The Tax Consideration You May be Overlooking

PFIC, ETFs and Mutual Funds

Tax considerations are beginning to take center stage for investors and financial advisor as we approach year end. Capital gains management and tax loss harvesting are common topics of conversation, but there is a unique and often overlooked tax consideration for many U.S. investors: passive foreign investment company (PFIC) income.

What is a PFIC?

A PFIC is a foreign corporation having 50% or more of their assets invested in cash or securities, or having 75% or more of their gross income originating from passive sources, including but not limited to interest, dividends and rents. In other words, these foreign companies primarily derive their revenue streams from investments (rather than operations).

Generally speaking, foreign companies that are in start-up mode or investing heavily in early stage projects may be considered a PFIC.

How do PFICs Impact Investors?

Under U.S. tax code, income and gains associated with PFICs are not eligible for advantageous capital gains or qualified dividend income treatment. This means that income and gains from PFIC investments are subject to ordinary income rates. Moreover, PFIC gains cannot be offset by losses.

The tax requirements of owning individual PFICs can differ from owning a mutual fund or exchange-traded fund (ETF) that holds PFICs. Owning individual PFICs may require an annual election and subject shareholders to complicated tax scenarios. Most mutual funds and ETFs that hold PFICs will pass through income and, often more impactful, mark-to-market unrealized gains of those PFICs and distribute them to shareholders in the form of ordinary income.

In other words, mutual funds and ETFs must assess their PFIC exposure and raise cash in order to distribute any applicable gain or income for the tax year to investors. If shareholders reinvest dividends paid from PFIC gains in additional fund shares, their cost basis in those shares is equal to the dividend they include in income. If they receive the dividend in cash, their cost basis is not impacted. Bottom line is that shareholders must treat dividends from PFIC income and gains as ordinary income taxable at their maximum tax rate.

How Common are Mutual Fund and ETF PFIC Income Distributions?

PFIC income distributions are more common than many investors realize. Broad-based funds that offer exposure to foreign companies often pay PFIC distributions but, because many tend to be concentrated in larger, revenue-generating companies, PFIC exposure tends to be small. In turn, PFIC income distributions tend to be a small percentage of those funds’ annual distributions.

Some areas of the equity market are more prone to PFIC tax treatment. Commodity producers, for example, often begin as exploratory companies and are considered a more speculative investments. There are many gold miners that invest heavily in locating gold and/or beginning the extraction process but do not yet generate revenue from the production of gold. Furthermore, many gold reserves are located around the world and therefore funds that invest in these “junior” gold miners may have significant exposure to PFICs.

Market performance also impacts PFIC tax treatment. Because funds mark-to-market unrealized gains of PFICs annually in order to distribute as income to shareholders, those funds with significant exposure to PFICs in a strong performing market may be required to distribute a significant amount of income to shareholders.

How Can Investors Plan for PFIC Income Distributions?

It is difficult to estimate PFIC exposure in a mutual fund or ETF. Funds work closely with auditors and tax accountants to determine PFIC exposure and issue distributions each year. But many investors may not learn of a PFIC income distribution until they are announced. Because of the complexity of this area of tax code, it is important to consult your tax advisor.