June 13, 2016 - Haoshen Zhong

Lookthrough rules for mutual funds held in nonqualified foreign pensions

Greetings from Haoshen Zhong.

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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.

Today’s newsletter will only deal with scenario 1: nonqualified plans. The next newsletter will deal with scenario 2: foreign plans that meet all qualifications to be a qualified plan, except that they are 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 under US tax law 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.

This is not surprising, when you consider what a trust is 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. They appear under the PFIC lookthrough rules.

PFIC lookthrough for nonqualified plans

A retirement plan that does not meet all qualifications of section 401(a) is a nonqualified plan. A nonqualified plan can be a grantor trust or nongrantor trust, depending on whether employee contributions are incidental to employer contributions. Reg. §1.402(b)-1(b)(6).

For PFIC lookthrough purposes, there is actually no difference between a nonqualified plan that is a grantor trust and one that is a nongrantor trust. The employee must look through the plan and report PFIC income, and here is why.

PFIC lookthrough for nonqualified plans that are grantor trusts

For grantor trusts, the regulation tells us clearly that the employee must look through to the underlying PFICs:

If a foreign or domestic trust directly or indirectly owns stock, a person that is treated under sections 671 through 679 as the owner of any portion of the trust that holds an interest in the stock is considered to own the interest in the stock held by that portion of the trust. Reg. §1.1291-1T(b)(8)(iii)(D).

This result is entirely unsurprising: In general, if the retirement plan is a grantor trust, then the employee must report the plan’s income as his own. There is no deferral in general for grantor trusts. You would not expect any deferral for PFICs held in the nonqualified plan that is a grantor trust either.

PFIC lookthrough for nonqualified plans that are nongrantor trusts

For nongrantor trusts, the regulations also tell us that the employee must look through to the underlying PFICs:

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 a long-winded way of saying a qualified plan.

What this regulation tells us is that other than for qualified plans, a beneficiary must look through a nongrantor trust. Because we are talking about nonqualified plans, the employee must look through the plan.

The implications of the lookthrough rule in practice

Section 401(a) contains 37 subparagraphs, laying out in detail what Congress thought a plan must satisfy to be a qualified plan. IRC §401(a). These criteria reflect the decisions of the US Congress. They do not reflect some fundamental understanding of what a fair retirement plan must satisfy.

Similar to Congress, the legislatures of most other countries laid out their own list of criteria that retirement plans in their country must satisfy. The result of these competing and complex requirements is that it is essentially impossible for a foreign retirement plan to be a qualified plan by coincidence. Unless a US citizen is working abroad for a multinational corporation, and he is specifically placed in a retirement plan designed for US citizens abroad, his retirement plan is almost certainly a nonqualified plan.

Through a combination of mandatory pension laws, collective bargaining, and industry practice, many US citizens who live and work abroad have foreign retirement plans. Like US retirement plans, the foreign retirement plan managers invest in assets such as mutual funds and government bonds as safe options.

Because these plans are almost certainly nonqualified plans, and the mutual funds are almost certainly PFICs, the US citizen must report income from the mutual funds held in their foreign retirement plans on an ongoing basis.


If a nonqualified foreign retirement plan invests in a PFIC, look through to the PFIC and tax PFIC income to the employee in the year the plan receives PFIC income.

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