June 30, 2016 - Haoshen Zhong

Lookthrough Rules for Mutual Funds Held in Foreign Pensions Meeting US Qualifications

Greetings from Haoshen Zhong.

You are receiving this email because you are subscribed to our PFICs Only newsletter, delivered to your inbox every other Thursday at 6:00 am Pacific time. To stop receiving these emails, scroll to the bottom and click “unsubscribe”. To browse our other newsletters, go to

Do I have to report PFICs held in an employer matching pension?

This week’s newsletter is a question we get frequently:

I have a US citizen client who is living and working in Hong Kong. The employer provides a retirement plan where the employee contributes, and the employer matches some percent of the employee contributions. The retirement plan invests in a foreign mutual fund. If the retirement plan has income from the mutual fund, does the employee have to report the income as income from a PFIC?

There are 2 possible scenarios:

  1. The retirement plan is a nonqualified plan
  2. The retirement plan meets all requirements to be a qualified plan under US tax law, except that it is foreign rather than domestic.

Our last post dealt with scenario 1: nonqualified plans. This post deals with scenario 2: foreign plans that meet all qualifications to be a qualified plan, except that it is foreign rather than domestic.

Why is the mutual fund a PFIC?

A passive foreign investment company (PFIC) is a foreign corporation where 75% or more of its income is passive income, or 50% or more of its assets are assets that produce passive income. IRC §1297(a). These are known as the income test and the asset test.

Some mutual funds are not organized as corporations, but they are nevertheless classified as foreign corporations. I addressed this in a previous post in the context of unit trusts, but the reasoning is generally true: Mutual funds are organized for investment purposes, so they are business entities. When they are organized outside the US, they are foreign business entities. They are usually organized so that the investors do not have personal liability for the debts of the mutual fund, so they are by default foreign corporations for US tax law.

Passive income includes income such as dividends, interest, rent, royalties, and gains from the sale of property that produce dividends, interests, etc. IRC §§1297(b), 954(c). Mutual funds’ income consists almost entirely of dividends, interest, and gains, and their assets produce these types of income.

Because mutual funds are foreign corporations that receive almost all passive income and hold almost all passive assets, they are PFICs.

Retirement plans are subject to trust lookthrough rules

If you look at the Code sections that provide for US based retirement arrangements (§§401, 402, 408, 408A), you will see that the sections refer to qualified retirement plans, 401(k)s, IRAs, etc as trusts. See IRC §§401(a), 402(b), 408(a), 408A.

We tend to not think of our retirement plans as trusts, but the classification is not surprising when you consider how a trust is defined under tax law: A grantor (the employer, employee, or both) gives property (cash for retirement funds) to a trustee (the account manager) to protect or conserve (for retirement) for a beneficiary (the employee) under rules applied to fiduciaries (ERISA and analogous foreign pension laws). Reg. §301.7701-4(a).

Because retirement plans are also trusts, we also look at trust rules when deciding whether PFIC lookthrough occurs.

Primer on grantor and nongrantor trusts

When you read rules related to trusts, you will frequently see the terms grantor trust and nongrantor trust.

A grantor trust is a trust where someone (typically the grantor) is taxed on the income of the trust, regardless of whether the trust makes a distribution. The person who is taxed on the income of the trust is referred to as the owner of the trust.

A nongrantor trust is a trust where the trust itself pays tax on undistributed income. If the trust distributes income, then the income is passed to the recipient. A nongrantor trust does not have an owner under income tax rules.

These terms are not defined in the Code or the regulations, but they are spread throughout the Code, the regulations, and tax practice and are used under these meanings. These terms also appear under PFIC lookthrough rules.

A qualified plan is a nongrantor trust, because the employee is not taxed as the owner of the plan’s income until the income is distributed to the employee.

No PFIC lookthrough for domestic qualified plans

This is the language of the lookthrough rule for nongrantor trusts:

If a foreign or domestic estate or nongrantor trust (other than an employees’ trust described in section 401(a) that is exempt from tax under section 501(a)) directly or indirectly owns stock, each beneficiary of the estate or trust is considered to own a proportionate amount of such stock. Reg. §1.1291-1T(b)(8)(iii)(C).

“An employees’ trust described in section 401(a) that is exempt from tax under section 501(a)” is just a long-winded way of saying a qualified plan.

The regulation does not directly state what happens when you have a qualified plan, but the negative implication is obvious: If a PFIC is in a qualified plan, there is no lookthrough.

So if there is a PFIC inside a domestic qualified plan such as a domestic 401(k), the employee does not have to look through to the PFIC.

The statutory and regulatory language are not clear for foreign plans that meet qualifications

If you look in section 401(a) to find out what “described in section 401(a)” means, you will see the words “a trust created or organized in the United States…”. IRC §401(a). By incorporating 401(a), Regulation section 1.1291-1T(b)(8)(iii)(C) seems to have dealt with domestic qualified plan only. It does not specifically say what happens with a foreign plan that meets all qualifications.

This is what the Internal Revenue Code says about foreign plans that meet all qualifications in general:

For purposes of subsections (a), (b), and (c), [a plan] which would qualify for exemption from tax under section 501(a) except for the fact that it is a trust created or organized outside the United States shall be treated as if it were a trust exempt from tax under section 501(a). IRC §402(d).

A foreign plan that meets all qualifications of a qualified plan is treated as a trust that is exempt from tax under section 501(a) for the narrow purposes of subsections (a), (b), and (c) of section 402. By the Code section’s own terms, there is no benefit for PFIC rules: The PFIC rules are not part of section 402.

The PFIC regulations carve out an exception to lookthrough only for “an employees’ trust described in section 401(a) that is exempt from tax under section 501(a)”. If we read the Code literally, even if a foreign plan meets all qualifications, it is not a “trust described in section 401(a)” generally–only for certain limited purposes.

Read literally, a foreign plan that meets all qualifications is still not a qualified plan, and the employee still must look through to underlying PFICs.

Our take: No lookthrough for foreign plans that meet qualifications

I prefer take the position that the language involved is an example of drafting error, and there is no lookthrough for a foreign plan that meets all qualifications of a qualified plan. Why? A few choice quotes indicating the intent of the retirement plan rules and PFIC rules:

The intent and purpose of section 402(d) is to give those employees […] essentially the same tax treatment as those covered by trusts described in section 401(a) and exempt under section 501(a)… Reg. §1.402(d)-1(a).

The IRS thinks the point of 402(d) is that if a plan meets all qualifications, then the tax results should not depend on where the plan is organized. It would be odd to then interpret PFIC rules to require an employee to look through a foreign plan but not a domestic plan.

Since current taxation generally is required for passive investments in the United States, Congress did not believe that U.S. persons who invest in passive assets should avoid the economic equivalent of current taxation merely because they invest in those assets indirectly through a foreign corporation. JCS-10-87, 1023.

The Joint Committee on Taxation tell us why Congress enacted the PFIC provisions: The US wants to tax either the investment vehicle or the investor on current income. If a US person invests through a foreign corporation, the US cannot tax current income: It can only tax income when it is repatriated to the US person. The PFIC rules eliminate the economic incentive for investing through the foreign corporation.

When you have a retirement plan, the investor is the retirement plan. As long as a retirement plan meets all the qualifications in section 401(a), the US exempts the plan’s income from tax. This is true whether the plan is domestic or foreign. Because the US does not tax the plan’s income at all, there is no incentive for the plan to defer tax by investing in foreign corporations. Therefore, it does not make sense to apply PFIC rules to the plan, regardless of whether it is domestic or foreign.

Based on the legislative intent behind the retirement plan and PFIC rules, I prefer to think that a person who has a foreign plan that meets all qualifications to be a qualified plan does not have to look through the plan to underlying PFICs. In other words, put a domestic qualified plan and a foreign plan that meets all qualifications on the same level, as Congress intended.

An extra warning and disclaimer

This post is based on my interpretation of how the legislative intent between different pieces of tax law interact. The IRS has not provided specific guidance on the subject through regulations, revenue rulings, notices, or even internal memoranda that became public. You should take a careful look at the issue yourself before deciding what to do with the PFICs held inside the foreign retirement plan.


If a foreign retirement plan meets all qualifications to be a qualified plan–except that it is not organized in the US–the rules are not clear. I prefer to advise clients that there is no PFIC lookthrough.

Thank you

Thank you for tuning in to our PFIC newsletter. Please send us any PFIC questions you have by clicking “reply” to this message.

Disclaimer: This newsletter is not legal or tax advice. You cannot use it to avoid penalties or for promotional purposes. Hire help.


Americans Living Abroad PFIC and CFCs