Passive Foreign Investment Companies (PFICS)
It’s not uncommon for British expatriates living in the US to hold Passive Foreign Investment Companies (PFICs). There’s a fair selection of these, but the main ones you might have heard of are collective investments, such as those held within an ISA or what’s commonly referred to as a unit trust. PFICs can also be ETFs, mutual funds, REITS, investment trusts, etc.
Problems with Passive Foreign Investment Companies (PFICS)
Many Brits relocate to the US with these types of investments, or sometimes they end up holding them later in life. For example, you have received them as part of an inheritance and left them in the investment account because the GBP to USD exchange rate wasn’t very favourable at the time.
Most of the time these are viewed quite unfavourably in the US and can attract a reasonably toxic rate of taxation.
The UK does have many investment wrappers (by wrapper, we are referring to a specific type of account such as a pension, endowment, ISA, insurance bond etc.) that can hold these types of investments. The wrappers don’t provide any protection from tax treatment as a PFIC.
You might be thinking:
“This doesn’t apply to me as my investment is in an ISA and that is tax-free”.
But this isn’t the case. The US doesn’t recognise the ISA wrapper and, as far as we are aware, there’s nothing in the tax treaty that provides any favourable terms. The US doesn’t acknowledge the tax-efficiency of an ISA wrapper. They look straight through it at the underlying PFICS investment and tax it accordingly.
Your once very efficient tax-free holdings are transformed into a punitively taxed investment in the US. To add salt to the wound, you must also report any distributions and gains to the IRS on each year separately from your tax return using form 8621. The filing of this form is lengthy and complicated. The IRS itself estimates it may take more than 40 hours to complete!
You might also be thinking:
“It doesn’t apply to me because I’m only coming to the US for work and have no plans to settle here long term.”
This is simply not true. Any US connected person must report these investments in the US. If you are paying tax in the US, you must report your PFIC investments while you’re here.
Taxation & Reporting of PFICs
We are caveating everything we write here with “I am not a tax-specialist so please ensure you seek advice from a qualified CPA who specialises in international taxation as what we are about to discuss is a really simplified version of what happens.”
The default method of taxation & reporting is aptly named the ‘default method’. This is where all realised gains and distributions (dividends) are taxed up to the highest rate of federal income tax.
Most distributions from a PFIC are considered “Excess Distributions” and will be taxed under quite a penal regime, with the excess distribution taxable up to the highest rate of federal income tax.
“Excess distributions” are classed as distribution amounts, within the taxable year, which are in excess of 125% of the average amount distributed in the 3 preceding tax years (or, if shorter, the portion of the taxpayer’s holding period before the taxable year). It’s a little complicated, and generally, if dividends are relatively stable from a PFIC investment, these excess distributions would be limited. However, upon disposal of the PFIC investment, a material excess distribution often occurs.
It’s important to note that we did not say ‘up to your personal rate of income tax’. You could be taxed up to the HIGHEST federal rate of income tax (currently 37% in 2022-23) regardless of your personal tax bracket.
It gets worse, though.
The US taxes income from dividends/coupons and capital gains on an annual basis, as they arise. If you, as the investor, in a non-US investment, have been accumulating income and gains, and not paying tax (let’s think ISA for a moment), then the IRS thinks it has been disadvantaged.
They will look to recoup their ‘loss’ by applying interest to the tax on your gain for each year, other than the current year, as that one isn’t considered late.
For example, let’s say you’ve been in the US for 10 years and you’ve made a $100,000 gain on your ISA and unit trust. The $100,000 gain will be split over the 10 years – $10,000 each year. You will not be charged interest for the current year (it’s not late, remember), but you will incur interest on each of the previous 9 years at the highest rate of federal income tax PLUS interest applied for each of the 9 years you did not declare the gain.
Invariably you will be taxed above the 37% top rate of tax for 9 of those 10 years.
Imagine if you’ve been in the US for decades and not declared this – that could be very expensive. Not to mention the jeopardy you would be in from being non-compliant with your tax.
As we mentioned at the beginning, if you are a US taxpayer then you must file a separate form 8621 for each PFIC each year, for each fund held within your investment.
For example, your ISA holds 15 different funds within the portfolio. You are required to submit fifteen 8621 forms each year.
Alternative taxation models
As an alternative to the default method of taxation is the Qualified Electing Fund (QEF). Essentially this is where the investor or manager of the PFIC has made a special ‘election’ and agrees to cooperate, from the get-go, with IRS requirements. This provides a more friendly level of taxation in the US and avoids additional interest, but it relatively rare as PFIC cooperation is unlikely.
Another option is Mark-to-Market. This is easier to achieve than the QEF, but less tax efficient. Under this option the PFIC is treated as if it has been sold at the end of each year, with the proceeds equalling the market value on December 31st. This means that all earnings (including unrealised earnings/gains) are still taxed as ordinary income, but no interest is charge. The PFIC is essentially rebalanced at the end of each year, so when you eventually sell it, the gain has been substantially reduced.
You need to elect to have your PFIC taxed under the mark-to-market rules, and this must be “timely” (i.e. actively selected in the first year of ownership or the first year of becoming a US person for tax purposes).
We have found that most investors holding PFICs have not applied for any of the elections (QEF or MTM), so I won’t go into them.
It’s safe to say that if you are holding an international collective investment in GBP that you should assume it is a PFIC and seek the assistance of a cross-border tax advisor as soon as possible.
Pensions and Passive Foreign Investment Companies (PFICs)
If your pension is held in a different currency (i.e., UK pensions held in GBP, Australian pensions held in AUD etc.) the chances are it contains non-US investments. The likelihood is that these are PFICs.
In cases where a foreign country has a tax treaty with the US, the foreign pension may be classed as a ‘qualified’ pension, thus receiving favourable tax treatment in the US. As a result, many tax advisers believe that PFICs are acceptable investments in such situations.
The US will not “look through” the pension wrapper to tax the PFICs and will not require completion of an 8621 form for each investment as the taxation is based on the qualified pension wrapper, not the underlying investment. This means that, in this instance, the PFIC can be held in a qualified pension without any repercussions. However, there are some opposing views on this matter.
It’s also worth noting that not all countries have tax treaties with the US. Pensions you hold in a particular country may not be considered a pension in the US, and those pensions would be subject to PFIC rules.
It is strongly advisable for US taxpayers, whether residing in, or outside, the US, to avoid investing in PFICs unless they are held in a qualifying pension. It is essential to ensure that the pension wrapper offers protection for PFICs in the eyes of the US.
If you are a US taxpayer and you hold any PFIC investments, it is crucial to address them immediately. Delaying the process will only exacerbate the situation and trying to conceal the investment is not only unlawful, but also unwise. Financial institutions outside the US may already be reporting data back to the US through FATCA (Foreign Account Tax Compliance Act). The likelihood of the IRS already holding the information you are hiding from them is high.
Will it be an expense to rectify? Yes.
Isn’t that expense preferable over an IRS audit? We think so.
If you’ve not yet made the move to the US, I cannot recommend pre-departure planning strongly enough. If you’re not sure what type of investment you have within your portfolio, including your ISA & pensions, that’s okay, it doesn’t hurt to ask; but it might hurt not to.
Regardless of how long you are intending to stay in the US, there are a number of planning options available before you move to avoid the punitive tax consequences of doing nothing.
As always, we recommend you seek the guidance of a cross-border tax expert and a cross-border financial planner with specific expertise and experience in the country where your non-US assets are situated.