For expats living and working in Singapore (or outside of the US), you may be considering investing in Singaporean mutual funds. However, it's crucial to understand the US tax implications of investing in foreign mutual funds before proceeding, as these can significantly alter the economic analysis of such investments.
Passive Foreign Investment Company issues
Foreign mutual funds are often classified as Passive Foreign Investment Companies or “PFICs” for US tax purposes. For the definition of a PFIC, please see here.
Congress enacted the PFIC rules to tackle tax deferral issues associated with US Persons investing in foreign corporations. Before these rules, US Persons had the potential to defer US tax on passive income earned through foreign corporations (assuming such corporations were not Controlled Foreign Corporations), or they could convert this income into capital gains (e.g., sell the stock of the foreign corporation instead of receiving a dividend), which would be taxed as capital gains. This offered a substantial tax advantage for US Persons investing in foreign corporations compared to those investing in US corporations, particularly since US corporations faced immediate US income tax on their worldwide income at the corporate income tax rate. Before the Tax Cuts and Jobs Act in 2017 (the “TCJA”) lowered the corporate income tax rate to 21%, the corporate income tax rate was at 35%. Although not directly aimed at foreign mutual funds, the PFIC rules significantly impact these investments.
In the absence of a specific tax election, which we'll delve into later, disposing of PFIC stock typically results in the proceeds being taxed as ordinary income. Currently, this means the gains could be subject to the top individual income tax rate of 37%. Contrasting this with the treatment of long-term capital gains, which is taxed at a more favorable tax rate, capped at 20%. Also, the 3.8% net investment income tax may apply but we’ll save that topic for another day.
Excess distribution regime
The gain from the sale of PFIC stock is often treated as an “excess distribution.” The excess distribution (i.e., the total gain) from the sale is spread out over the entire period you owned the stock. This means that a portion of the gain is allocated to each year that you owned the PFIC stock. The tax rate applied to each portion of the gain is based on the highest tax rate for that particular year (but the gain associated with the current year would not be subject to the highest tax rate). So, the rate might vary from year to year, for example, the highest individual income tax rate before the TCJA was 39.6%.
There is an additional interest charge on the excess distribution. This is because the IRS treats the gains as if you should have been paying tax on them each year you owned the stock, rather than all at once when you sell. So, they charge you interest for this "delay" in payment.
PFIC reporting and penalties
Owning PFIC stock can significantly complicate and increase the cost of filing your US tax returns. Each PFIC must be reported on Form 8621, and professional accounting services for this form typically range from $100 to $2,500. If there's an excess distribution involved – necessitating more intricate calculations for additional tax and interest – the costs can escalate. Moreover, failing to accurately and promptly file Form 8621 can lead to a US$10,000 penalty assuming you are also obligated to file Form 8938. It's important to remember the 'once a PFIC, always a PFIC' rule, which mandates that you continue to treat a foreign entity as a PFIC for tax purposes, even if it ceases to meet the PFIC criteria in subsequent years.
While indirect ownership of PFIC stock is outside the scope of this post, I would like to flag that the costs for compliance and analysis would increase if the foreign mutual fund itself held PFIC stock. Technically, in this situation, you would have to file an additional form 8621 for each PFIC that the foreign mutual fund holds.
For those holding smaller amounts in PFICs, there's a 'de minimis' exception that might simplify your reporting obligations. If the total value of your PFIC investments does not exceed US$25,000 (US$50,000 for married filing jointly), you might not have to report your PFIC investments at all. However, this exception comes with its own set of requirements and limitations, including potential restrictions on certain elections (discussed below) you might otherwise consider. To determine if you're eligible for this exception and to understand the consequences, I highly recommend that you speak with a tax advisor.
Elections
There are two main elections available to US Persons that can help mitigate the potentially harsh consequences discussed above: the Qualified Electing Fund election (the “QEF Election”) and the Mark-to-Market election (the “MTM Election”).
The QEF Election under section 1295 of the Internal Revenue Code
Opting for the QEF Election means you're required to report your proportion of the PFIC's income and gains on your annual tax return, irrespective of whether the PFIC actually distributes any cash to you. For instance, if you hold a 1% stake in a foreign mutual fund that earned $10,000 in a year, you're obliged to include $100 in your income for that year's tax return, even if you don't receive any actual income distribution from the mutual fund.
However, a critical aspect of the QEF Election is the need for the foreign mutual fund to provide you with an annual PFIC statement. This statement is essential as it contains detailed financial information about the PFIC's earnings and profits, enabling you to accurately report your share of its income and gains on your personal tax return. Typically, the QEF Election should be made in the first year of your ownership of the PFIC stock. For example, if you acquired a PFIC stock in 2023 and didn't opt for the QEF Election on your 2023 tax return, you would generally be unable to elect it in 2024.
The advantage of this election is that it exempts you from the excess distribution regime and allows any gain from the sale of the foreign mutual fund stock to be taxed at the preferential long-term capital gains rate assuming you held the stock for over a year. Additionally, in the rare scenario where the foreign mutual fund ceases to be a PFIC, you would no longer be bound to treat it as such because the “once a PFIC, always a PFIC” rule does not apply to PFICs with a proper QEF Election.
The MTM Election under section 1296 of the Internal Revenue Code
The MTM Election treats your PFIC stock as though it is sold at the end of each tax year. This means any gains are taxed as ordinary income, while losses can offset previous income inclusions. By making this election, you would not be subject to the excess distribution regime. It's particularly useful if you're unable to opt for a QEF Election – perhaps because the PFIC does not provide an annual PFIC statement, or you simply prefer not to choose the QEF route – but still want to avoid the complexities of the excess distribution rules. However, it's important to note that the MTM regime is applicable only to marketable PFIC stocks, which somewhat limits its applicability.
There are two main drawbacks of the MTM Election. First, for US individuals opting for this election, the benefit of lower capital gains tax rates, which are available under the QEF Election, would not apply. Instead, all gains are still taxed at the ordinary income tax rate. Second, the MTM Election's scope is restricted primarily to direct holdings in PFIC stock or stock held through a foreign pass-through entity. This limitation means that if a foreign mutual fund (assuming it is a PFIC) owns other foreign entities that are also PFICs, the MTM Election won't address the PFIC issues related to the other foreign entities. In fact, it could potentially lead to a scenario of double counting. Moreover, like the QEF Election, there's ambiguity regarding whether a US shareholder of a PFIC can make a protective MTM Election in cases where there is uncertainty about a foreign corporation's PFIC status.
To determine if you're eligible for the QEF Election or the MTM Election and to understand the consequences of such elections, I highly recommend that you speak with a tax advisor.
Conclusion
Before you invest in a foreign mutual fund, please factor in the US tax costs discussed above into your economic analysis. Hopefully, the return on investment is still attractive after accounting for the US tax leakage.
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