invested in foreign mutual funds
- FinCEN 114 (FBAR), depending on how much you held in a foreign account
- Form 8938, depending on the value of your foreign accounts and foreign assets
- Form 3520 and 3520-A, if your foreign pension is held in a trust
Foreign pension withdrawals and the subsequent reporting requirements may need the input of your CPA.
Where can I find a financial advisor with cross-border expertise?
Bright!Tax has an extensive network of US expat tax experts that we are pleased to provide upon request.