By Raoul Rodriguez
If you are a US person1 you should avoid foreign mutual funds like the plague! After talking to clients about the reasoning behind this admonition, I often get calls or emails from the managers of Mexican financial institutions, bewildered and sometimes angry, asking why I would make such a recommendation. After all, these funds often show attractive performance numbers, and the institutions are following all Mexican rules and regulations. Let’s explore my reasoning.
From a Mexican perspective, and indeed from the perspective of most of the world, it is very strange to think that a Mexican resident would be simultaneously subject to the tax rules of a different country other than Mexico. But as you may know, tax authorities in the US apply income tax on US persons regardless of where in the world they live. What this means for a US taxpayer living in Mexico is that they need to follow all the US rules and regulations regarding taxation, as well as all the Mexican rules and regulations. As such, a great investment in a purely Mexican context might be a terrible investment from the US point of view once tax factors are considered.
All foreign mutual funds are considered Passive Foreign Investment Companies (PFICs) per rules that were first established in the US under the Tax Reform Act of 1986 and modified by the Tax Cuts and Jobs Act (TCJA) in 2017. The purpose of the PFIC rules was to attack the abusive use of foreign investment vehicles by relatively few US persons. As usual, the IRS used a very blunt instrument to squash the abusive use of foreign vehicles, leaving smaller investors holding the bag. PFICs are defined as any foreign entity where 75% of its income is derived from passive sources (such as interest, dividends, capital gains, rent, etc.) or a foreign entity where at least 50% of its assets are held to produce passive income. Mutual funds and Exchange Traded Funds are clearly PFICs. Certain entities, such as SA de CV or SRL in Mexico, can also be caught up on the PFIC trap, especially in a startup phase.
While most US persons will want to avoid PFICs, not everyone can. For example, pension systems around the world often use local investment vehicles for investment purposes. Participation in these programs is often not optional. If these accounts are invested in national mutual funds, these will be considered PFICs, and a US beneficiary is subject to US rules in this regard. This is the case of the Mexican pension system, where all employees in the country are required to have a retirement account, known as an AFORE.
The IRS has kindly provided three different alternatives on how these investments can be taxed.
The first is called the Default Method. It applies if you do not select either of the two other methods described below. Under the default method, “excess distributions” are taxed to the extent there are any. Excess distributions are defined as any distributions from the fund that exceeds 125% of the prior three-year average distributions, or any capital gain from the sale of the PFIC itself. To the extent that there are excess distributions, these will be taxed not at preferential capital gains rates, but at the highest marginal tax rate possible, currently 37%. What if there are no distributions or you decide not to sell the investment? Uncle Sam applies an interest rate penalty to any undistributed amounts, which compounds daily! Adding the taxes due on top of the interest penalties can easily result in burdens of over 50% of the distribution. Distributions that are not considered excess distributions are taxed at marginal tax rates.
The next method is called the Mark-to-Market (MTM) election. Here the value of the shares is reported each year on the US tax return and taxed, even if there are no distributions. If the value of shares increased from one year to the next, the difference is taxed at the taxpayers’ ordinary marginal rates. Losses are recognized only to the extent that gains have been reported in previous years. The fund value at the end of the year forms the starting point for next year’s calculation. When the security is eventually sold, any gain is taxed at marginal tax rates.
The final method is called the Qualified Electing Fund (QEF) election. This is the ideal way for the PFIC to be taxed, since it would receive similar treatment to that of a US fund. In this case, distributions are taxed at more favorable regular rates applicable to dividends and capital gains. Notably, however, tax also applies to undistributed interest, dividends and gains within the fund! In order to qualify, the foreign fund sponsor has to agree to follow all rules and regulations of US funds, and provide additional annual informational statements. Most foreign funds and entities are not prepared or refuse to comply with US tax laws.
Taxpayers with PFICS need to file Form 8621, calculating any taxes due per one of the methods described previously. The form is due, even if the taxpayer does not otherwise have a filing requirement. Form 8621 is often not even supported by traditional tax preparation companies, such as Turbo Tax, which can be frustrating if you prepare you own tax returns each year. About the only good thing I can say is that failure to file the form does not result in a stated penalty, but the statute of limitations will run indefinitely until the form is filed. What this means is that the IRS can come back and audit you at any time in the future and review the entire tax year and all pertinent forms. While failure to file the form itself does not result in a monetary penalty, it is very common that taxpayers that have a requirement to file Form 8621 may also be required to file other related forms, such as the Foreign Bank Account Report (FBAR) and/or Form 8938, the Statement of Specified Foreign Financial Assets. The penalty for failure to file an FBAR starts at close to US$13,000 per account in 20232 and US$10,000 for form 8938, per year. In egregious cases, failure to file these last two forms can also lead to criminal penalties.
Form 8621 does not need to be filed if you are filing single and have less than US$25,000 invested (US$50,000 if married filing joint) in foreign funds in the aggregate and you have received no distributions and have not elected to be treated under the MTM or QEF elections described above. However, the filing threshold does not exempt the fund from PFIC status, and you may need to file Form 8621 in the future.
How will the IRS find out that you have one or more of these foreign investments? Any accounts owned and registered to US taxpayers in Mexico have already been reported to the US Treasury Department per the FATCA agreement between the countries. If you own one of these, the US government likely already knows.
So what to do if you have an investment in a Mexican fund that has not been properly reported or not reported at all? You may want to talk with a CPA or attorney about taking advantage of the Offshore Voluntary Disclosure Program. Don’t take any action without discussing this matter with an experienced professional.
Better yet, do not ever invest in foreign mutual funds. If you are interested in investing in Mexico, purchase individual securities or buy a Mexico fund registered in the US.
1 US citizens, green card holders and US tax residents
2 The courts in the US have split on whether the penalty for applies on a per account or a per form basis. The US Supreme Court has taken un the case to provide a final answer in United States v. Bittner (No. 20-4059, 5th Cir. 11/30/21).
