US tax authorities impose an especially aggressive tax treatment on those who hold mutual funds outside of the country. Often, this makes the investment less-than worthwhile. This form of taxation pertains to non-US registered mutual funds known as PFICS.
What is PFIC?
PFIC is an acronym that represents the term “Passive Foreign Investment Company.” PFICs are pooled investments located outside of the US that meet one of the following two criteria:
1. The income test: Over 75% of the company’s annual income is passively earned.
2. The asset test: Over 50% of the company’s assets are passively generated or can generate passive income, such as capital gains, dividends, interest, or rent, where cash is also considered a passive asset, as it does generate interest.
What is a mutual fund?
A mutual fund is a financial instrument that pools together money from investors for the purpose of investing (together) in tradable assets. Namely, a group of people pour money into a given account that is managed by a single investment or fund manager. They are essentially making a joint investment into a sort of large investment portfolio that is managed as one deal. Since nearly all the income generated by the mutual fund is passive income, it falls under the PFIC category. As do ETFs and certain provident funds, like Provident Funds (“Kupat Gemel”) for Investment.
Why should US citizens avoid investing in mutual funds outside of the US?
The US tax system is considered particularly thorough. Some might even call it aggressive. It applies to anyone who holds US citizenship or a Green Card, even if they do not currently live in the US, and requires that these people file annual tax returns , even if their income was earned outside of the US. But the tax system’s impressive reach does not stop at the taxation of income from salaries and businesses. It extends to income from mutual funds and passive financial instruments earned abroad as well.
PFIC taxation makes investments “not worthwhile”
Most of the income from mutual funds is generated passively and obtained from dividends, capital gains, or interest. However, unlike Israeli funds that accumulate profits and only require tax payments when said profits are redeemed, US funds must share their profits at the end of each year. The United States does not allow mutual funds to accumulate dividends and capital gains from year to year, and requires fund managers to distribute the profits among its investors, and thus be required to pay tax each year; not only upon redeeming the funds. At first glance, it seems as though funds outside of the US could be the magic solution for Americans interested in avoiding having to pay tax on income and dividends earned from the year in which they were generated. However, the Passive Foreign Investment company law (PFIC) was passed to limit US citizens’ investments in foreign funds.
Why is it not worthwhile for US citizens to invest in these funds?
Because the profits are calculated according to the year in which the investment was actualized and the fund was redeemed, and these profits are then divided according to all of the years during which the investor held the fund. The profit attributed to each year is then taxed at the highest tax bracket for that year. In addition, Interest on the late tax due is calculated according to the interest rate for each individual year.
The goal of this law is to eliminate the advantage that foreign funds present to US citizens and create equal tax payment conditions for US and foreign funds. This, so that Americans do not run to invest outside of their home country. The high level of taxation makes this sort of investment “not worthwhile” and achieves exactly the goal it set out to accomplish: it ensures that the law discourages Americans from taking their money to foreign countries and funds and engaging in tax planning that distances US taxation.
It is critical that you are aware of the above information when investing in funds, avoid investing in PFICs, and pay attention to the classification of various financial instruments. For example, pension funds are defined as Employer Funds and therefore do not fall under the PFIC category and are not subject to the aforesaid tax law described above. However, there are other forms of pension funds that can meet the law’s criteria, such as Provident Funds(“Kupat Gemel”) for Investments.
What can you do with your money?
Invest it in the US, or invest it in other assets abroad, such as real estate, Personally Managed Stock Portfolios, or bonds.
It is important to note that there are ways to avoid the aggressive taxation imposed upon PFICs, but this requires advance planning and certain actions vis-à-vis the IRS during your first year of holding the asset.
It is recommended to utilize the skills and expertise of a tax professional that specializes in US taxation laws, to avoid entering situations that can lead to high tax payments made to Uncle Sam.