Are “non-U.S. mutual funds” foreign corporations AKA #PFIC? Does your tax preparer know for sure?

I have written many posts that include a discussion of PFICs. This post has been motivated by a post by Karen Alpert at “Fix The Tax Treaty” (well it can’t really be fixed). The post focuses on the use of “non-U.S. mutual funds” in retirement planning. The post is written from the perspective that “non-U.S. mutual funds” ARE PFICs.

If you don’t know what a PFIC is be happy, be happy! A bit of knowledge (especially if you know things that aren’t true) can be a dangerous thing. Although most “tax professionals” treat non-U.S. mutual funds as PFICs, there is little explanation or analysis of WHY or HOW a “non-U.S. mutual fund” is a PFIC. In other words, most “tax professionals” know that “non-U.S. mutual funds” are PFICs. But, they don’t do a good job of explaining why. This post is based on a series of comments on Karen’s post that are consolidated as tweets in this Storify post.

Ultimately, the issue turns on whether the particular “non-U.S. mutual fund” is a corporation under U.S. law. This is NOT a simple question. What follows are the comments of Olivier Wagner, CPA.

The remaining of this article is written under the assumption that Canadian mutual funds (treated as trusts under Canadian law) are PFICs. It is however noteworthy to note that while Canadian mutual funds definitively meet the “passive” part of the PFIC definition (income test & asset test discussed below), it is debatable that it is a corporation.

The IRS says that it is a “business entity” if it is not a trust (Section 301.7701-2(a)) [Read note 2]

A Canadian mutual fund might or might not be an investment trust as described in 26 CFR 301.7701-4 (c)(1) – in which case the mutual fund will not be a PFIC [Read note 3]

The IRS has issued a private ruling letter (200752029) in the context of PFIC in which it ruled that the mutual fund was an eligible entity (for check the box classification – in this case, the fund elected to be treated as a corporation on form 8832). Absent such an election, the eligible entity (with several members) would be treated as a partnership, hence it would be a pass-through entity and the PFIC rules wouldn’t apply.

Outside the PFIC context, the IRS issued a private ruling letter (200024024) also indicating that a mutual fund is an eligible entity.

– Private Letter Ruling 200752029:

“The Fund is not a trust under Treas. Reg. § 301.7701-4(a) because it is not simply an arrangement to protect or conserve property for the beneficiaries. The Fund is a device to carry on a profit-making business.[…]Because the Fund is a business entity that is not classified as a corporation under Treas. Reg. § 301.7701-2(b)(1), (3), (4), (5), (6), (7), or (8), it is an eligible entity. As an eligible entity, the Fund can elect its classification for federal tax purposes under Treas. Reg. § 301.7701-3.[…]On Date 1, the Fund filed a Form 8832, Entity Classification Election, indicating that is was a foreign eligible entity electing to be classified as an association taxable as a corporation for U.S. income tax purposes.”

– Private Letter Ruling 200024024:

”Based solely on the facts submitted and representations made, we conclude that the Fund is a “business entity” within the meaning of § 301.7701-2(a). The Fund represents that it is not classified as a corporation under § 301.7701-2(b)(1), (3), (4), (5), (6), (7) or (8). Accordingly, we further conclude that the Fund is an eligible entity and can elect its classification for federal tax purposes as provided in § 301.7701-3T and § 301.7701-3.” Finally, the following might have been seen as indicating that mutual funds are corporations (this memo was not written in the context of PFIC rules)

– Memo (UILC: 2103.00-00):

”Assuming the Canadian mutual funds held by Decedent’s RRSP are classified as corporations for U.S. tax purposes, which appears to be the case, no portion of the RRSP would be includible in Decedent’s gross estate for federal estate tax purposes.”

The IRS has not issued a revenue ruling on the subject so in theory it would still be possible to roll the dice.

Also, if unsure if you have a PFIC, you can make a protective statement (described under “Protective statement regime” on page 5 of the instructions – if it later turn out to be a PFIC, the protective statement allows the taxpayer to make a late election)

The case for “some” mutual funds being “corporations” and “some not”

Why might YOUR Canadian mutual fund NOT be a PFIC?

How about because it couldn’t have been the intent of Congress to prevent Americans abroad from investing in mutual funds in the country of their residence. As David Kuenzi of Thun Financial pointed out in a nice “op ed” to the Wall Street Journal:

U.S. reporting rules for non-U.S. registered mutual funds are a particularly good example of the problem. An American family living in Germany that buys five or six different German-domiciled mutual funds to create a diversified portfolio is faced with tax complications that almost defy belief. They will have to report each of their six non-U.S. mutual funds on separate forms, every year. The IRS Instruction manual for this Form 8621 estimates that the time needed to prepare the form include “Recordkeeping, 15 hr., 4 min; Learning about the law or the form, 11 hr., 13 min; Preparing and sending the form to the IRS 20 hr., 21 min.”

In other words, the U.S. government expects this family to spend more than 200 hours annually preparing and filing the forms necessary to report their six mutual funds bought from a local German investment advisor. Furthermore, once the filing is made, the tax payers will find their investment gains taxed annually and subject to a tax rate no less than 39.6%, and potentially much higher.

Few U.S. tax preparers have any understanding of the special rules regarding non-U.S. assets and income. So Americans abroad can routinely expect to find major mistakes in their returns. They can also expect to pay anywhere from three to 20 times as much to have a return prepared compared to the cost of a similar domestic filing. The point is that middle-class Americans abroad face a nearly impossible task in both saving for their future financial needs and properly preparing their U.S. tax returns.

One of the many ironies embedded in this Orwellian tax nightmare is that the complex foreign asset and foreign income reporting rules were not written with Americans abroad in mind. Their original purpose was to discouraging Americans living in the U.S. from using off-shore tax shelters. As originally intended, the rules were a reasonable legislative response to a gaping tax loophole. Applied to Americans living abroad, however, they are absurd.
But, that is a common sense answer. We know that the the U.S. tax treatment of Americans abroad is NOT based on Common sense. They are based on the strict and aggressive application of the law.

Conclusion (if there really is one) …

This comment should NOT be interpreted to mean that non-U.S. mutual funds are NOT PFICs. I am NOT taking a specific position on whether they are or are not PFICs (or whether the same classification applies to ALL mutual funds).

With that caveat and disclaimer …

John Richardson

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