Investing in US compliant securities and funds is almost always going to be the better option over exotic alternatives, not to mention the lower costs. US expats will want to carefully weigh up their options to see if they are making the right choice.
What are PFICs and should I invest in them?
Broadly and simply speaking, a Passive Foreign Investment Company (PFIC) is a mutual fund registered outside of the US (1). It can contain mutual or hedge funds, foreign ETFs as well as insurance products.
PFICs are disadvantageous to American investors as they can be taxed anywhere between 37% or over 50% dependent on when the investment was declared. In addition, once an investment is classified as a PFIC, it becomes extremely difficult to bring it into a lower tax bracket.
As such, it is best for US-based investors to avoid investing in PFICs.
Is it worth investing in PFICs and using various techniques to pay less tax?
One way to reduce the heavy tax that comes with investing in PFICs is to file under a Qualified Electing Fund (QEF) tax regime. A QEF election will generally bring the PFIC investment into the same tax bracket as American investments. The exception to this being the dividends, which continue to be taxed at a higher rate.
If using this method, it is advised to take a QEF election the same year the related investment was made, otherwise it becomes more difficult to take the election.
While it may seem like a good option, the reality is that opting for a QEF regime also brings complex tax filings. Form 8621 is mandatory for every asset. This form is considered to be extremely complex, with seasoned tax accountants requiring at least 24 hours of work to complete properly. Consider the additional accounting costs when considering PFICs and QEFs.
Another strategy is called Mark-to-Market. This is an even more difficult strategy, as the asset has to be valued in line with current market conditions using complex calculations. It is a lengthy process that can quickly become expensive. In certain jurisdictions, it is also the only option as the QEF election is not available.
What about a portfolio without PFICs?
Avoiding PFICs altogether is a common approach used by financial planners for American expats. This is also the approach adopted at Dunhill Financial. By avoiding PFICs completely, investors are able to realize gains without having to fall under any such onerous tax regimes. This also aids in simplifying tax filings and removes the need to file complex forms such as 8621.
This does not mean that investors are no longer able to invest in European funds. Instead, one can invest in American funds that invest in European funds - thereby holding the same investments but avoiding the PFIC rules.
Is a QEF Election or Mark-to-Market approach worth it?
It is important to note that, in the table above, not all of the costs are factored in. Filing the necessary forms for a QEF election is very costly and has to be done every year for every asset. Prices for filling this form can vary greatly with more affordable specialists charging $150 USD per form/asset. As such, a QEF can also exacerbate losses by adding extra administrative fees. In addition, a delay in opting for a QEF regime can quickly become costly.
The same goes for Mark-to-Market, the expenses incurred by this can quickly go up. The process for it can quickly become extremely complex, with even the IRS occasionally struggling to properly value an asset. Not having any PFICs in a portfolio therefore provides a more accurate figure for returns after tax, requires less paperwork and provides more security in case of error.
(1) A mutual fund can also be a company. It is important to note that once an investment is classified as a PFIC, it will nearly always be considered a PFIC.