Thursday, June 16, 2016

Foreign Mutual Funds: The Horror Story

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Investopedia defines Mutual Funds as "An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets." 

The logic behind Mutual Funds being instead of a conservative investor putting his money directly in the Stock Market and losing money due to incorrect speculation, he invest in a Mutual Fund which is handled by efficient fund managers. Risks are lowered due to the diversification of the portfolio according to an individual's risk tolerance. 

That's what mutual funds are for those who didn't know, let's cut to the chase however and discuss the "Horror Story" for the day! This story actually hit quite close to home for us this year. We have clients who are US Citizens and have moved abroad and have started investing locally in the country of residence. Many of them invested in local mutual funds which in many parts of the world are doing extremely well. And that's when the horror starts like when Pastor Merrin finds the amulet in "The Exorcist"! 

Generally, mutual funds are treated similar to a partnership with respect to income & gains in the fund. The income is passed on to the shareholders in proportion to their holdings and reported to the IRS by the mutual fund. The IRS pairs up the information on the investor's return with that filed by the fund. Unlike domestic mutual funds, the IRS is not able to keep an eye on foreign investment companies or mutual funds and the foreign mutual funds do not want to have anything to do with the IRS either. Hence the burden of reporting the income & balances in these offshore investment companies falls on the investor. 

Any type of a corporate mutual fund based outside the United States of America is referred to as a Passive Foreign Investment Company or a PFIC.   

The PFIC Taint: 
The rules regarding taxation of income and gains from PFICs are onerous to say the least! The logic clearly is to deter US persons from using PFICs as an investment fund. If a mutual fund is a PFIC, US citizens or persons who are shareholders are subject to the most severe tax treatment of all on any distributions from the PFIC:

  • Unless the PFIC elects to be subject to SEC and IRS reporting requirements
  • Or the US shareholder makes one of several elections to pay tax on the undistributed income of the PFIC
  • Or the PFIC is listed on a national securities exchange and the shareholder elects to pay tax on any increase in the market value of shares from one year to the next. 

The most effective of the elections all agree is QEF election (QEF~ Qualified Electing Fund). Making this election preserves the capital gains treatment, the qualified dividend treatment and the loss deductions for the foreign mutual funds. The other more favorable election is the Mark-to-Market Election. These elections are made on form 8621. 

Unless one of these elections are made, the investor ends up paying the default Section 1291 tax on the accumulated income distributions even if there weren't any and pay capital gains taxes every year he has gains on income which he may have never physically received. 

The above should now bring us to the conclusion that in almost all cases, having offshore mutual funds is not the best investment tool for a US person. If you are planning a move outside the US for a long period of time, keep in mind that pre-migration planning is an important step that you need to take. 

There may be a chance an exception applies to the above filing but do talk to your tax professional or an Enrolled Agent who specializes in cross-border taxation if the above applies to you and to learn more about the exception to file the Form 8621. 

Bibliography: Form 8621; Private Letter Ruling 200752029; Internal Revenue Bulletin 2014-3


As always, read my disclaimer here. Please consult a qualified tax professional for your unique tax needs. More of my contact information is on my website,