If you are a US citizen or permanent resident and have been living and working outside the US and investing your savings through a non-US financial institution, you need to learn what a Passive Foreign Investment Company (PFIC) is very quickly.

Why? Because the passage of the Foreign Account Tax Compliance Act (FATCA) in 2010 is ushering in a new era of dramatically heightened enforcement of US laws regarding taxation of and reporting on investments held outside the country by US Citizens or permanent residents. There has already been much discussion about the new IRS Form 4938, which is now a required filing for Americans abroad with a total of more than USD 300,000 of financial assets held outside the country (for Americans resident in the US, the threshold is only USD 50,000). This Form requires not only the listing of assets held outside the US, but also specifically requires a box to be checked if the assets are PFICs.

What exactly are PFICs and do I own any?

The moniker "Passive Foreign Investment Companies" (PFICs) sounds like some exotic and highly-specialized investment, so many Americans automatically assume that they do not own any. For many of them, this conclusion would be a mistake whose consequences are about to become very significant.

PFICs are simply "pooled investments" registered outside of the United States. This includes almost all foreign mutual funds, hedge funds and many insurance products. It might even encompass your bank account if that account is a money-market fund rather than just a straight deposit account, because money market accounts are essentially short-maturity fixed-income mutual funds. Furthermore, PFIC rules generally apply to investments held inside foreign pension funds, unless those pension plans are recognized by the US as "qualified" under the terms of a double-taxation treaty between the US and the host country.

The problem with PFICs

Although too complex to be fully elaborated on here, the tax treatment of PFICs is extremely punitive compared to that of similar ‘pooled investments' that are incorporated in the US. For example, an American holder of a US incorporated mutual fund invested in European stocks pays the low long-term capital gains rate of 15% if the fund is held for more than one year. The same American investor who buys a nearly identical fund listed in the UK or in Switzerland (or any place outside the US) will find their investment subject to the PFIC taxation regime, which counts all income (including capital gains) as ordinary income and automatically taxes it at the top individual tax rate (35%). In some cases, the total tax on a PFIC investment may rise to well above 50%.  Furthermore, capital losses cannot be carried forward or used to offset other capital gains.

The other major complicating factor of PFICs is the onerous task of simply complying with IRS reporting rules. Ownership is most common among expatriate Americans, many of whom employ accountants specializing in tax preparation for Americans abroad. But hiring an expatriate tax specialist does not guarantee that the proper PFIC-related filings are being made. Often, the client inadvertently fails to divulge (and the tax accountant fails to request) the necessary information on the client's mutual fund, hedge fund, or other financial holdings.

In other cases, if the client and the tax preparer have negotiated a fixed fee for tax preparation, the preparer may be reluctant to ask about possible PFICs because record keeping and preparation time for the complicated form 8621 (a required filing for each PFIC investment) requires an IRS-estimated 22 hours per year! Alternatively, Americans abroad could quickly run up a tax preparation bill of many thousands of dollars, no matter how much (or little) the underlying investments are worth or how well they have performed.