As a U.S. citizen, no matter what country you live, you have tax duties. IRS requires all U.S. citizens, including expats, to submit standard income taxes. Expats must also file an informational return on their assets for their foreign bank accounts through FinCEN Form 114 or the FBAR (Foreign Bank Account Report).
Wages and self-employment income are examples of everyday income items. These types of incomes are also considered active income. But, dividends, capital gains, and interests are examples of passive income. Yet, having foreign investments in PFICs or Passive Foreign Investment Companies means another story. Read further to learn more.
How PFICs Differ
PFIC is an investment classification in a foreign mutual fund. There is a much more complex system that taxes PFICs. This system imposes much stricter rules than the country’s exchange-traded funds and the U.S. mutual funds.
How to Determine If You Have a PFIC
If your foreign corporation meets either the asset test or the income test, you will be considered as a PFIC, according to the U.S. tax law. If the PFIC generates 75% or more of its gross income from investments through passive sources, the income test is met. Among these passive sources are rent, dividends, capital gains, and interests. If the company’s 50% or more of its total assets are generated through passive income, IRS will consider it qualified for the asset test. Thus, passive income would not create a business income.
To prevent U.S. taxpayers from putting off tax on passive income, the IRS implemented regulations on PFICs. Such an approach is ideal for entities that are organized into low-tax jurisdictions. This tax law aims to discourage shareholders from investing in foreign mutual funds. The removal of the benefits was to gain more appeal towards U.S.-based funds.
How are Expats Affected by PFICs?
An expat should use Form 8621 for income reporting. Take note that Form 8621 is a very long form, and it is complicated to do. The PFIC, along with its shareholders, must maintain accurate records of all the transactions. Among these transactions are dividends received, cost basis, and undistributed income. These are what the PFIC earns. The Internal Revenue Code subjects PFICs under strict and extremely complicated guidelines for tax duties. These are all elaborated under Sections 1291 up to 1297.
If there are excess distributions received from PFICs, these are accounted pro-rata to each day in the investor’s holding period. This is one of the guidelines under Section 1291 of the Internal Revenue Code. The excess distributions are also subject to interest charges on taxes supposedly owned in the past years. If you are a U.S. expat and you own PFICs, you need to file more tax requirements. extraconal filing requirements should report the ownership of those foreign accounts.