To the IRS, your ETF is a PFIC: what Form 8621 requires

Across Europe, a monthly ETF savings plan is seen as the most sensible way to build wealth. For US citizens and green card holders, the tax picture is different. US law has its own category for foreign funds, the Passive Foreign Investment Company, or PFIC, and deliberately treats them differently from American funds. This page explains why European funds fall into that category, what the three taxation regimes mean, when Form 8621 is due and how your country of residence taxes the same funds at the same time. It does not replace an investment decision. It explains the tax, so you can make that decision with your eyes open.

1Why the IRS treats an ETF as a corporation

The law defines a PFIC in 26 U.S.C. § 1297. A foreign corporation is a PFIC if it meets either of two tests. The income test: at least 75 percent of its gross income for the year is passive income. The asset test: on average over the year, at least 50 percent of its assets produce passive income or are held to produce it. For what counts as passive, the law refers to the rules in § 954(c), which list first of all dividends, interest, royalties, rents and annuities, plus gains from selling property that produces such income.

That is exactly what an index fund is made of. It holds stocks or bonds, collects dividends and interest and realizes capital gains. The remaining question is whether the fund is a corporation for US purposes at all. The classification rules in 26 CFR § 301.7701-3 treat a foreign entity whose members all have limited liability as a corporation, unless it elects otherwise. Investors in a fund are not liable beyond what they put in. For most funds sold in Europe, that makes them PFICs. For certain fund types, such as contractual funds without legal personality, the classification still needs to be checked.

This affects everyone who is fully taxable in the US: US citizens, green card holders and dual citizens, even if they have never lived in the US. Who falls into that group is explained under US tax obligations for Americans living in Europe.

2Which investments are affected and which are not

As a rule, this covers exchange-traded index funds, actively managed retail funds, money market funds and bond funds domiciled outside the US. Where the fund is managed or sold makes no difference. What matters is that it is a foreign entity under the law it was formed under.

If a fund itself holds shares in other foreign funds, you get a chain. The instructions for Form 8621 then generally require a separate form for each PFIC in the chain, including the ones held indirectly.

Individual shares in companies that earn mainly from their operating business are usually not affected. An industrial company or a retail group normally fails the tests, because its income and assets are mostly active. Funds set up in the US are not affected either: a PFIC has to be a foreign corporation. How you can access such funds as a US citizen in Europe, and which brokerage accounts are an option, is covered under Brokerage accounts and investing as a US citizen in Europe.

There is one exception for retirement savings. If you hold fund shares through an arrangement recognized as a foreign pension fund under a tax treaty, Part I of Form 8621 may not be required under Regulations § 1.1298-1(c)(4). Whether your home country's pension product qualifies depends on the relevant treaty.

3The default rule: excess distributions under § 1291

If you make no election, § 1291 applies. It does not tax you year by year, only when money flows. But it is harsh. Two events trigger it.

The first is an excess distribution. That is the part of a distribution that exceeds 125 percent of the average distributions of the three previous years, or of the shorter holding period if you have held the shares for less time. Steady payouts from a distributing fund usually stay below that and are taxed normally in the year you receive them. A jump in the payout goes above it.

The second is a sale. Any gain from selling PFIC shares is treated under § 1291(a)(2) as if it were an excess distribution. That means no long-term capital gains rate applies to it.

Here is how the calculation works. The amount is spread evenly over every day of your holding period. The portion that falls in the current year and in periods before the fund became a PFIC is taxed as ordinary income. The portion that falls in earlier years is taxed at the highest rate for each of those years, and interest is added to that tax at the rates for tax underpayments, running from the due date of each year to the due date of the year of sale. With an accumulating fund held for many years and then sold, the interest charge builds up over the entire holding period.

4The QEF election: pay as you go instead of catching up later

With the election under § 1295, you treat the fund as a Qualified Electing Fund. You then pay tax every year on your share of the fund's ordinary earnings and net capital gain, whether distributed or not, and the § 1291 interest charge no longer applies.

The election has a requirement that is out of your hands. The fund has to provide you with a PFIC Annual Information Statement for each year, showing your share of earnings and capital gain or the information you need to calculate it. If the fund does not provide this statement, the QEF election is not available. So before you rely on this election, check whether the fund issues such a statement.

5The mark-to-market election for exchange-traded funds

The third regime is in § 1296. It only applies to marketable shares, meaning shares regularly traded on a recognized exchange. According to the instructions for Form 8621, this includes foreign exchanges regulated or supervised by a government authority that meet the criteria in the Regulations.

With this election, you pay tax every year on the increase in value up to year end, as if you had sold. That amount is ordinary income, and so is any later gain on sale. If the value falls, you can only deduct the loss up to the gains you have already taxed under this election in earlier years. For exchange-traded ETFs this election is an option because it needs no statement from the fund. The trade-off: the increase in value is taxed at ordinary rates every year, even without a sale.

6Form 8621: when you file it

The instructions for Form 8621 list five situations in which a direct or indirect PFIC shareholder files the form: receiving certain distributions, realizing a gain on a sale, reporting information on a QEF or mark-to-market election, making an election reported in Part II, and being required to file annually under § 1298(f). The form is filed per PFIC and attached to your tax return, due with it, including extensions.

Small holdings get some relief. If the total value of all your PFIC shares on the last day of the tax year is $25,000 or less ($50,000 if filing jointly), Part I is not required for a § 1291 fund, as long as you have neither received an excess distribution from that fund nor sold shares at a gain. For indirectly held shares, a separate limit of $5,000 per fund applies.

One consequence is easy to miss. Under § 6501(c)(8), the statute of limitations for a tax return missing information required under § 1298(f) does not end until three years after the IRS receives that information. A missing Form 8621 keeps the return open. The fund also counts as a foreign asset for account and asset reporting; the rules are covered under FBAR: reporting foreign accounts and FATCA in Europe.

7The European side: same funds, different rules

While the US treats the fund as a PFIC, your country of residence taxes it under its own law, often before you have sold anything.

In Switzerland, under Circular No. 25 of the Swiss Federal Tax Administration, the retained income of an accumulating fund is attributed to the investor as taxable investment income at the time it is booked by the fund.

What this means for you: the European tax and the US tax fall due at different times and are charged on different amounts. Whether, and in which year, the European tax can be credited against your US tax therefore belongs in a joint calculation covering both returns. How a tax treaty handles the credit is explained under US double tax treaties.

8Existing funds and catching up on past years

Many Americans in Europe only learn about the PFIC rules once their savings plan has been running for years. Then it comes down to two questions. First: which rule applies to the shares you already hold? Without an earlier election, it is Section 1291. How a later election interacts with the years you have already held the shares is part of reviewing your holdings. Second: which forms are missing for past years?

For missing forms together with missing returns, there are the Streamlined Filing Compliance Procedures. The IRS expressly lists Form 8621 among the information returns filed under these procedures. How they work is explained under Streamlined Procedures explained. If you filed your returns and only forgot the forms, the IRS page on the Delinquent International Information Return Submission Procedures describes how to submit late information returns with an amended return.

For new investments, it pays to look before you buy. Mount Bonnell Advisors does not name providers or recommend products. But once you know the tax consequences of each option, you can decide with your investment adviser whether a fund, an individual stock or a US-domiciled fund fits your portfolio.

In short

• A foreign corporation is a PFIC if at least 75% of its gross income is passive or at least 50% of its assets produce passive income. European investment funds typically meet these tests.
• Without an election, Section 1291 applies: distributions above 125% of the three-year average and every gain on sale are spread over the holding period, taxed at the highest rate for each year and charged interest.
• The QEF election requires a PFIC Annual Information Statement from the fund; the mark-to-market election requires marketable shares.
• Form 8621 is due for each fund if one of the five situations in the instructions applies. Up to $25,000 ($50,000 for joint filers), Part I may be omitted for Section 1291 funds.
• If a required Form 8621 is missing, the statute of limitations on the affected return does not run out.

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