Why Americans Should Avoid Foreign Mutual Funds (Hint: Taxes)

Buying & Selling Foreign Mutual Funds & ETFs, PFIC  

Over the past 10-to-20 years, there has been a significant increase in taxpayers who have elected to invest in pooled funds such as mutual funds, ETFs, and other pooled funds as opposed to investing in individual stocks. The same holds true for taxpayers abroad. And, with the globalization of the US market, it is very common for individuals who are considered US persons to invest in foreign mutual funds, ETFs, SICAVs, etc. One of the biggest drawbacks for US persons investing in foreign pooled funds is that oftentimes they are considered to be PFIC for US tax purposes (Passive Foreign Investment Companies) and therefore subject to the incredibly harsh PFIC tax regime. But, just because the US may invoke the PFIC tax rules does not mean the foreign investment is not worthwhile; likewise, just because you already have a foreign pooled fund that you want to get rid of does not mean you should run off and sell the fund because you may become subject to significant taxes in the US. Let’s take a brief look at some of the basics when buying and selling foreign mutual funds.

Buying a Foreign Mutual Fund (8621)

In general, taxpayers must report foreign funds on forms such as the FBAR. Depending on whether the funds are in an account or whether they are being held individually can impact the extent of the reporting. In addition, taxpayers may often have to file a Form 8621 — depending on the value of the funds and whether or not there are any excess distributions in the year. Form 8621 can be daunting, as it requires a taxpayer to report each fund individually, which can become a very overwhelming situation in which a taxpayer has a very large portfolio.  There are various exceptions, exclusions, and limitations to be aware of as well, and these may reduce or eliminate the reporting in a given year.

Making a PFIC Election

In order to minimize the tax implications of having a PFIC, the US government developed various elections that a taxpayer may make. The two main elections are the Mark-to-Market (MTM) election and the Qualified Electing Fund (QEF) election. Out of the two different elections, the QEF election typically results in a better tax outcome for the US person, but it does require some cooperation from the foreign financial institution. Unfortunately, many foreign financial institutions are not in the business of wanting to provide you (a US Person) the financial information necessary for you to make the QEF election. In fact, even just asking them for the information may put you on their naughty list, since many foreign investment companies do not want to deal with the headache of having a US person investor (thank you, FATCA).

Timely Election vs Late Election

It is important to try to make a timely election, which generally means in the first year of the investment. If you want to make a late election but use reasonable cause, there are very strict requirements for doing so — and it is very difficult to qualify for reasonable cause when it comes to a late PFIC election. Likewise, you can make a late election in most situations, but you also have to make a purging election at that time – which may result in a large tax liability under the excess distribution tax regime.

Dividend Reinvestment vs Dividend Distribution

If you are investing in funds, it is very important to determine from the outset whether you will be receiving distributions that are being reinvested or distributions that are being distributed out to you. If they are being reinvested, then you may be able to circumvent the excess distribution rules depending on how the distributions are being reinvested. If they are being distributed out first and then you must transfer them back in for reinvestment, that may pose a problem — so you should try to confirm with the investment company if you can.

Are Dividends Distributed from the Outset

Another important aspect of dividends from foreign mutual funds or other pooled funds is whether you will be receiving distributions in the beginning year or whether those distributions will begin later down the line. If they begin in the early years — and remain relatively constant — then you may not have any dividend excess distribution. Conversely, if you go several years without receiving any distribution and then you begin to receive a large distribution, you may have a significant excess distribution tax, at least in the first year.

Selling a PFIC

When you sell a PFIC, chances are you will have an excess distribution. With excess distributions, taxpayers do not get taxed at the long-term capital gains rate of 15% or 20%. Rather, the taxpayer must pay tax at the highest tax rate available at the time, in addition to interest for the amount of time that the investment was sitting in the fund but not distributing any income. The concept behind the excess distribution is the IRS does not have the ability to track many foreign mutual funds, so they have no idea what is going on within the fund — since the foreign funds are not required to report similar to US funds.

Switch-Outs and Mirror Funds

When it comes to mutual funds, there are ancillary actions that the fund may take beyond dividends and capital gains, such as performing a fund switch-out (as opposed to a sale or distribution) which can cause additional tax complexities. Likewise, not every pooled fund is necessarily a PFIC; for example sometimes a mirror fund may not qualify as pooled fund sufficient to be treated as a PFIC, and something to consider (common with foreign insurance companies).

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