Haig Bathgate, Chief Investment Officer at Turcan Connell explains how PFICs affect US citizens based abroad and non-US citizens resident in the US.
The US has criticised the UK for making it extremely difficult for US citizens to invest in UK funds. The US, however has similar rules in places called Passive Foreign Invest Companies (PFIC) Laws
Many non-US based collective investment funds fall within the US Passive Foreign Investment Companies (PFIC) rules. The tax treatment of PFICs can make such funds significantly less attractive to US taxpayers compared to other types of investment. This means that the PFIC rules require careful consideration, particularly when constructing portfolios for US citizens based abroad or non-US citizens resident in the US since these groups may wish to have exposure to non-US investments.
A non-US corporation will be treated as a PFIC where 75% or more of the corporation’s income is passive or where more than 50% of the corporation’s assets are composed of investments earning interest, dividends or capital gains.
If the PFIC rules do apply then ordinary income tax applies to any current distributions from the PFIC. Since the distributions may be comprised of capital gains as well as income, part of such distributions will often be at a higher rate of tax than equivalent distributions from a US mutual fund.
In addition, distributions deemed to be from earnings of the PFIC in prior years are taxed at the highest rate for ordinary income in each prior year and are also subject to interest charges on the deferred tax on the allocated gains and excess distributions. Where a PFIC has significant accumulated income, the effective rate of tax with the interest charges can be very significant.
It can be possible to make a qualifying elective fund (QEF) election, in which case, the full effect of the PFIC rules will not apply. Instead the investor will pay tax on his share of the income and gains in the fund on an annual basis. However, in order for a QEF to apply the co-operation of the fund is required in providing the requisite information. Many non-US funds do not wish to be subject to these requirements. It is also common for non-US funds not to accept US investors at all.
How to deal with these restraints when constructing a portfolio? There are a few of options available:
- Purchase US based mutual funds – this is an obvious option although the universe is, as you would expect, very much focused on US investors. For example, it is very difficult to find many US mutual funds which focus on the UK. The investment management houses in the US are often reluctant to deal with non-US counterparties which makes this option more tricky even if you could live with the restricted fund universe.
- Use Exchange Traded Funds (ETFs) – there is a very broad range of US based ETFs which can be traded through brokers very easily. This provides the most flexible route to gain non-US exposure although clearly the vast majority of ETFs are passive investments that simply track the performance of the underlying index.
- Invest in directly held equities or bonds – the PFIC rules do not apply to directly held equities or bonds. However, direct investment is likely to mean that the diversification and specialist knowledge advantages of a collective investment fund will be lost. It would be highly unlikely that any individual manager would have a firm grasp of global equity, bonds and other direct investments.
There are a number of areas that require consideration when investing on behalf of US taxpayers, particular US citizens resident abroad or non-US citizens resident in the US. The combination of legal, tax and investment issues mean that it is worth taking advice before purchasing investments if an investor falls into either of those categories.
