US Tax Disaster – Investing in Offshore Funds, Life Policies, Portfolio Bonds

What Every Overseas American Investor Must Know ….

Many American investors are confused by sales pitches of expat investment advisors who are most often completely unfamiliar with US tax laws. While it is true that no tax may be payable in the fund’s jurisdiction (Isle of Man, Guernsey or the UAE, for instance), significant US taxes are payable by the American owner.

Confusion abounds when Americans invest in foreign mutual funds, life policies, savings plans, portfolio bonds and similar fund arrangements as compared to when they invest in US-based funds.  Don’t let the label on the investment fool you.  Foreign life insurance policies and portfolio bonds, for example, almost always involve assets invested in foreign mutual funds.   So, if you have a foreign life insurance policy you must be on the red alert to determine if you have PFIC exposure.  If you do (which is most likely), then you may be hit to pay PFIC taxes.

Why the Tax Treatment Difference?

Generally, with a US fund virtually all of the income and the gains are distributed annually to investors and reported directly on their US tax returns.  The fund sends both the investor and the IRS a form 1099 detailing the shareholder’s income earned in the fund.

Foreign investment vehicles are not subject to this kind of disclosure. The American investor must flounder along and determine the proper US tax treatment of his investment.

The US tax laws are clearly designed to deter US persons from investing in offshore funds, whether the investment is made directly or indirectly (e.g., through a BVI company, non-US trust etc.). They prevent the income or gains from escaping US taxation and, not only that, the US tax rules impose harsh sanctions on the US investor by eliminating any possible tax deferral.  If you think a main goal behind enactment of the PFIC rules was to protect the US mutual fund business, you’d be right.

Unfortunately, the PFIC rules are overly broad an capture not only passive investment funds, but can and do capture active foreign businesses. You can read more on this issue at my earlier blog post here.

“Passive Foreign Investment Company”- Offshore Mutual Funds

Generally, offshore funds are taxed as a so-called “passive foreign investment company” or a “PFIC”.   PFIC status can result if the entity meets either an “income” or “asset” test. As relevant in the case of foreign mutual funds and similar investments, a PFIC includes any non-US corporation if 75% or more of its gross income for the year consists of “passive income”. Passive income generally includes dividends, interest, rents, royalties, most foreign currency and commodity gains, and capital gains from assets that produce such income. Just about all of the income of a fund will usually qualify as passive and so, nearly all foreign funds will qualify as PFICs!

Harsh Tax Results – Compounded Interest, Loss of Capital Gain Treatment

Once a corporation qualifies as a PFIC, very harsh tax consequences can result. In the absence of making a special election, taxation will generally occur when the fund makes a distribution to the investor or, when he disposes of his PFIC shares.  When taxation occurs, the amounts will be taxed at the highest possible ordinary income tax rate for the investor without regard to other income or expenses (currently the highest individual rate is 37% with a possible 3.8% Medicare surcharge tacked on for high income earners).  The PFIC rules contain many punitive bites .  For example, long-term capital gains treatment does NOT apply regardless how long the investment was held. Further, the amounts are treated as if they were earned ‘pro rata’ over the investor’s holding period for his fund shares (in other words, the amounts are “thrown back” evenly over each of the earlier tax years, tax assessed for each year at the highest rate, and interest compounded on the tax deemed due for each year).  This is very punitive because compounded interest charges are computed on the ‘deferred tax’ owed; the high rates can quickly eat up the investment by removing the benefit of any tax deferral.

Possible Elections

A so-called “Mark-To-Market” election may be possible. If eligible for this election, the investor can “mark gains to market” at the end of each year thus choosing a relatively simple taxation scheme that is less punitive. The fund shares must be “regularly traded” on a registered national securities exchange. A foreign exchange can qualify under certain delineated circumstances.

Another election that readers may have heard of is the so-called “Qualified Electing Fund” or QEF election.   This election permits the US investor to avoid the punitive interest charge and to treat the PFIC as a pass-through, thus picking up the income etc. directly on the investor’s US tax return each year.  With respect to foreign mutual funds, making the election has proven to be impossible. To make a QEF election, the PFIC itself must provide a lot of information to the US investor. This has proven to be an insurmountable hurdle in the cases I have seen.  For example, the entity must agree to provide its shareholders with a PFIC annual information statement which must include significant detailed information, including: (1) the shareholders’ pro rata share of the PFIC’s ordinary earnings and net capital gain; (2) sufficient information for a shareholder to calculate his pro rata share of the PFIC’s ordinary earnings and net capital gain; or (3) a statement that the PFIC has permitted the shareholder to examine its books and records to calculate his pro rata share of the PFIC’s ordinary earnings and net capital gain for US income tax purposes. Calculating the income according to US federal income tax principles is a burden in and of itself, but that’s not the end of the matter!  A QEF must also generally provide its US shareholders with access to its books and records.  The foreign mutual funds typically have absolutely no connection to the United States other than some “troublesome” minority US shareholders!  They simply will not provide the information.

Pension Plan Alternative?

Here in the United Arab Emirates, most employers do not provide any kind of pension.  As such, the investment that is most often touted by advisors in the UAE, and which should cause the most concern for US taxpayers, are regular savings plans marketed as an alternative form of “pension”.  These are really not pensions but rather a contractual form of investing where the client is regularly setting aside monies (e.g., monthly, quarterly), which are invested into a variety of mutual funds.  With such plans, it is very difficult to opt for the less punitive “Mark-To-Market” election.  This is due to the need to calculate the basis on each regularly invested amount, which is then spread out across a number of funds, and then re-adjust the basis annually for each underlying fund.  It is even more difficult if the provider offers mirror funds instead of the actual direct funds because mirror funds are not “regularly traded” and would likely not qualify for the ‘Mark-To-Market’ election.

Returns and Filings

A US investor in a PFIC must file various information and tax forms (e.g., Form 8621, Form 8938, FBAR).  Record-keeping and preparation time for the Form 8621, alone, is extremely complicated and a separate Form must be filed for each PFIC owned.  The IRS estimates that the time required with regard to Form 8621 for each PFIC investment is at 22 hours per year!  The tax preparation costs may certainly outdo the value of the investment.  To avoid possible penalties, the investor should examine the proper tax treatment and filings with a tax professional.

Ignoring the Rules?

Just in case a taxpayer thinks of ‘ignoring’ the rules regarding self-reporting on PFICs, please note that under the infamous 2010 tax legislation commonly referred to as FATCA, “foreign financial institutions” are required to report directly to the IRS (or to their home country government which will forward the information to the IRS) about assets held by US persons with that institution. The FATCA rules will make it very easy for the IRS to cross-reference the information provided by the foreign financial institution with the taxpayer’s Form 8621 or Form 8938, for example, to determine whether taxes and reporting on the foreign fund have been properly undertaken.

Given the significant tax complexities, Americans must be well advised before investing in the offshore fund market.

Posted: December 17, 2018

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