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August 9, 2008

Watch Out for Foreign Mutual Fund Investments

We have learned that a lot of US expats are being sold foreign mutual funds or shares in foreign corporations that invest solely in securities. They are being told that those investments will grow tax free (legally) until such time as they decide to take a distribution. That statement is true but the brokers and sales people are not telling their US citizen and permanent resident clients all of the facts how a distribution will be taxed when it is finally made.

When you purchase a foreign investment company or mutual funds it is general classified for US tax purposes as a Passive Foreign Investment Company (PFIC). These have special treatment under US tax law. To learn the technical details read the instructions to IRS Form 8621.

It is true that you are not taxed until a distribution is made, but unless you file a special election and special IRS form to have the fund marked to market each at the end of each calendar year the results can be disastrous. When the distribution is finally made (if no election has been made and no form 8621 filed) it will all be taxed at the highest personal income tax rate then in effect and the profit included in that distribution will be treated as if earned ratably during each year the investment was held without distribution. You cannot get capital gains rates on capital gains or any qualified dividend rate on dividends. In addition to paying the highest tax rate, you must pay interest calculated on those ratable earnings for each year on the taxes you should have paid if it were taxed in each of those years you did not take a distribution. The interest added onto the tax rate can mean you pay 50 to 75 percent or more of the distribution in taxes and interest on your US tax return. .... depending on how long you held it without making a distribution, leaving you with little net cash profit.

If you own a PFIC you can avoid this result by electing to mark the fund value up to market at the end of each year and paying tax on any gain at ordinary income rates with your tax return that year. You will not then owe any interest on past distributions and if you are not in the highest tax bracket, you will only pay taxes at the rate you are in for that year. Their is a third choice which is difficult to comply with and rarely used.

So if you do own a PFIC, it is important under most circumstances to file Form 8621 each year and make the mark to market election (you can also take losses if that is the result of the year) on your tax return. If you delay, you may have to pay a lot or almost all of your profits as taxes and interest. How do you avoid this problem? Invest directly in a foreign stockof an individual foreign company. Then the dividends will be taxed as such each year (and if there is a treaty with the country of incorporation those dividends might be qualified) and when you sell the stock you can pay tax on the gain at long term capital gains rates.