It ranks at the very top of potential tax nightmares, especially if you invest internationally.
This nightmare could become a reality if you happen to invest in what the IRS deems a Passive Foreign Investment Company (PFIC), which are taxed at exorbitant rates and have highly complex reporting rules. Most foreign mutual funds are PFICs, as are certain foreign stocks.
It’s not illegal to invest in a PFIC, but practically speaking, the costs of doing it are so incredibly onerous that it’s prohibitively expensive in the vast majority of cases.
PFIC rules amount to unofficial restrictions on investing in certain foreign assets and are yet another indicator of the disturbing trend of creeping capital controls in the US.
Capital controls are used by many countries and come in all sorts of shapes, sizes, and labels. The purpose, however, is always the same: to restrict and control the free flow of money into and out of a country so that the politicians have more wealth at their disposal to plunder.
What Is a PFIC Investment?
As always, it’s important to first define our terms.
As far as the IRS is concerned, passive income includes income from interest, dividends, annuities, and certain rents and royalties.
If a foreign corporation or investment vehicle meets either of the two conditions below, it will be deemed to be a PFIC.
1) If passive income accounts for 75% or more of gross income, or
2) 50% or more of its assets are assets that produce passive income.
If you own a foreign mutual fund—even a cash management fund—it probably qualifies as a PFIC. But it’s not just foreign mutual funds; it can be any foreign stock that meets either of the above conditions as well.
Bottom line: even the simplest international investments can create significant tax problems.
(Clarification: an offshore LLC that makes an election to be classified as a disregarded entity or a partnership is not a PFIC.)
What Are the PFIC Rules?
