What is a PFIC or QEF, and How Are They Taxed?
Investing abroad? Does your portfolio have index, mutual, or exchange-traded funds (ETF), unit trusts, real estate investment trusts (REIT), or anything similar?
Chances are that if you have non-US investment accounts, and hold securities other than direct stock in publicly-traded companies, you could easily hold a PFIC or QEF.
What the heck is a PFIC? PFIC is the abbreviation for ‘Passive Foreign Investment Company’ and it is a classification that may result in onerous and punitive taxation rules in the US, as reported on Form 8621. Many brokerage firms are not aware that they are using PFICs in your portfolio. In fact, even experienced US tax practitioners have struggled to identify the reporting obligations. This is because it is an issue endemic to US persons with non-US investments, and it is a highly specialized topic even within US international taxation.
The PFIC’s purpose is to generate passive income, i.e., income such as interest, dividends, capital gains, rents, royalties, and the like - which makes sense because it arises in the context of investments. At a high level, the PFIC is created when brokerage houses and investment firms create a separate entity such as a fund, trust, or company to hold their investment cocktails. When the separate entity is created outside the US, it provides the foreign flavor in the passive foreign investment company. The fact that it is called a passive foreign investment company is misleading, because it need not be an actual corporation or business entity. There are more specific diagnostic tests for the PFIC’s income and assets, which are the subject for a separate article.
Now, unless you make an election in the first year you own a PFIC, your US tax reporting will likely be complicated, and that complication is increased for every year the PFIC goes undetected and unreported. If you have to report PFIC under default treatment (per Internal Rev Code Sect 1291), you will be taxed up to 37 percent on a per-transaction basis. That’s right - every transaction. And if you sell the PFICs, it triggers immediate taxation and you still have to report all the transactions prior to sale.
Fortunately, many PFICs report their annual activity to your investment firm, which allows you to report them as a QEF, or ‘qualified electing fund’. Basically, the company that creates the investment fund or trust takes on a portion of the IRS reporting burden, and all you have to report is your allocable portion of regular investment income, capital gains, and property distributions (after some light math). No automatic 37 percent rate (unless that’s your normal tax rate), and no reporting per transaction. To determine if a particular investment qualifies for QEF treatment, you can ask your investment advisor at tax time about your annual QEF or PFIC statement.
