This article will look at PFICs for UK residents. For questions and advice – firstname.lastname@example.org.
For those that prefer video content, the below video introduces PFICs:
‘Passive Foreign Investment Company’ also known by the name ‘PFIC’. A Company is said to be a PFIC if it follows two conditions. They are:
- Depending on the income of the company, a minimum of 75% of the gross income of the company should be a passive type of income. It should not be generated from the company’s active and regular business methods.
- Depending on the company’s assets, a minimum of 50% of the company’s assets should be investments that generate income in the form of Capital Gains, Dividends or Earned Interest.
By satisfying any of the above-mentioned two conditions, a company can be declared as a PFIC. PFICs were first recognized in the tax reforms passed in 1986.
These were designed in such a way that they create a tax loophole by which some of the U.S. investors/taxpayers were able to avoid taxation of offshore investments.
Afterward, the tax reforms removed this tax loophole by bringing them under the U.S. taxation and introduced higher tax rates for such practices in order to make investors/taxpayers less likely to invest in such types of investments.
‘IRS and the PFICs’ – IRS (Internal revenue Service) has subjected the PFICs to an extreme set of complicated tax guidelines. These can be referred by a person under sections 1291 through 1297 in the U.S. income tax code.
It is mandatory for the PFICs as well as the shareholders to keep an exact record and details of the transactions such as share costs, details of the dividends earned, undistributed income that a PFIC might be able to earn, etc.
While dealing with the PFICs, the guidelines related to the cost basis present an example of the strict taxes that are applicable to the shares in a PFIC.
A person inheriting the shares from a PFIC is allowed by the IRS to set up a cost basis according to the fair market value at the time of inheritance. This is applicable to any other marketable security and assets virtually.
Although the cost basis can be set up, the boost in the cost basis is not usually allowed in case of shares in a PFIC. It is also considered a very confusing process to declare the acceptable cost basis for shares in a PFIC.
‘Taxation for the PFICs’ – People from the United States who own shares in a PFIC should file an ‘IRS Form 8621’. This is the form that generally reports the actual distributions and profits along with the income earned and the increases in the ‘QEF Elections’.
Form 8621 is very complicated that a person can take up to 40 hours to fill this form. Hence, it is advised to let a tax-related professional fill this form in order to avoid any mistakes or hassles.
There is an exception for the U.S. shareholders (approximately 10% or more) in terms of tax and interests, who have bought the shares of a PFIC before the year 1997. Investors of this kind won’t be charged with any kind of taxes or interests. However, they might be subjected to the ‘CFC (Controlled Foreign Corporation)’ rules.
There is an availability of some options for the investors in PFIC for reducing the tax rate of their respective shares. One of the famously available options is that the individual has to seek a PFIC investment which has been recognized as a ‘QEF (Qualified Electing Fund)’.
This type of process might reduce some taxes but may cause problems related to other taxes for the investors. It is better to take the help of a financial advisor and do some actual research in order to avoid such tax-related problems for the investors.
‘Examples for PFICs’ – Foreign-based mutual funds, Insurance products, Minimized tax savings products (such as ISAs), and startup companies that satisfy the conditions (that should be fulfilled in order to make it a PFIC) are considered to be the best examples for a PFIC. In the case of foreign mutual funds, they might only be considered as a PFIC only if 75% of their respective income is produced from passive sources (such as dividends and capital gains).
In the year 2018, the IRS and the United States Treasury Department have proposed some changes to the existing tax guidelines of the PFICs. If they will be approved, then a new regulation might be formed and will reduce some already existing rules of the ‘FACTA (Foreign Account Tax Compliance Act)’ and therefore, will be considered as an actual investment entity.
We might now be able to come to a conclusion by now that the US policymakers (like the IRS) have been making a continuous effort in order to bring back the US-owned assets back onshore so that they can be able to keep an eye out and track them properly. They have been doing this by creating initiatives such as the FACTA.
PFICs for US Expats in the UK:
Most of the US expats who have moved to other countries, primarily the UK, make the most common mistake of investing in the PFICs without contacting any Specialist Investment Advisor or a Financial Advisor.
Some non-specialist IFAs (Independent Financial Advisors) and Wealth Managers also recommend the expats in doing so without having an idea about the further consequences that the investor might have to face.
The PFIC tax is mentioned to be very difficult. There is no reduction in holding the investments for a longer time and the capital gains are taxed at the investor’s high current income tax rate.
It was described by the IRS that all the profits and gains were countered by the burden of the interest due to the delayed tax. This leads to an increase in the taxes so high that they will counter the entire gains without leaving any profit for the investor.
If we consider carefully, we know that there exist some rules in the United States for the PFICs which make sure that the investor won’t be able to avoid or reduce or defer the tax that is payable by the investor to the government.
Similarly, the United Kingdom has a set of reporting fund status rules which make sure that the investor won’t be able to avoid or reduce or defer the tax that is needed to be paid by the investor to the government. Let us take a closer look at each set of rules individually.
Rules set by the United States for PFICs:
As we have discussed earlier, PFIC is a company that satisfies either of two conditions that are required to be fulfilled. They are:
- For the income, greater than or equal to 75% of the gross income of a company should be generated from passive sources (capital gains, dividends, etc.) for each taxable year.
- For the assets, greater than or equal to 50% of the assets held by the company/corporation should be able to generate passive income or successfully generating passive income each taxable year.
In most cases, shares that have been bought from companies for normal investment purposes will be able to satisfy the second condition mentioned that should be satisfied in order to make it a PFIC.
They are some investment companies that generally do not undertake any sort of activities to earn income (such as manufacturing of products), hence making 75% of their gross annual income being generated from passive sources and satisfy the first condition.
Any sort of non-US funds such as offshore mutual funds, UK investment trust, offshore hedge funds, etc. are considered as a PFIC. This leads to a lot of disadvantages to US taxpayers in terms of taxes. If a person owns shares in a PFIC, they are subjected to three different types of tax treatments, which are:
- If the necessary reporting information (Annual Information Statement) is provided to the investor by the fund, then the person can file a Qualifying Electing Fund (QEF) election for each PFIC owned by the individual. This should also be done for the PFICs owned by the PFICs that the individual owns.
This is similar to producing a Form 1099 to the IRS. The QEF election allows the individual’s investment to treated just like the US fund. Anyhow, most of the non-US funds and offshore funds do not produce the required information in order to create an Annual Investment Statement and hence considered as a scarcely available option to the US taxpayers.
- The investor might be able to make an MTM (Mark to Market) election every year and show that they have sold and repurchased the fund at the end of every year as the year changes.
‘MTM’ – MTM is a process of Valuing the position and determining the profits and losses used for statement reporting purposes. It is a fair value for the accounts that are subjected to change over time (such as assets and liabilities). Mark to Market provides a practical evaluation of the company’s financial status.
Most of the Futures, Mutual Funds and Securities are marked to market to declare the present market value of these investments during the investment processes.
- If an investor does not make a QEF election or an MTM election and proceeds to pay tax on the hidden capital gains and income earned each respective year, then the person will eventually add the capital gains and income inside the fund. The capital gains and income in the PFIC would be taxed in a manner that the investor has sold the fund each year, received the gains from his fund, and has reinvested the whole amount again without paying any taxes.
This can cause a major problem to the investor, as he/she hasn’t paid any tax according to the reports and will be charged with interest. Such type of interest is compounded for each year the PFIC was held with the investor. This causes tax liability and can exceed the 100% value of the investment amount.
Even if a person doesn’t come under tax treatment, they must and should report the respective ownership of a PFIC on the form 8621. This should be done in case of the other PFICs owned by the respective PFIC that the investor owns.
By considering the above-mentioned factors, we can come to an understanding that being a US expat, it is wise not to invest in any type of PFICs. These are not the only set factors that tell us not to invest in the PFICs, there are even more.
As we have discussed both the United States and the United Kingdom have a different set of their own rules when it comes to the PFICs. Now let us know more about the rules that have been set by the UK (which have been made in order to make people less interested or completely prevent investing PFICs by being a UK taxpayer).
Rules set by the United Kingdom for PFICs:
Any offshore fund or a non-UK fund might be able to apply to receive the Reporting Fund Status from the UK tax authorities. They can apply to ‘Her Majesty’s Revenue and Customs (HMRC)’ in order to apply for this. For this, the fund must be able to provide the information regarding the fund’s income to both the investor as well as the HMRC.
This can be similar to the Form 1099 that is received by the US Investment Manager. This Reporting Fund will create a report on the income of the respective PFIC even if the income has not been distributed. Gains that have been received from a PFIC are taxed as they rise. These are taxed as per the capital gains tax rate.
But most of the non-UK funds are non-reporting funds and only creates a tax liability for the UK taxpayer only when the gains have been distributed.
In the case of remittance-based taxpayers, the tax liability is created only when the distributed amount is actually remitted into the United Kingdom. These gains are usually taxed at a higher income tax rate per income.
The offshore funds’ administration in the United Kingdom is applicable only to the ‘Collective Investment Scheme’. This scheme includes the plain vanilla United States ETFs (Exchange Traded Funds), Mutual Funds, and most other Investment Vehicles (does not include the partnerships) regardless of them taking place inside the United Kingdom or not. This is also applicable to the UK collective funds which do have the ‘Distributor Status’.
With the PFICs in the UK, taxation can be typically very exhausting. Any sort of capital gain will be taxed at a high tax rate of the United Kingdom’s income tax rate.
This can be considered to be as high as 45%, unlike the normal 20% tax rate that is applicable to the capital gains for the investments inside the United Kingdom. Another important factor that needs to be considered is that the dividends and the interest payments will also be treated as income.
It is better to check if any offshore fund or non-UK fund has the distributor status before making an investment. If a person is confused to choose between two similar offshore funds (one having a distributor status and the other not having the distributor status), it is better to choose a fund that has a distributor status. It is considered as more efficient related to taxes.
Most of the US people who move to the UK, might not be aware of the consequences that have to faced by them while making an investment in the PFICs. They often make investments unaware of the situation and face problems later.
Most US investment platforms might not be able to differentiate capital and income. It is advised to choose a platform that is able to separate capital and income and give clarity to investors about the risk factors that cause problems while transferring the money successfully into their accounts in the United States.
Hence, it is therefore advised not to invest in PFICs or any other non-UK funds which do not have a Reporting Fund status. By considering the above-mentioned factors, we can come to the conclusion that the benefits that have been gained the investor may overweigh in disadvantages later on.
The best option available to the investors is to choose from the funds which have a Reporting Fund status in order to avoid the problems caused by the taxes on capital gains, dividends, interests and any other sorts of income.
There are two considerable and best alternative options available to US residents living in the UK. They are:
- The investors can be able to buy individual stocks and bonds of a company directly from the stock exchanges. For example, an investor can be able to buy a number of shares of a respective American company listed on a US stock exchange directly or they can be able to buy a number of UK shares that are listed on a UK stock exchange directly.
In both of the cases described above, none of the operating businesses are considered as a fund or an investment company. They can be able to happily invest in such type of investments without having the type of problems (which exist while making an investment in a PFIC).
The investor is not required to give attention to details such as whether or not they have a distributor status or a reporting fund status. But the process of creating a diversified portfolio by investing in individual stocks or bonds one at a time requires a lot of attention, a lot of time and may be more expensive in most cases.
- The investor can contact his financial advisor or an Investment manager and discuss with them about the process of investing in PFICs. Then, they can be able to do some research on the PFICs that are available with a UK reporting fund status.
In most cases, the investor may not able to find such PFICs that may create interest in them based on their requirements but there a few chances that the investor might be able to find such type of opportunities.
While making an investment in the PFICs, the investor must be concentrated and should focus on all the above-mentioned factors such as taxation details, form that have to be submitted, choosing the right type of PFICs in order to avoid the huge losses that can occur while dealing with the PFICs.
Hence, making an investment in the PFICs might not be considered as the best process for the investors to gain profits from their investments.
Although most people either get lured into it by the taxation benefits (which later prove to be disadvantageous) or get into it unaware of the consequences that have to be faced by them in the future, it is highly advised not to take a quick decision while making an investment in the PFICs and some effective background research is suggested in order to prevent the damages and problems that might have to be faced by the investors.
An individual might not be able to do all the above-mentioned processes, hence it is highly advised to contact a financial advisor or an Investment manager (like us) in order to gain benefits from their investments which either maybe in PFICs or any other type of asset classes.
It is not easy for a single person to manage the investments on their own and are highly likely to get losses than profits in most cases.
Therefore, contact an advisor, discuss with them your requirements and make them clear about the investment strategy that you have planned and make changes to that strategy if you and your advisor think that the changes might be necessary.
Also make sure that you do some background research about the details of the company, taxation (involved in the country of residence as well as the country in which the investments have been made), and regularly monitor the activity that is going on with the invested assets. Never take decisions in a hurry due to emotions, otherwise, you would have to regret the decision made in haste by you.
We wish that you might have great success in your investment career and be able to gain a lot of benefits from the investments made by you. Hoping that this article helps you and you might be able to reap greater benefits with the help of this valuable information.