The mutual funds, insurance policies and other things you should not own as an Expat

Today’s post is about the big mess created for American expats by the U.S. government’s tax treatment of “Passive Foreign Investment Companies” (PFIC’s). The whole PFIC tax regime was meant to prevent U.S. taxpayors from putting money offshore as part of a tax loophole. So, the law is meant to be punitive: PFIC’s are taxed at a very high rate, and they come with extra reporting requirements. Any U.S. accountant or financial advisor will tell you to avoid them. Unfortunately, in its haste to close a tax loophole, the U.S. government seems to have inadvertently roped in a number of innocent expats just trying to use basic mutual funds in the places where they live. So let’s look at where the traps lie for American investors in France.

First, what is a PFIC?

In creating the category of a “Passive Foreign Investment Company,” the IRS is trying to distinguish between an investment in an active business outside the U.S. and an investment made in an entity that is really just meant to produce income for its shareholders from other businesses. The latter group often just shield income from taxation in a fairly dodgy fashion.

But this definition gets at some very common, not at all dodgy investments, as well.  For example, if you buy shares in a company that manufactures solar panels in Provence, that is almost certainly an active investment—no problem. But if you buy into a fund that itself owns shares of companies that manufacture solar panels or whatever else and then pays ocassional distributions to its shareholders, that is almost certainly a passive investment vehicle. And you can see how we have just arrived at the majority of old-fashioned mutual funds, exchange-traded funds (ETF’s) or here in France, SICAV’s (Société d’investissement à capital variable).

What’s more, like a mutual fund in your 401k, a PFIC can appear inside of a pension, retirement account or another investment where you might not notice it. Most U.S.-based retirement accounts and tuition savings accounts are exempt from the PFIC regulations, but most foreign-based equivalents are not. It is not always easy to see that you have become an “indirect shareholder” under the IRS’s definition.

How can I avoid investing in a PFIC?

You can find the IRS’s definition of a PFIC here (scroll down to “Definitions and Special Rules”) or Investopedia’s more user-friendly explanation here. But because of the gray areas around PFIC’s, most people will be better off to stick with some of the common investments that are definitley not PFIC’s. Here are some of the most popular in France:

•  Basic bank accounts, savings or checking, that hold your money and might make interest payments on that money. That includes your French comptes d’épargne.

• French Livret accounts – Livret A, Livret de développement durable et solidaire (LDDS), and others for low-income earners or young savers.

• French Plans d’épargne logement (PEL’s), which allow you to save up for a house or home improvement.

• An investment account with stocks held directly in active foreign businesses (so long of course, as those businesses themselves are not holding companies!). In France, these accounts are generally Plans d’épargne en actions (PEA) or for pension savings, Plans d’épargnes retraite (PER).

• Government bonds from any government entity.

• Stock in a foreign business that you own outside of an investment account.

There is one common French investment to avoid, though: the French Assurance Vie policies. Despite the name, these are not life insurance policies (those are Assurancse Décès). These operate much like American variable annuities and other insurance products that have an investment component. Fortuntely, most French financial institutions are familiar with the American tax problem and will not try to sell you one of these. But they are one of the most popular investment vehicles in France. And they most definitely qualify as PFIC’s for Americans.

What happens if you do own a PFIC?

The IRS will require a Form 8621 every year from any taxpayor who has PFIC shares during the year. You will then need to do a bit of calculation on your reportable income. The IRS requires that you determine the average distribution level from the fund during its previous three years and use that as a baseline for determining “excess distributions.” If the distributions you received during the year were more than 125% of baseline distributions, they are excess. You will now pay taxes on those excess distributions based on the highest income tax bracket available.

Between the incredibly high tax rate and the complexity of trying to figure out excess distributions, no one wants to own a PCIF. If you think you are currently holding shares in a PFIC or failed to report on PCIF income in the past, it’s probably time to seek some professional help.

So can I still own my U.S.-based mutual funds and ETF’s?

Yes! Well… maybe. The U.S. government’s regulations on PFIC’s don’t have anything to do with U.S.-based investments. But EU regulations known collectively as MiFID II can have an impact on how you are taxed on your U.S. investments account. That has its own complications, and I address them here.