While many portions of the U.S. tax code possess confusing and sometimes harsh rulings, the tax regime for Passive Foreign Investment Companies (PFIC) is almost unmatched in its complexity and almost draconian features. Countless times, our international clients have come to us to prepare what they thought would be straightforward tax returns- only to later learn that the small investment they had made in a non-US mutual fund was now subjecting them to all the concomitant filing requirements and tax obligations. While it is beyond the scope of this article to cover all the numerous details related to PFIC reporting requirements, my hope is to provide guidance and insight into the world of PFICs.

History
The PFIC tax regime was created via the Tax Reform Act of 1986 with the intent to level the playing field for US based investment funds (ie mutual funds). Prior to the legislation of 1986, U.S.-based mutual funds were forced to pass-through all investment income earned by the fund to its investors (resulting in taxable income). In contrast, foreign mutual funds were able to shelter the aforementioned taxable income as long as it was not distributed to its U.S. investors. After the passage of the Tax Reform Act of 1986, the main advantage of foreign mutual funds was effectively nullified by a tax regime that made the practice of delaying the distribution of income prohibitively expensive for most investors. To employ this punitive regime, the IRS requires shareholders of PFICs to effectively report undistributed earnings via choosing to be taxed through one of three possible methods- Section 1291 fund, Qualified Election Fund, and Mark to Market election.

Basics
Defined in the Internal Revenue Code (section 1297), a Passive Foreign Investment Company is any foreign corporation that has either:
1. 75% or more of its gross income classified as passive income (i.e. interest, dividends, capital gains, etc…), or
2. 50% or more of its assets are held for the production of passive income.

While there are a few exceptions to above rules, most foreign mutual funds, pension funds, and money market accounts would be good examples of PFICs. Furthermore, many foreign REITS also get trapped in the PFIC web. Finally, a foreign holding company that possesses passive investments (like rental real estate or government bonds) would be subject to PFIC regulations if the company was set up as a corporation.

PFIC related information is reported on Form 8621 .

Taxation Methods
Section 1291 Fund
The Section 1291 Fund election (Excess Distribution) is the default taxation regime unless the taxpayer chooses either of the two alternatives. Under the Sect 1291 regime, all “excess distributions” for prior years will be taxed at the highest marginal rate for each particular year an excess occurred and will incur underpayment interest expenses on those unpaid taxes. In contrast, the current year “excess distributions” are added to the “Other income” line of one’s personal tax return. For the purposes of this election an “excess distributions” are either:
1. The part of the distribution received from a section 1291 fund in the current tax year that is
greater than 125% of the average distributions received in respect to such stock by the shareholder during the 3 preceding tax years (or, if shorter, the portion of the shareholder’s holding period before the current tax year; or
2. Any capital gains that result from the sale of PFIC shares
To add to the complexity- excess distributions that are taken (in either of the two aforementioned forms) must be allocated ratably over every year since the most recent excess distribution was taken (if any). Furthermore, all dividends are still required to be reported on Schedule B of the income tax return but any capital gains or losses do not get reported on Schedule D.

To provide an illustration:
1 share of XYZ Inc. (a foreign mutual fund) that was purchased for $100,000 on January 1, 2008. It distributed $8,000 of dividends on July 4 of each year. On December 31, 2010, the share was sold for $400,000. Since the dividends for each year never exceeded the prior year’s amount, there are no excess distributions relating to the dividends. However, since the sale resulted in a capital gain of 100,000, the gain is an excess distribution and will be allocated ratably of each day the share was held. In particular, the excess distributions would result in $100,000 being allocated to 2008 and 2009 and taxed at the highest marginal tax rate (35% in 2008 and 2009). Also, interest would be charged to both years for the amount owed as of the due date for the particular tax year’s tax return- i.e. interest would accrue from April 15, 2009 for the 2008 excess distribution tax). Finally, the allocation of excess distribution for 2010 would be added to ordinary income line of the income tax return (line 21 for those filing Form 1040). Assuming the taxpayer was in the 33% income tax bracket for 2010, the additional tax caused by the PFIC regime would exceed $120,000. Please note that the transaction will not be recorded on the taxpayer’s Schedule D and that the dividends, though not taxed as part of the excess distribution regime, would still need to be reported on the taxpayer’s schedule B as non-qualified dividends.

To have perspective on the degree of additional taxation that can occur with the Excess Distribution method- if the $300,000 gain listed in the aforementioned scenario would have come from the sale of a non-PFIC, the tax would have been $45,000 (almost a third of the total PFIC tax liability). As you can clearly see- the IRS wants to discourage investing in foreign mutual funds.

QEF Election (Qualifying Electing Fund)
A second, simpler option for shareholders of PFICs is the QEF election. A first glance, it would appear to be a much better option for most investors since effectively results in the PFIC being treated like a US based mutual fund- the ordinary and capital gains income of the PFIC separately flow through to the shareholder according to percentage of ownership. For example, a taxpayer with a 1% stake in a PFIC that earns $100,000 in ordinary income and another $50,000 in capital gains income will report $1,000 as “other income” on the tax return while $500 will be reported on Schedule D.
However, there is one huge obstacle to making this election- most PFICs are unable to be classified as a QEF since the IRS demands that a QEF comply with IRS reporting requirements (a large request for a non-US based company). Consequently, the QEF election is not frequently available.

Mark-to-Market Election
The third option available to PFIC shareholders is to make a mark-to-market election. This method allows the shareholder to report the annual gain in market value (i.e. unrealized gain) of the PFIC shares as ordinary income on the “other income” line of their tax returns. Unrealized losses are only reportable to the extent that gains have been previously reported. The adjusted basis for PFIC stock must include the gains and losses previously reported as ordinary income. Upon the sale of the PFIC shares, all gains are reported as ordinary income whereas losses are reported on Schedule D.
To choose this method, the PFIC generally must be traded on a major international stock exchange and can only apply to the current and future tax years.

Also, this election is independent of prior PFIC elections (i.e. QEF or Sect 1291 election). for example: If stock X was purchased in 2007 for $100, has a FMV on 12/31/11 of $120, and no PFIC forms were filed until 2011 (when Sect 1296- Mark-to-market- election was made), no PFIC filings would be needed for the prior years as long distributions were less than 125% and no capital gains occurred. For the current year, 8621 would be filed using Mark to market and the ordinary income would be $20. see Section 1.1296-1 3 b.iii

EARNED VS. UNEARNED INCOME

For purposes of claiming the foreign earned income exclusion, one must have income earned in a foreign territory. Income is considered earned in a foreign country if services were performed there regardless of whether the payment is deposited to a bank account in the United States. It is often a challenge distinguishing between earned and unearned income. For this reason, we will carefully examine each category in order to determine the types of income allowed for exclusion.

Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad, defines earned income as pay for personal services performed. It includes salaries and wages, commissions and bonuses, tips and professional fees. However, it also includes related payments such as vacation, sick leave, severance, certain reimbursements and allowances. Furthermore, if noncash income were received through meals, lodging, or the use of a company car, the fair market value of such benefits will be considered earned income.

Just as much as there is a list of earned income, Section 911(b)(1)(B) of the federal tax code outlines the types of income that are unearned: annuities, alimony, gambling winnings, capital gains, dividends, interest, unemployment and social security benefits.

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2011 has been a very good year for me.  I lived in Prague, Czech Republic to become a certified TEFL teacher.  I traveled back to my motherland, South Korea, a place I have not visited since I was adopted.  I moved to Australia and traveled up the East Coast to Brisbane and Surfer’s Paradise.  And last week, I spent one week in the Philippines.

It was my first trip to South East Asia, a region that I have been dying to visit since I started this epic journey around the world, and it was also my first time visiting a third world country.

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Many U.S. expats living in foreign countries are already overwhelmed by the complexity of the federal government’s international tax laws and regulations. And yet these complexities are nothing compared to the challenges same-sex couples or registered domestic partners endure under the federal government’s discriminatory tax laws. Factoring in the fact that these same-sex couples live abroad makes matters worse

Currently, the federal government does not recognize the union between gay and lesbian couples. According to P.L. 104-199, Section 3 of the Defense of Marriage Act (DOMA), the term “marriage” is referred to as the legal union between a man and a woman. In other words, same-sex married couples, civil unions, and registered domestic partners do not exist in the eyes of Uncle Sam. Consequently, many gay and lesbian couples get married in other states that recognize their union. Others even go as far as move to another country to tie the knot and to start a new life.

However, same-sex couples living abroad that are U.S. citizens or residents face a more rigorous process when it comes to complying with their filing obligations. For example, depending on their foreign country of residence, a same-sex couple usually files their foreign taxes jointly. But since the United States does not recognize their marriage to be legal, they must claim the “single” status when filing their U.S. tax returns; married filing jointly or married filing separately is not allowed.

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Did you know that American expats need to file U.S. taxes? I didn’t.

Which is why I’m glad that I discovered Tax Planner CPA.  Not only because they were kind enough to hire me as a blogger, but also because they specialize in filing expatriate taxes and maybe I can convince them to file my taxes at a discounted rate.

As the New Year quickly approaches, so does the dreaded U.S. tax season.  So if you’re living abroad and need to file your U.S. taxes, how do you do it?  Where do you go?

Well, you could hire a family friend’s accountant to do your taxes, though you may risk a chance of them being inaccurate.  Or you could just not file your taxes this year (obviously not recommended), but then you risk jail-time.  Or you could find a company, like CPA Tax Planner, who specializes in Expatriate Tax returns.

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Resident and nonresident aliens worry about the complexities of their tax filing requirements. However, these U.S. aliens can usually refer to the guidelines of their respective residential status and easily fulfill their filing obligations. This is not the case for individuals who are both residents and nonresidents of the United States or dual-status aliens. A Dual-status alien is taxed separately for the period he was a resident and for the period he was a nonresident. In general, according to Code Sec. 871 and Reg. §1.871-1, a resident alien is taxed on income derived from all sources, even those that are from outside the United States. On the contrary, a nonresident alien is only taxed on income derived from the United States and certain foreign income that is effectively connected with a trade or business in the United States. For example, this means that if you received interest income while a nonresident from an Australian bank that is not effectively connected with a trade or business in the United States, you are not required to report that interest income in filing your U.S. taxes.

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Australian Department of Immigration highly advises anyone moving to Australia to invest in some type of health insurance.  Considering Australia is home to some of the world’s deadliest snakes, spiders and other insects, would you really want to take your chances living here without health insurance?

As a tourist / foreigner or U.S Expat,  Americans are not covered by Australia’s national health scheme because the United States does not have a reciprocity health care agreement with Australia.

So, what are your options?

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As of August 2011, the U.S. unemployment rate was 9.1%.  Businesses around the U.S. are still making cutbacks and trying to find ways to pinch pennies.  For recent college graduates, it’s no wonder why many of them are looking to work abroad.  Many foreign countries, including Australia, boast better job opportunities for Americans.

Many Americans that come to live in Australia visit on a 12 month work and holiday visa.  Americans who are under 30 years of age, hold at least a High School Diploma and are in good health can apply for a subclass 452 work and holiday visa though the Australian Immigration website.

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The benefits of living in the Philippines can vary by the individual. I think that one the word that applies to most is “opportunities.”

I have a retirement annuity that would not go very far in the USA. I have much more full life by living in the Philippines. The cost of living in the Philippines can be substantially less than that of the USA. The cost of housing and services is significantly less in the Philippines. I rent a large four bedroom home. It is less than a mile from the beach, It cost under $300 a month. I have a live in nanny that cost me about $30 a month. A visit to the doctor cost me $12.00 or less for the office visit. I go out to eat at the BBQ with my girl for about $7.50. Also, travel cost in the Philippines is much less than that of the USA. US taxes are higher than the taxes in the Philippines.

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Just as U.S. citizens and residents who are employed abroad can take advantage of the foreign housing exclusion, self-employed expatriates may also benefit from the foreign housing deduction. While the words “exclusion” and “deduction” have similar connotations, they are different for the purposes of determining foreign earned income tax liability.

The main difference between the foreign housing exclusion and the foreign housing deduction is that the former must be employer-provided amounts while the latter requires the taxpayer to have self-employment income. Specifically, Code Sec. 911(c)(4) and Reg. §1.911-4(e) states that in lieu of the exclusion, self-employed expatriates are entitled to a lower gross income as a result of deducting certain foreign housing expenses. As defined in Reg. §1.911-4, “foreign housing expenses” are those reasonable expenses incurred or paid for the housing of the taxpayer and his family in a foreign country. The taxpayer’s spouse and dependents do not necessarily have to live with him if they will be safer in a second home due to adverse conditions near the taxpayer’s tax home.

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