PFIC Excess Distribution Calculation Example

PFIC Excess Distribution Calculation Example

PFIC Excess Distribution

When it comes to Form 8621 and PFIC (Passive Foreign Investment Companies), one of the biggest complications involves calculating excess distributions. In general, whether an investment is US-based or foreign-based, the Long-Term Capital Gains (LTCG) and Qualified Dividend (QD) rules still apply. This would mean that under most circumstances Long-Term Capital Gains and Qualified Dividends are taxed at 15% or 20%. With Excess Distributions, these LTCG and QD taxpayer-friendly tax rules do not apply. Rather, the US Government developed an incredibly complicated tax regime, which essentially serves to penalize the taxpayer for making overseas investments. For many taxpayers, the PFIC excess distribution calculation comes into play because they have overseas pooled funds, such as Mutual Funds, ETFs, or SICAVs. In order to explain how this tax injustice works, we will provide a brief example for comparison purposes.

Foreign Mutual Funds and Other Pooled Funds

Mutual funds and other types of pooled funds come in all shapes and sizes. It may be that you simply own some foreign mutual funds in India through SBI, Kotak, or the like. You may have mutual funds in a foreign retirement plan such as a Singaporean CPF, Malaysian EPF, Hong Kong MPF – or another non-treaty country where the treaty PFIC exception rules would not apply. You may also have your pooled funds in a retirement fund that is not considered employment-born and more of an ancillary retirement scheme such as UK ISAs. These are all examples in which Form 8621 may be required to report a PFIC – and you may be required to calculate an excess distribution.

Domestic Mutual Fund

David is a US person who has US investments. He has a mutual fund based in the United States that generated $10,000 in qualified dividends. Therefore, David can utilize the qualified dividend tax rate of 15% and will end up paying roughly $1500 on the income that he earned from the qualified dividend from a US-based Mutual Fund.

Foreign Mutual Funds

Using the same equation, Jennifer is a US person who has a $100,000 investment in a foreign mutual fund. Unlike the above-referenced example, there are many steps that Jennifer must take in order to determine her tax liability on the same $10,000.

Was it the First Year of the Investment?

The idea behind excess distributions is the idea that the distributions in the current year exceed 125% of the average of the three prior years — or less than three years, depending on how long a person is invested in the foreign fund. But, if it is the first year of the investment then there are no excess distributions because it is the first year so it is not an excess of anything prior—thus, there would be no excess distributions on this particular $10,000.

First Distribution vs First-Year Distribution

If the investment is more than one year old and this is the first distribution, then that is not the same for PFIC tax purposes. It helps to illustrate the purpose of the excess distribution, which is that the US government does not know what is going on within the mutual fund overseas during the years in which no distributions are being made. That is because foreign financial institutions generally are not required to report foreign mutual fund information or how the investment works, to the IRS. Thus, if this is the first distribution, then the full amount of the $10,000 may be considered an excess distribution.

Prior Year Distributions as Well

If this is not the first year of the distribution, then the taxpayer must prepare the calculation to determine if there is any excess. In general, the taxpayer takes the average of the three prior years of distributions and then determines 125% of the average of those three years. Then the taxpayer will calculate what portion of the current year’s distribution is considered an excess distribution and what portion is considered a non-excess distribution. The excess distribution is the tax differently — and by differently, we mean badly.

Tax Rate on Excess Distributions

Here’s the kicker: the portion of the distribution that is considered an excess distribution is then taxed at whatever the highest tax rate is available under the tax code – – and not the 15 or 20% for qualified dividends or long-term capital gains. In addition, the taxpayer must pay interest for the time that the investment was sitting in the foreign fund but not being distributed. Essentially, the taxpayer is being penalized for having an overseas investment. And, the higher the excess distribution and the longer amount of time the investment has been sitting in the fund will result in higher interest due. When the first distribution is made (excluding a first-year distribution) after several years of sitting in the investment, and it is a high distribution that has been sitting the account for multiple years, the amount due can end up exceeding 50% when factoring in taxes and interest.

Sales/Redemptions of Foreign Mutual Funds

In general, when a taxpayer sells or redeems the mutual fund — or another type of pooled fund — that is based overseas, it may result in a very large excess distribution if the amount of the value on the date of redemption is much higher than the amount of the acquisition.

Elections

Taxpayers may qualify to make certain elections in order to reduce or minimize taxes that would otherwise be deemed excess distributions. The two main types of elections for individual taxpayers are the Mark-To-Market election (MTM) and the Qualified Electing Fund (QEF). The latter is typically much better from a tax perspective for the individual, but it requires documentation and cooperation from the foreign financial institution — and they may not want to assist you in providing that type of information to the IRS.

Current Year vs Prior Year Non-Compliance

Once a taxpayer missed the tax and reporting (such as FBAR and FATCA) requirements for prior years, they will want to be careful before submitting their information to the IRS in the current year. That is because they may risk making a quiet disclosure if they just begin filing forward in the current year and/or mass filing previous year forms without doing so under one of the approved IRS offshore submission procedures. Before filing prior untimely foreign reporting forms, taxpayers should consider speaking with a Board-Certified Tax Law Specialist that specializes exclusively in these types of offshore disclosure matters.

Avoid False Offshore Disclosure Submissions (Willful vs Non-Willful)

In recent years, the IRS has increased the level of scrutiny for certain streamlined procedure submissions. When a person is non-willful, they have an excellent chance of making a successful submission to streamlined procedures. If they are willful, they would submit to the IRS Voluntary Disclosure Program instead of the Streamlined Procedures. But, if a willful Taxpayer submits an intentionally false narrative under the streamlined procedures (and gets caught), they may become subject to significant fines and penalties. 

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