What are the tax consequences of offshore mutual funds for US expats and taxpayers? US expatriates have faced a substantial number of challenges over the past several years as a result of FATCA. It can be hard to simply open a bank account. Almost all Foreign Financial Institutions (FFIs) require substantiated documentation of the "beneficial ownership interest" in any offshore bank and investment accounts. The FFIs use this information to provide electronic submissions directly to the IRS regarding the activities and accounts of US taxpayers worldwide.

This allows the IRS to track specific accounts, transactions and balances to the unique social security number or taxpayer ID of any US taxpayer, including expats. Perhaps one of the greatest surprises to US expats is the issues associated with a reasonably common investment on the surface: the purchase of mutual funds outside of the United States. This leads to a question: should US taxpayers own foreign mutual funds, and what are the US tax consequences for offshore mutual funds for US expats and taxpayers?

The problem with foreign mutual funds (those outside of the United States) is that the IRS may characterize them as Passive Foreign Investment Companies (PFICs). Two primary tests determine whether or not an offshore mutual fund is a PFIC: the asset test and the income test.

The mutual fund will be classified as a PFIC if 50% or more of the assets within the fund during the relevant tax year generate passive income or are intended to generate passive income. A foreign corporation (including a mutual fund) is classified as a PFIC if 75% or more of the investment’s gross income for the relevant tax year is determined to be passive income. Passive income sources include rent (real estate), interest, dividends, royalties, annuities, specific types of gains from commodities, the sale of properties that produce passive income, and or transactions involving foreign currencies.

If a given investment qualifies as a PFIC, there will be additional tax consequences of offshore mutual funds for US expats and taxpayers. There are three primary elections for managing IRS income reporting to the IRS: Mark-to-Market, Qualified Electing Fund (QEF), and Excess Distribution. This is why it is important to seek the advice of an experienced international tax attorney in the US if you have any investment(s) in offshore mutual funds. Which election is best based upon your unique situation?

The investment income from a PFIC is taxed at the highest personal federal income tax rate (presently 37%). The net tax rate on offshore mutual funds is, in actuality, much higher. PFIC gains are reported and taxed on an annual basis, whether the expat receives a distribution or realizes the gain.

This often raises a genuine and potentially expensive accounting issue: GAAP standards for accounting in the US are different than in Europe and around the world. In many cases, the taxpayer (or their tax attorney) must reconstruct every aspect of the individual investments associated with a mutual fund to establish basis and whether the investment has generated a taxable capital gain or a loss for the tax year. A substantial majority of US taxpayers and expatriates in this situation will be forced to hire an external accounting firm that will charge them thousands of dollars to, in essence, reconstruct the transactions within each separate investment within the fund to meet IRS filing requirements. To make matters worse, the US taxpayer or expatriate may not use losses in the PFIC to offset gains in other non-PFIC investments.

In addition, IRS tax rules require the US expatriate to report each separate foreign mutual fund PFIC on the IRS Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.”. The IRS Form 8621 is quite complex and requires extensive and detailed documented record keeping. The IRS estimates that a typical Form 8621 will take 30 hours or more of time to file, which is associated with accounting adjustments and preparation.

What are the tax consequences for offshore mutual funds for US expats and taxpayers? The genuine answer is usually a much higher tax rate and associated expenses than are warranted based on the actual benefit of the investment itself. Each PFIC (mutual fund) must be meticulously tracked and reported to the IRS to avoid non-compliance, penalties, and exposure to additional civil and criminal consequences.