Brexit has sent economic tremors throughout the United Kingdom, with one symptom being the rapid fall in the value of the pound.
But what does this mean from a tax perspective for US expats living in the UK?
The more obvious implication is that the rise or fall of local currency typically has exchange gain or loss implications for US citizen taxpayers living abroad.
However, a more subtle tax opportunity actually arises with respect to UK investments that are treated as passive foreign investment companies (PFICs) for US income tax purposes, writes Joshua Ashman, partner at Expat Tax Professionals.
PFICs – a brief introduction
The PFIC rules can be nuanced and intricate, but a general understanding is important for US persons with foreign investments, because the tax implications of PFIC ownership can range from harmless to quite severe.
To start with a practical example, most foreign mutual funds are considered PFICs as a tax rule of thumb, even if held through a tax-deferred savings account.
Why is this the case?
In brief, a PFIC is defined as a non-US corporation for which either of the following holds true:
(i) At least 75% of the corporation’s income is considered “passive” (eg dividends or interest), or
(ii) At least 50% of its assets are passive-income producing assets (eg stock, loans, or cash). Foreign mutual funds, whether held directly or indirectly, often fall within this definition.
PFICs – Tax Implications
A US person that holds any percentage interest in a PFIC, even a very small percentage, is potentially subject to the PFIC regime.
Under default rules, both investment income in the form of distributions from a PFIC and gain from the sale of a PFIC can be subject to highly punitive US federal tax rates, namely the highest marginal tax rate that can be imposed on an individual taxpayer (currently 37%), regardless of whether lower capital gains tax rates would otherwise apply.
Furthermore, the default rules impose a significant (and non-deductible) penalty interest charge, which compounds regularly while holding the PFIC.
Two PFIC elections
Two elections are available to reduce the otherwise severe outcome under the default rules.
First, a Qualified Electing Fund (QEF) election allows shareholders to include in gross income the pro rata share of earnings of the QEF and include as long-term capital gain the pro rata share of net capital gain of the PFIC.
If this election is made, the punitive tax rates and interest charge are not imposed.
In order to make this election, a shareholder must have received a PFIC Annual Information Statement from the PFIC, a process which is often difficult or impractical.
Second, a Mark-to-Market (MTM) election allows shareholders to include each year as ordinary income, the excess of the fair market value of their PFIC stock as of the close of the tax year over its adjusted basis in the shareholder’s books (typically, the purchase price).
If this election is made, the punitive tax rates and interest charge are also not imposed.
The MTM election is generally available only with respect to marketable securities, but since many PFIC investments consist of marketable securities, the MTM election is more accessible than the QEF election.
Timing matters
Ideally, a PFIC holder should make a MTM election for the first year of PFIC ownership in order to avoid the default rules altogether. Many US expat investors, however, unfortunately realise they have a PFIC issue years into their investments.
A PFIC holder can transition from the default regime to the MTM regime by making an election for the current year, with the following consequence: The default rules apply in the first year of the MTM election and the MTM rules only kick in the following year.
Further, in the first year, the PFIC holder must treat the excess of the year-end fair market value over the basis in the PFIC as gain from a deemed sale of the PFIC subject to the default rules (ie the highest rates apply and a penalty interest charge is imposed).
The fall of the pound
Getting back to the basics for a moment, all US citizens, even expats, are treated for US tax purposes as using the US dollar as their “functional currency” for all monetary transactions, including those involving foreign investments.
This is what triggers exchange gain and loss for US taxpayers.
As such, if the value of a PFIC has appreciated over the years, due to the fall in the value of the pound, the US dollar value of the PFIC investment may have actually decreased (or at least hasn’t increased significantly).
The deemed PFIC sale resulting from the late MTM election should therefore have little to no adverse tax consequences, because there should be little to no excess (of fair market value of the PFIC over its adjusted basis) that can be taxed under the default rules.
Given the above, US expats with UK investments (mutual funds or similar) should take time to consider whether the current economic environment provides an opportunity to limit any adverse PFIC implications.
This can have significant positive consequences by making PFIC ownership much less of a tax liability moving forward.
This article was written for International Adviser by Joshua Ashman, parter at Expat Tax Professionals, a firm specialising in the needs of US citizens living abroad. He spent the majority of his career at PwC and Ernst & Young (EY).
