PFICs Explained: A Practical Guide for U.S. Expats

What Is a PFIC? A Clear, Practical Explanation

A PFIC - Passive Foreign Investment Company - is generally defined under U.S. tax law as a non-U.S. corporation meeting one of two tests:

1. Income Test

At least 75% of the corporation’s gross income is passive.

2. Asset Test

At least 50% of the corporation’s assets produce (or are held to produce) passive income.

In practical terms, many foreign-domiciled pooled investment funds may meet one or both of these tests.

This includes products commonly used outside the U.S., such as:

• foreign mutual funds
• UCITS ETFs
• OEICs (UK funds)
• SICAVs (European funds)
• offshore pooled funds
• certain savings and insurance-based investment products
• local retirement schemes that invest in foreign pooled funds

Because these vehicles are designed for local markets, they typically do not provide the reporting required for U.S. taxpayers.

Important:

‍Not all foreign funds are PFICs, but many foreign-domiciled pooled investment products may fall within the PFIC rules.

PFIC classification depends on the underlying structure and the corporation’s income and assets. When uncertain, individuals often choose to review the investment’s domicile and reporting availability.

Why PFIC Rules Exist

PFIC rules were created as part of the Tax Reform Act of 1986. The IRS and Congress introduced these rules to ensure that U.S. taxpayers report income from certain foreign pooled investments in a manner consistent with U.S. tax policy.

The PFIC regime aims to prevent:

• tax deferral through foreign pooled structures,
• differences between U.S. and foreign mutual fund treatment, and
• long-term accumulation in structures not aligned with U.S. reporting standards.

As a result, PFIC tax treatment differs from the treatment applied to U.S.-domiciled funds.

How PFICs Are Taxed (Three Different Methods)

There are three primary tax methods that may apply to PFIC investments, depending on the fund’s structure and the elections made by the investor.

1. Default Method - Excess Distribution Regime

If no election is made, PFIC investments generally fall under the default regime, where:

• gains may be allocated across the holding period,
• tax may apply at rates higher than long-term capital gains,
• interest charges may apply to certain amounts,
• losses are treated differently from U.S. capital losses,
• annual reporting via Form 8621 may be required.

The default method can result in tax outcomes that differ significantly from U.S.-domiciled investments.

2. Mark-to-Market Election (MTM)

Available when the PFIC shares are publicly traded.

Under MTM:

• each year’s unrealised gain is taxed as ordinary income,
• certain losses may be deductible,
• annual Form 8621 reporting is still required.

This method avoids the default regime but results in annual taxable income based on fluctuations in market value.

3. Qualified Electing Fund (QEF) Election

A QEF election allows taxation based on the PFIC’s underlying income.

However:

• this requires the fund to provide an annual PFIC statement,
• many foreign funds do not supply this information.

Because of this, QEF elections may be difficult to implement.

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Why PFIC Treatment Can Be Challenging for U.S. Expats

PFIC classification can create outcomes that differ significantly from typical U.S. investment taxation, particularly in the areas of:

• tax timing,
• applicable tax rates,
• ability to use losses,
• required reporting (Form 8621),
• administrative requirements.

Foreign investment products are typically designed for local tax systems. As a result, they rarely provide the information required by U.S. rules. For this reason, individuals living abroad may review the PFIC status of foreign-domiciled funds before purchasing them.

Common Investments That May Be Treated as PFICs

Depending on structure, the following may require PFIC evaluation:

• UCITS ETFs (Europe)
• OEICs and unit trusts (UK)
• SICAV funds (EU)
• foreign index funds
• foreign mutual funds
• certain insurance-based savings plans
• offshore “portfolio bonds” holding foreign funds
• pooled investments inside certain local pension schemes

The determining factor is not the product’s purpose or marketing name, but whether it qualifies under PFIC income or asset tests.

Where PFIC Exposure Commonly Appears

U.S. expats may encounter PFIC-related issues when:

• opening local brokerage or investment accounts abroad,
• purchasing foreign pooled funds,
• investing through local banks or robo-advisers,
• participating in locally popular index funds,
• investing in foreign savings plans with underlying pooled funds,
• purchasing foreign pension products that hold offshore funds.

In many countries, these investment vehicles are entirely standard for local investors but may be treated differently under U.S. rules.

U.S.-Domiciled Alternatives to PFICs

Many U.S. citizens living abroad choose U.S.-domiciled investment products because they:

• avoid PFIC classification,
• follow U.S. tax rules familiar to domestic investors,
• integrate with U.S. brokerage platforms,
• are compatible with IRAs and Roth IRAs,
• simplify reporting and administration.

Examples of U.S.-domiciled alternatives include:

• U.S.-listed ETFs
• U.S. mutual funds
• U.S. equities
• U.S. fixed-income funds
• globally diversified U.S.-listed index funds

These products provide global exposure while remaining U.S.-compliant.

Currency Considerations for U.S. Expats

Even when using U.S.-domiciled investments, individuals living abroad may wish to consider how currency exposure affects long-term planning. This depends on:

• the currency in which income is earned,
• the currency of planned retirement spending,
• the currencies of major financial goals,
• expected relocation or repatriation.

For example:

• An individual earning in AED may measure future spending in USD or EUR.
• Someone living in the UK may have long-term liabilities in GBP.
• A mobile professional may require flexibility across multiple currency zones.

There is no single correct approach.
Considerations depend on individual circumstances and objectives.

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Interaction With U.S. Retirement Accounts

PFIC rules do not apply to investments held within certain U.S. retirement accounts such as:

• Traditional IRAs
• Roth IRAs
• 401(k)s
• Rollover IRAs

This is because U.S. retirement accounts are governed by U.S. tax rules and hold U.S.-domiciled investments.

Individuals considering purchasing foreign pooled funds outside these structures may review PFIC considerations before making decisions.

Illustrative Case Studies

The following examples are hypothetical and do not represent actual clients or outcomes.

Case Study 1 - Expat Living in the UAE

Situation:

‍An individual living in the UAE opens a local brokerage account and purchases UCITS ETFs, unaware of PFIC considerations.

Approach:

‍The individual reviews PFIC rules and evaluates whether U.S.-domiciled investments may offer simpler reporting.

Potential Considerations:

• understanding PFIC reporting requirements,
• potential differences in tax treatment,
• reviewing U.S.-domiciled alternatives.

Case Study 2 - Professional Living in Singapore

Situation:

‍A Singapore-based robo-adviser automatically invests into non-U.S.-domiciled ETFs.

Approach:

‍The individual reviews the U.S. tax implications and evaluates whether U.S.-domiciled ETFs may simplify their structure.

Case Study 3 - UK-Based Individual With an ISA

Situation:

‍An American living in the UK holds OEIC funds inside a stocks & shares ISA.

Approach:

‍The individual reviews whether those funds may meet PFIC criteria and explores U.S.-domiciled alternatives.

Case Study 4 - Globally Mobile Household

Situation:

‍A family with investments across multiple countries discovers that some holdings may require PFIC evaluation.

Approach:

‍The household reviews which investments fall under U.S. rules and considers consolidating into structures aligned with U.S. reporting.

Practical Checklist for Avoiding PFIC Surprises

How Skybound Wealth USA Supports Individuals

Skybound Wealth USA assists U.S. citizens and U.S.-connected individuals with:

• evaluating investment holdings for PFIC considerations,
• identifying U.S.-domiciled investment options,
• coordinating with tax professionals when needed,
• structuring globally diversified portfolios using U.S.-domiciled funds,
• integrating PFIC considerations with broader cross-border planning,
• reviewing local and long-term residency implications,
• ensuring coordination across retirement accounts, brokerage accounts, and multi-currency needs.

Conflict Disclosure:
As disclosed in our Form ADV, Skybound Wealth USA may receive compensation when individuals choose advisory services involving assets under management. Individuals should evaluate all options before making decisions.

Next Steps

If you would like to understand how PFIC rules may apply to your situation or review your current investment structure in the context of U.S. reporting requirements, you may schedule a discussion with Skybound Wealth USA.