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November 30, 2017 - Haoshen Zhong

Foreign Mutual Funds Investing in the US Are Still PFICs

Foreign mutual funds investing in the US

This is a question from an email:

I have a foreign mutual fund that invests in stocks of US corporations. Is the mutual fund a PFIC?

In this post, I will discuss why this mutual fund is a PFIC. Here is the tl;dr version: There is no exception in the PFIC rules for invests in the US.

What are PFICs?

Passive foreign investment company (PFIC) is a classification under US tax law. When a US person receives a distribution from a PFIC or sells shares in a PFIC for a gain, special rules apply. The rules are less than desirable for the taxpayer, so it is desirable to avoid PFIC classification.

A PFIC is a foreign corporation that meets at least 1 of 2 tests:

  • Income test: At least 75% of the corporation’s income is passive income.
  • Asset test: At least 50% of the corporation’s assets produce passive income or are held for the production of passive income. IRC §1297(a).

We need to verify that the foreign mutual fund is a foreign corporation, and that it meets either of the tests for PFICs.

The mutual fund is foreign

“Foreign” is easy. A business entity is domestic if it is organized in the US; otherwise, it is foreign. Reg. §301.7701-5(a). I assume “foreign mutual fund” means a mutual fund that is organized outside the US. Therefore, it is a foreign business entity.

The mutual fund is a corporation

There are several alternative reasons why the mutual fund is almost certainly a corporation.

  • (Rare) The mutual fund is organized as a publicly traded limited company and is listed as an entity type that is always a corporation. Reg. §301.7701-2(b)(8).
  • The mutual fund provides limited liability for all its members and is a corporation by default. Reg. §301.7701-3(b)(2).
  • The mutual fund is classified as a partnership under the regulations, but because it is publicly traded, it is classified as a corporation under a special Code provision for publicly traded partnerships. IRC §7704.

Any one of the reasons is sufficient. The mutual fund almost certainly falls under at least one of these categories. The mutual fund almost certainly is a corporation.

The mutual fund satisfies the income test and asset test

Passive income is income that would be foreign personal holding company income in the hands of a controlled foreign corporation. IRC §1297(b).

These include interest, dividends, rent, royalties, annuities, gains from the sale of property that produce these types of income, and gains from the sale of property that produce no income. IRC §954(c)(1).

Stocks produce dividends, and they produce gains when sold. The mutual fund likely holds some cash that produces interest. The mutual fund’s income is almost entirely passive. Because all its property produce passive income or are held for producing passive income, almost all its assets are passive.

The mutual fund satisfies the income test and the asset test.

No exception for mutual funds investing in the US

It is tempting to think that there is some exception for foreign mutual funds that invests in the US, because the US gets to tax the mutual fund on its US source income, and it encourages investments in the US.

This assumption is wrong. There is no special exception for mutual funds that invest in the US. See IRC §§1297, 1298, 954(c).

It is not surprising that the PFIC rules do not contain such an exception.

First, a foreign corporation is not subject to tax when it sells US stocks for a gain. See IRC §§881, 882. A US person is taxed on capital gains from the sale of stocks. IRC §61(a)(2). Thus, the foreign mutual fund has a much smaller tax base than US investors. Congress would not want US persons to use foreign investment vehicles to defer tax on capital gains.

Second, the PFIC rules function as a protective measure for US based mutual funds and their investment advisers.

A foreign mutual fund that invests in stocks in US corporation is classified as a PFIC (or not) under the same rules as a foreign mutual fund that invests in foreign stocks. It almost certainly is a PFIC.

 

PFIC and CFCs