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Guide to Passive Foreign Investment Company (PFIC) for US Expats

What is a PFIC and What Does it Mean For US Expat Workers?

The PFIC, or Passive Foreign Investment Company is a foreign-based corporation often used for investment vehicles and funds.  Offshore investments are attractive to many US investors since they permit diversification, and avoid the typical filing and reporting requirements of domestic investment companies.  But PFICs are also of interest to those who live and work outside the country, since they may carry strict reporting rules and a heavier tax burden for anyone holding even one share of a PFIC. 

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US expatriate workers may have a need to understand how PFICs work and are viewed by the IRS for financial and tax planning purposes. There may be occasions when foreign employee pensions or statutory payments are invested in PFICs, which would require the expat employee to meet the IRS requirements, and could mean higher taxes than one believed.

What is a Passive Foreign Investment Company (PFIC)?

The Passive Foreign Investment Company (PFIC) has to meet one of two requirements:

1.      A minimum of 75% of the corporation’s income is passive, which means is derived from investments rather than active business operations, or;

2.      50% or more of the corporate invested assets produce passive income such as interest, dividends or capital gains. 

By qualifying under one of these two criteria, the PFIC can offer shares for investment that are taxed as passive income for the shareholder.  However, the approach used to calculate tax is not the same as for similar domestic investments. 

In general, the IRS does not favor offshore investment since there is no way to determine the actual holdings or financial returns for the PFIC.  Although the PFIC may supply that type of information for the benefit of shareholders, there is no way to know if it is accurate or complete.  Therefore the burden falls on the taxpayer in the form of strict reporting requirements and higher tax rates.

Effect on US Expatriate Workers

The use of PFICs and the regulations surrounding taxpayer reporting may be an issue for US expat workers.  The use of foreign pensions, mutual funds or pooled investment funds may trigger the reporting requirements, and affect the taxability of any investment. There are several key areas to consider the affect of a PFIC:

How to Know When One is Invested in a PFIC

There are instances where a US expat worker may utilize a PFIC, either intentionally for personal investments, or involuntarily as part of their employment.  If a foreign country requires that the expat make certain type of contributions or payments into local holding companies, then they may qualify for Passive Foreign Invesment Company (PFIC) tax status, and trigger the IRS reporting rules for the worker. 

Some workers may not even realize this is the case, unless they are told by their employer or investigate the holding company’s status.  For example, the frequently required social security or pension payment for most countries might be placed with a PFIC for investment management, potentially drawing the expat worker into PFIC reporting.  

Threshold for Reporting

The actual threshold for specifically reporting income from a PFIC was changed in 2014 to make it easier for small investors.  The threshold amount for filing Form 8621 is an aggregate of $25,000 for all shares held in one or more PFICs.  The threshold is $50,000 for married couples filing jointly.  Even if the PFIC threshold is avoided, there still remains the other tax filing requirements as for all taxable investments and accounts held in foreign jurisdictions on Form 8938.

Tax Rate for PFIC Held Investments

Tax rates for PFICs are very complex, but a simple explanation is that income will generally be taxed at the highest rate possible for the type of distribution, plus an interest charge.  Here is the breakdown:

  • All income distributions are taxed at the highest marginal rate:  39.6%
  • Capital gains tax rates do not apply and gains are also taxed as income at 39.6%, compared to a rate of 15% for domestic, long term capital gains
  • Deferred gains receive an interest charge for the entire time period that gains are held in the PFIC

For some investments these high rates and interest charges can equal more than 50%.  For this reason, most US based investors are wise to avoid PFICs, but expat workers may have no choice, where statutory or employee contributions are automatically channeled into a PFIC.

Tips for Dealing with PFICs

Any expat worker should be aware of the PFIC status of their foreign investments given the filing and tax consequences that are at stake.  The primary approach would include:

  • Determine if employee pension or social security payments are held in a PFIC 
  • Calculate whether the aggregate shares in all PFICs exceeds $25,000, triggering the 8621 reporting requirement
  • Consult with a tax professional to determine whether any elections such as mark-to market or other exceptions apply to the filing requirements or taxability of gains
  • Project the final tax burden imposed by the IRS rules, and re-evaluate the financial benefit of either increasing or decreasing optional employees contributions to a PFIC
  • Fulfill all reporting and tax payment requirements or risk IRS penalties of up to $10,000 for failing to disclose PFIC investments of any amount on Form 8938 listing of foreign accounts

Summary

While no expat worker will be pleased to learn that their pension and employee fund holding are taxed at a higher rate than their domestic counterparts, it is one challenge of working in a foreign jurisdiction. It inevitably impacts the expat salary of the expatriate workers. The employer deals with similar financial and regulatory hurdles in entering new markets and adhering to local laws and regulations. 

The main objective is to learn exactly where one’s investments are being held, consult with human resources on payment options, and fulfill any tax reporting requirements. Once the information is obtained, a review of financial and contribution choices should be reviewed for any means of minimizing the impact of PFIC investments, and avoiding penalties for non-disclosure of PFIC holdings of any amount.

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