By Stephen J. Dunn
U.S.-based mutual funds annually issue to each of their shareholders a Form 1099 reporting the shareholder’s share of interest, dividends, and capital gains realized by the mutual fund during the year. The mutual funds send a copy of the Forms 1099 to the Internal Revenue Service, so that it can verify that the shareholders properly report their share income of the funds on their U.S. income tax returns. U.S.-based mutual funds are required to do this by U.S. law.
U.S. law does not, however, control foreign mutual funds. Foreign mutual funds do not report interest, dividends, or capital gains to shareholders. Interest, dividend, and capital gain income accrues within a foreign mutual fund and, presumably, raises the value of shares in the foreign mutual fund, which the shareholders realize upon selling the shares.
A distribution from a foreign mutual fund takes the complexity for U.S. income tax purposes to another level. Is the mutual fund a corporation for U.S. tax purposes and, if so, what are its earnings and profits? Or is the mutual fund a trust for U.S. tax purposes?
Congress was concerned that foreign mutual funds were converting U.S. shareholders’ ordinary income from their shares into capital gain, and deferring recognition of the income for tax purposes until sale of the shares. Congress’ answer was to enact the personal foreign investment company (“PFIC”) regime of Internal Revenue Code Sections 1291-1298. Under this regime, when a U.S. shareholder sells PFIC shares, the gain recognized on the sale is taxed at the highest tax rate in effect for ordinary income, currently, 39.6% for an individual. In addition, the tax is allocated to each day of the shareholder’s holding period; tax allocated to days after December 31, 1986, the effective date of the PFIC regime, is subject to additional tax representing an interest charge.
“Excess distributions” from a PFIC—distributions to a shareholder in a taxable year in excess of 125% of average distributions from the PFIC to the shareholder in the preceding three taxable years—are subject to PFIC taxation the same as gain on sale of PFIC shares.
A PFIC is any foreign corporation if—
- 75% or more of the gross income of the corporation for the taxable year is passive income, or
- The average percentage of assets held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50%.
“Passive income” generally means dividends, interest, royalties, rents, annuities, and the excess of gains over losses from sales of property producing such income.
There are two ways for a U.S. taxpayer to avoid the PFIC regime of Internal Revenue Code Sections 1291-1298 with respect to PFIC shares held by the taxpayer. First, the shareholder can make a “qualified electing fund” or “QEF” election with respect to the PFIC shares. Under a QEF election, the taxpayer reports his proportionate share of the PFIC’s interest, dividends, and capital gain for the taxable year, as the taxpayer would if the PFIC were a U.S. mutual fund. A QEF election is almost never practicable, as shareholders are almost never able to ascertain their proportionate share of interest, dividends, and capital gains with respect to a PFIC for a taxable year.
Second, the taxpayer can make a mark-to-market election with respect to the PFIC. Under a mark-to-market election, a taxpayer adjusts his basis in PFIC stock to the fair market value of the stock as of the end of the taxable year. The taxpayer recognizes an increase in the adjusted basis of the stock as ordinary income. The taxpayer recognizes a decrease in the adjusted basis of the stock as ordinary loss to the extent of “unreversed inclusions,” and in excess of unreversed inclusions as capital loss. Unreversed inclusions are mark-to-market increases previously recognized by the taxpayer, to the extent not ‘offset by mark-to-market writedowns.
A taxpayer must file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, with the taxpayer’s U.S. income tax return for each PFIC in which the taxpayer owned shares during the taxable year. There are no forms reporting for PFIC tax calculations—such reporting is done on sheets of paper attached to the top of the tax return.
PFIC reporting is elusive in the abstract. But for a taxpayer who has many PFIC trades during the taxable year(s), PFIC reporting is oppressively burdensome, and costly in terms of professional fees. U.S. taxpayers are well advised indeed to avoid foreign mutual funds and their attendant PFIC reporting regime.