“Invest in tax-free offshore funds!” Sounds great, right?
Each year, many U.S. investors fall for these familiar sales pitches. Other investors are simply looking to diversify risk by investing in offshore opportunities. Still others have immigrated to the U.S. and have retained some investments from their home country. In all of these cases, it is important to be aware of the Passive Foreign Investment (PFIC) rules and the tax considerations associated with these investment vehicles.
A PFIC is a foreign corporation that meets either an asset test (at least 50% of the foreign corporation’s assets are passive assets) or an income test (at least 75% of gross income is passive). In the investment world many foreign pooled investment funds, such as mutual funds and foreign hedge funds, are considered PFICs.
Paying the Piper
In general, a U.S. investor in a PFIC defers U.S. taxes until the investment is sold or until certain “excess distributions” are made. That’s the good news. The bad news is that once either of these events occurs, the shareholder must pay tax at ordinary income tax rates — plus a punitive, compounding interest charge for every year that income was deferred. This essentially negates the economic benefit of deferring the taxes in the first place.
Easing the Pain
For shareholders of privately held PFICs, the harsh consequences of the default regime may be avoided by making a qualified electing fund (QEF) election. If this election is made, the shareholder is taxed annually on his or her pro-rata share of the PFIC’s income for the year — similar to a U.S. mutual fund. Importantly, this option allows the various categories of income to retain their character, including preferential capital gain treatment. So why do so few investors make this election? It’s probably because it’s nearly impossible to do so in many cases. Oftentimes foreign funds simply do not provide shareholders with U.S. books and tax records, which is a requirement for making a QEF election.
A New Twist – The Net Investment Income (NII) Tax
Adding even more complexity to the equation, the new 3.8% NII tax rules, effective in 2013, are not the same as income tax rules with respect to PFICs taxed as QEFs. For income tax purposes, a QEF investor is taxed on all ordinary earnings whether distributed or not, while for NII tax purposes these earnings are not currently taxed. Conversely, the NII tax on PFIC income is imposed on the actual distribution or gain amount, while for income tax purposes this amount may not be taxable. This discontinuity can complicate recordkeeping for taxpayers.
The IRS does provide a way to simplify matters. In the case of those investors who have made a QEF election, the regulations allow a QEF investor to make an election to be subject to the NII tax at the same time the income is recognized for regular income tax purposes. Once the election is made, it will remain in effect for all future years. The election simplifies the associated recordkeeping but may not benefit all taxpayers depending on their individual circumstances.
Before investing in a PFIC, make sure you consider all relevant tax considerations with your advisors, including the ability, or inability, to make a QEF election and whether to make the special NII tax election.
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This communication is published by Cohen & Company for our clients and professional associates. Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this publication should be taken only after a detailed review of the specific facts and circumstances.