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Taxation of PFIC investments in The United States

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Due to the scope and complexity of taxation provisions, many Israelis with dual U.S. citizenship may find themselves submitting an incomplete or inaccurate tax report to the U.S. Internal Revenue Service thus exposing themselves to extremely heavy tax burdens. This is all the more true when it comes to investing in passive foreign investment companies – PFIC companies.

And so, Israeli citizens with dual U.S. citizenship may find themselves investing in a popular venture such as an Israeli mutual fund, without knowing that this investment requires special reporting to the U.S. tax authority and that it exposes them to the heaviest tax burdens. In the article before you, we will explain what PFIC is, what are the characteristics used to identifying PFIC, what is the tax imposed on them, and when and how the tax liability can be minimized.

 

What is a PFIC? 

A passive Foreign Investment Company (PFIC) is a company incorporated under foreign (non-U.S.) law, and most of its revenues are passive. The phrase passive income refers to income from dividends, capital gains, interest, foreign exchange differences, royalties, and more. 

 

PFIC Identification Tests

The characteristics that describe a PFIC as a foreign company with a majority of its revenues are generated in passive income are insufficient, and therefore the law in the united states defined two tests for identifying PFIC. A company will be designated as a PFIC member if one of the following conditions apply: 

 

Income test

If more than 75% of the company’s revenue is passive revenue.

 

Asset Test

If more than 50% of the company’s assets issue passive income or are held to generate passive income.

It should be noted that classifying a company as PFIC will be made per investor, and if the company was once defined as a PFIC company, it will continue to be defined as such for that particular investor, even if the company’s data has changed and most of its revenues are now actively generated. 

 

Financial tools that are usually defined as PFIC:

Mutual funds, exchange-traded notes, exchange-traded funds (ETF), real estate investment trusts (REIT), foreign companies generating income passively, or foreign companies that hold a large cash balance, pension funds, provident funds, and training funds. These financial tools, which are considered to be the most thought out and popular investment, will be defined by law in the United States as a PFIC tool and will be subject to heavy taxation. 

 

PFIC Taxation

The investment structure through a PFIC has often enabled taxpayers to avoid paying the full amount of their tax to the U.S. tax authorities. The reason for this is that often PFICs are foreign companies that do not distribute profits but tend to reinvest their profits and thus they constitute a tax deferral mechanism and are not tracked by the American Tax Authority. In order to deal with this situation, the PFIC rules were formulated, and a heavy tax was imposed on their activities.

According to the rules regarding PFIC, a defendant who holds a company identified as a passive foreign investment company will be forced to make a conceptual sale of his holdings once a year, and pay tax at the relevant rate and the period of investment.

Even for this conceptual gain, the taxpayer will pay tax and arrears interest that may exceed 37%. For the purpose of comparison, and to understand the scope of the tax burden, it is worth mentioning that if the taxpayer had actually sold the holdings in the company, the tax rate that would have been imposed on the capital gain would have been about 20%. 

 

PFIC Reporting

If you are a U.S. citizen and hold foreign mutual funds, you are obligated to make a separate report to the U.S. Tax Authority through Form 8621. The lack of reporting can expose you to hefty taxes, fines, and other sanctions. 

 

PFIC and  FATCA 

In order to ensure the enforcement of U.S. reporting and payment provisions, the FATCA Act was enacted in 2010. The law, which came into force in 2013, imposed a number of obligations on U.S. citizens and corporations. The main obligation is the obligation to report to the US Treasury Department on foreign financial accounts whose cumulative amount exceeds $ 10,000 at the end of the tax year or at some point during the tax year.

The essence of this directive is in an additional obligation imposed under the law – foreign financial institutions are obligated to report to the U.S. Tax Authority financial accounts that are managed by them, and in which U.S. citizens have an interest. According to the law, a financial institution that does not comply with these rules will be subject to a tax deduction of 30% from any income derived from the American source that is transferred to the institution.

Following the FACTA Act, the United States signed a Financial Exchange Treaty with a large number of countries. A similar agreement was signed with the State of Israel. According to the convention, the financial institutions in Israel (banks, insurance companies, pension funds, etc.) are obliged to monitor the financial accounts of American citizens operating within the same institution and to transfer this information to the American Tax Authority.

This means that the U.S. Tax Authority has a lot of information about the accounts of American citizens in Israel, including accounts that contain PFIC devices. The ability of the U.S. Tax Authority to cross-reference information about various financial accounts increases its ability to enforce PFIC rules and exposes many citizens to heavy tax burdens and even sanctions for non-reporting.

In light of the above, if you are a U.S. citizen or hold an American green card, it is of great importance to identify financial instruments that are within the scope of PFIC and to formulate an appropriate strategic plan.

 

Dealing with PFIC rules

There are several optional strategies to deal with these rules, but they require full professional advice that takes into account all your circumstances and your investments. When it comes to pension funds, study funds and provident funds, one of the possible ways of coping is choosing to classify the fund as a Qualified Electing Fund.

This classification allows the taxpayer to pay tax on the fund’s profits on an ongoing basis in accordance with its share of the company’s revenues. In this way, the assessee refrains from paying interest or arrears interest for the conceptual distribution. Furthermore, PFIC profits will be taxed in accordance with capital gains tax rates. 

 

In summary

It is of great importance to identify PFIC financial tools and to carry out a tax plan that will ensure minimal tax liability.

The MasAmerica team is at your service and will be happy to tailor asuitable tax route that suits your needs.

The aforesaid should not be regarded as legal advice. It is advisable to consult with the MasAmarika team before any action. The service is provided by a professional team, fluent in English and Hebrew, and includes attorneys and accountants with American licenses.

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