If you are a citizen or permanent resident who has been living and working outside the US and investing your savings through a non-US financial institution, you need to learn quickly what a Passive Foreign Investment Company (PFIC) is. Why? Because the Obama administration and its allies in Congress are pushing through legislative and administrative changes designed to increase tax compliance among American citizens living abroad.

For the typical American expatriate who is properly reporting and paying taxes on their global income, the impact of the legislation will be minimal, with one potentially consequential exception: taxation of investments in non-US mutual funds, hedge funds and any other type of ’pooled investment’.

Non-US incorporate pooled investments typically meet the definition of what the tax code defines as Foreign Passive Investment Companies. The tax treatment of PFICs—too complex to elaborate on here—is extremely punitive compared to the tax treatment 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 percent if held for more than one year.

The same American investor who buys a nearly identical fund listed in the UK or in Switzerland (or anywhere outside America) 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 percent). In some cases, the total tax on a PFIC investment may rise to well above 50 percent. Furthermore, capital losses cannot be carried forward or used to offset other capital gains.  

Unaware of risks

The most interesting and important aspect of this issue is that very few of the estimated hundreds of thousands of Americans who own PFICs in their investment portfolio are aware of it. Ownership is most common among expatriate Americans, many of whom employ accountants who specialise in tax preparation for Americans abroad. But hiring an expatriate tax specialist is no guarantee that the proper PFIC related filings are being made and the taxes paid.

Often, the client inadvertently fails to divulge and the tax accountant fails to request the necessary information on the client’s mutual fund or hedge fund 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 simply preparing the complicated IRS form 8621 (required for PFIC disclosure) is estimated to take at least nine hours. The IRS estimates the necessary record keeping will consume an additional 13 hours. Finally, because the PFIC rules have been so rarely enforced over the years, many expatriate tax specialists are simply unfamiliar with them.

Indeed, until now, individuals who failed to declare and pay the onerous tax on PFIC investments have had little to fear. The IRS faced many obstacles to enforcing the rules and lacked the resources to pursue filers on this issue. But this situation is changing fast. The Obama administration’s plans to crack down on Americans shielding income abroad will dramatically increase the reporting requirements by non-US financial institutions that service accounts owned by US citizens.

The plan includes the hiring of 800 new IRS tax inspectors just for international tax enforcement. Already steep penalties for failure to report foreign investment accounts are slated to be doubled. These measures are primarily designed to draw out wealthy individuals who are knowingly evading US taxation, but the effect will also be to dramatically increase the IRS’s ability to obtain the information necessary to enforce the PFIC rules on the thousands of American investors who are unwittingly not in compliance with them.