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IGHLANDS, NORTH CAROLINA
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Foreign Mutual Funds

"Invest in our high-flying offshore mutual funds tax-free!  Pay no tax until you repatriate your profits back to the U.S.!!"

Such are the familiar cries of many offshore investment advisers.  Each year, many U.S. investors fall for these pitches and invest in foreign mutual funds, usually filtering the invested funds through an offshore company, typically an IBC or LLC, specifically established for the purpose of investing in foreign mutual funds.  Other U.S. investors who may own foreign mutual fund shares for non-tax reasons are U.S. expatriates who simply bought shares from a local foreign broker and U.S. resident aliens who have moved to the U.S. and still own the portfolio of foreign mutual fund shares they owned at home.

While no tax may be payable in the fund's jurisdiction, U.S. taxes are payable if the owner of the fund is:

What the SEC Rules Really Say

Furthermore, the reason given for using the IBC or LLC as the owner is that the use of a foreign entity is necessary to avoid SEC rules and state securities laws regarding the sale of securities which are not registered in the U.S.  It is generally true that a foreign entity is not a 'U.S. person' under SEC rules.  However, if a foreign entity is owned by U.S. persons and if the foreign entity was formed principally for the purpose of investing in unregistered securities, SEC rules treat the foreign entity as a U.S. person, thus subjecting advisers who market and sell unregistered securities to SEC sanctions if any activity related to the marketing and sale of such securities takes place in the U.S.  Failure to meet SEC muster in this regard will not cause problems for the investor, although the mutual fund will likely redeem any shares deemed to be held by U.S. persons.

Taxation of Foreign Mutual Fund Shares

Foreign mutual funds are treated under the Internal Revenue Code as "passive foreign investment companies" (PFICs).  While foreign mutual funds used to offer tax deferral benefits to U.S. investors, that has not been the case since 1986.  Foreign mutual funds offer no tax benefits to U.S. investors.  Technically speaking, a PFIC is any foreign company that derives at least 75% of its gross income from passive activities or that derives passive income from at least 50% of its assets.  Nearly all of the income of a mutual fund is generally passive income.  So, nearly all foreign mutual funds are PFICs.

So, how are PFICs taxed?  There are three alternatives from which a taxpayer may choose.

Excess Distributions Method.  First, the default method (i.e., the method used unless one of the alternatives is affirmatively elected) is the excess distributions method.  At first glance it sounds good because the basic premise is that you pay no tax until you cash out.  The devil is in the details.  First, when tax is paid, all income and gains are taxed at the highest ordinary income rate (presently 39.6%).  There is no long-term capital gains treatment.  Second, you have to assume that all of the gains are earned ratably over the time the investment was held -- even if the fund lost money the first few years and only made its gains in the last year when you cashed out.   Why is that bad?  Because of the third part of the triple whammy - interest charges, compounded annually.  Annually compounded interest at a rate of 9% to 10% is charged on deferred tax.  The results can be ugly.  Consider this example:

$100,000 is invested in foreign mutual fund (PFIC) shares on 1/1/1995.  The fund performs poorly from 1995 to 2001, but does phenomenally well from 2002 to 2004, growing to $500,000 by the time the shares are redeemed on 12/31/2004.  The rule requiring the assumption of ratable returns will force you to assume that the $400,000 gain was earned one-tenth in 1995, one-tenth in 1996, etc.  For each year, tax is calculated at the highest tax rate with interest calculated on the deferred tax and compounded annually.  The result would be an effective tax rate of about 69% on redemption after 10 years.  69% of the $400,000 gain -- about $277,000 -- would be lost to tax.  The much-touted power of compounding obviously works in the government's favor here.

Mark-to-Market Method.  This new method, added to the Internal Revenue Code in 1997, allows an owner of PFIC shares to mark gains to market at year end.  In other words, you pay tax on the difference between the fair market value of the shares at the beginning of the year and the fair market value of the shares at the end of the year, and you start fresh each January 1st.  Gains and losses are ordinary, not capital, so while this method is relatively simply to use and less punitive than the excess distributions method, it's no great deal.  There are requirements that must be met by the fund in order for a shareholder to make a mark-to-market election, two of the most important of which are that fund prices must be readily available (e.g., from the Financial Times, etc.) and that the fund cannot require a minimum investment of more than $10,000.

Qualified Electing Fund Method.  If the PFIC meets certain accounting and reporting requirements, a PFIC shareholder can elect to treat the PFIC as a qualified electing fund.  The effect is that the PFIC shares are taxed like U.S. shares.  So, a foreign mutual fund treated as a QEF is taxed just like a U.S. mutual fund.  Sounds like a good deal.  Why doesn't everyone make a QEF election for foreign mutual fund shares?

The reason that few investors make QEF elections for foreign mutual fund shares is that it is impossible to do so in most cases. Foreign mutual funds, even those that are essentially offshore clones of U.S. funds, simply do not keep U.S. books and tax records and provide U.S. tax information to their shareholders, which is a requirement for making the QEF election.  I don't know of any publicly traded foreign mutual funds that keep records that allow shareholders to make a QEF election for U.S. tax purposes (If any reader knows of any such funds, please let me know at criser@mayer-riser.com).

Whichever of the foregoing three methods is chosen, an IRS Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, must be filed.  If you are a do-it-yourself filer, be prepared to spend a good deal of time working through the Form 8621 instructions to learn how to complete it properly.  If you use a CPA, be prepared to spend a good deal of money while your CPA learns how to complete it properly.  Whatever you do, be sure it is filed.  Failure to file the 8621 when required to do so can result in a $10,000 fine.

The bottom line?  Don't believe any foreign investment adviser regarding the U.S. tax consequences of any investment.  Know the consequences of investing in foreign mutual funds before you invest by getting tax advice from a qualified U.S. tax practitioner.

For more information, contact Chris Riser at criser@mayer-riser.com or by telephone at (828) 526-3731.


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