TL:DR
Passive Foreign Investment Companies (PFICs) are a serious headache, and something Americans really need to watch out for when considering how to invest while you’re living in the UK.
PFICs are “pooled investments” registered outside the US whose income is primarily “passive.” This includes mutual funds, ETFs, hedge funds, insurance products, etc. that are registered outside of the US.
In many cases, US expats in the UK may wish to avoid investing in PFICs altogether, because the tax rates will be much higher than for similar US-based investments, and because the reporting requirements are particularly onerous.
What is a PFIC?
A Passive Foreign Investment Company (PFIC) is a foreign corporation that meets one of the following two tests:
- 75% or more of its gross income is “passive,” which can include capital gains, dividends, royalties, rents, and annuities.
- 50% or more of its assets produce passive income
Unfortunately, many UK-registered investment products qualify as PFICs, including mutual funds, ETFs, hedge funds, etc. Tax-incentivised savings products such as ISAs can also be affected, meaning if you invest in a stocks & shares ISA, gains could be taxed at a much higher rate than in the UK. Even a UK-registered fund that invests solely in US-based companies would qualify as a PFIC, though a US-registered fund investing solely in UK-based companies would not.
Here are a few examples of funds that are considered PFICs
- Vanguard funds registered in Ireland
- Index funds on Hargreaves Lansdown
Why PFICs matter: they are taxed punitively
The IRS taxes PFICs at punitive rates to discourage you from moving your income outside the US federal tax net, meaning that in many cases similar products (mutual funds, ETFs, etc.) that are registered in the US rather than in the UK will be taxed at a lower rate and be much less onerous from a paperwork perspective.
Example: if Sally is invested in a US-based mutual fund that tracks the global economy, she will pay the IRS a low, long-term capital gains rate of 0-20% (depending on your income) if the fund is held for more than a year. If Sally decides to buy a nearly identical fund listed in the UK, that investment will be subject to the PFIC tax regime, which counts all income (including capital gains) as ordinary income and automatically taxes her gains at the top individual tax rate of 39.6%.
So...what exactly are the tax implications?
Tax rates for PFICs can be very complex (you can read more about the complexities from KPMG here), but a good rule of thumb is that they will generally be taxed at the highest possible rate for the type of distribution. Since PFICs do not qualify for capital gains rates, this generally means the highest possible marginal tax rate (currently 39.6%). Deferred gains receive an interest charge for the entire time period that the gains are held in the PFIC (meaning the total tax can often be over 50%!).
The above is the default method of taxation; you may be able to avoid the highest tax rates by electing to use one of two methods:
- The Qualifying Elective Fund (QEF) rules allow you to be taxed on the sale of a PFIC at Capital Gains rates rather than the punitive PFIC rates mentioned above. This only applies to PFICs that are willing and able to disclose an Annual Information Statement each year that meets the requirements of the IRS. Making a QEF election will require you to report and pay tax on your pro rata share of the PFIC’s ordinary earnings and net capital gains each year, regardless of whether those gains were distributed to you. In other words, you might have to pay taxes on money you have not yet received, though in some cases this still may be worth it.
- The Mark-to-Market accounting method allows you to have your PFIC gains taxed at your marginal tax rate. In most cases your marginal tax rate will still be higher than the capital gains rates you would expect on similar funds in the US, but this method is less punitive than standard PFIC taxes.
Again, it is worth working with a tax specialist and/or financial advisor to help determine what the best route will be given your specific situation.
Reporting Requirements
In addition to high tax rates, PFICs present complications (and compliance costs) as far as reporting is concerned. You are now required to submit a separate Form 8621 for every PFIC each year, and the IRS estimates that completing the form can take as long as 22 hours. So we’re talking thousands of dollars per investment per year to simply comply with the reporting requirements.
It is important to note that you will not need to submit Form 8621 if the total value of all of your PFIC stock on the last day of the tax year is less than $25,000. This doesn’t mean that this income won’t be taxable, or that it will be subject to preferential capital gains rates; merely that you (a) don’t have to spend huge amounts of time dealing with reporting requirements and (b) you won’t be risking the most punitive of the PFIC taxes.
Our recommendation: Proceed with Caution
For most Americans, investing in PFICs doesn’t make much sense. Doing so is likely to be less lucrative (and much more complicated!) than sticking to US-based funds. If you believe PFICs are a good option for you, we highly recommend seeking the advice of an international tax specialist to make sure you can avoid high fees and penalties.
Oh, and the fun doesn’t stop there: once you’ve been domiciled in the UK for long enough, you’ll also be subject to punitive UK tax rates on your non-UK-registered investment funds if they do not report to UK accounting standards.