US expat investing: PFIC tax on ISAs, PEAs and local funds

How does the US tax a US citizen's investments abroad?

The US taxes a citizen's interest, dividends and gains the same way wherever the citizen lives and wherever the account is, and green card holders generally the same way. A local tax break does not carry over to the US return, and investment income is never foreign earned income (IRS Publication 54). What changes the US tax most is the legal form of each holding: a pooled fund organized outside the US is usually a passive foreign investment company (PFIC), while most single company shares, deposits and US-domiciled funds follow the normal rules.

A case stops being simple when you hold several foreign funds (each one needs its own Form 8621), when you sold or switched funds in years you never reported, when you must decide on a PFIC election that is hard to reverse, or when a wrapper might be a foreign trust. Two countries tax the same income, so the choice of holding can also change your local tax.

Gather before you or a preparer start:

• Each account's year-end statement and its highest balance during the year, in the original currency
• For every fund: its name, country of organization, the prospectus or key information document, purchase and sale dates, costs and distributions
• Dividend and interest statements showing foreign tax withheld
• The account terms for any tax-free wrapper (ISA, Junior ISA, PEA or similar)
• The exchange rates you used to convert each amount to US dollars
• Prior US returns, including any Forms 8621, 8938 and FBARs already filed

Which investments abroad bring the PFIC rules?

A foreign fund treated as a corporation for US tax is usually a PFIC, and most foreign funds whose investors have limited liability are treated that way by default, even when organized as a trust whose manager can change its investments or as a contractual fund (26 CFR 301.7701-4; 26 CFR 301.7701-3); a bank deposit, a bond, a single share in an operating company and a US-domiciled fund usually are not. A foreign corporation is a PFIC if 75% or more of its gross income is passive, or at least 50% of its assets produce or are held for passive income (26 U.S.C. 1297). A pooled investment fund meets those tests almost by design.

Under the default rules, a gain on selling a PFIC is spread over every day you held it. The part that falls in the year of sale is ordinary income; the parts that fall in earlier years are taxed at the highest rate for each of those years, plus an interest charge, with no capital gains rate. An unusually large payout (an excess distribution) is taxed the same way (26 U.S.C. 1291). A US person who owns a PFIC through a US IRA or another US tax-exempt account listed in the Form 8621 instructions is not treated as its shareholder. A foreign tax-free account is not on that list.

What a PFIC is, when Form 8621 is due and the small-holding exception are explained in foreign funds on a US return. Whether a particular product is a PFIC, and how to fix missed years, is in Form 8621 filing and missed years. A QEF or mark-to-market election can replace the default rules; the shareholder makes it on Form 8621 by the return's due date, including extensions, for the first year it applies (Form 8621 instructions). Details are in QEF and mark-to-market elections.

Does a stocks and shares ISA, Junior ISA or PEA keep its tax break on a US return?

Generally no. The US usually taxes the income and gains inside a local tax-free account as if you held the investments directly, even if the other country sends no tax form. What is inside decides the PFIC question: a foreign fund or ETF inside the wrapper is still a PFIC, while cash and shares of a single operating company follow the normal rules. A listed company that mainly holds investments, such as an investment trust, is a PFIC like any fund (26 U.S.C. 1297). The wrapper's exemption comes from the other country's law, and US tax treaties let the US tax its own citizens as if the treaty did not exist, except for listed articles (IRS Publication 54).

A treaty helps only where an article the treaty keeps outside its saving clause covers the arrangement. In the US–UK treaty, the saving clause in Article 1(4) gives way to Article 18(1) on pension schemes (US–UK treaty). Article 3(1)(o) defines a pension scheme as an arrangement generally exempt from tax and operated principally to provide pension or retirement benefits. A savings account that is not run principally for retirement falls outside that relief. Other treaties have their own wording; read the one for your country.

Whether a wrapper is itself a foreign trust, which would bring Forms 3520 and 3520-A, depends on how it is set up under local law. Revenue Procedure 2020-17 removes that Form 3520 reporting only for certain tax-favored foreign retirement trusts and for medical, disability or education savings trusts that meet its limits, and only for a person who has reported the trust's income on US returns; it does not change how their income is taxed. For other wrappers, including most ISAs and PEAs, the answer depends on the account terms and is unsettled.

A local tax-free account is also a foreign account for the FBAR and Form 8938; see which accounts count on the FBAR. For a TFSA or FHSA in Canada, see TFSA and FHSA for US citizens.

Do the foreign earned income exclusion and the foreign tax credit cover investment income?

The foreign earned income exclusion never covers investment income; the foreign tax credit can. The exclusion applies only to pay for work done abroad, and the IRS says investment income is not earned income but must still be reported in full (IRS Publication 54).

Foreign income tax withheld on your dividends and interest can be claimed as a credit, but only the tax you actually owe: tax withheld above a treaty rate, which you could get refunded, does not count, and tax withheld on a dividend earns no credit unless you held the share at least 16 days in the 31-day period that starts 15 days before the ex-dividend date (Form 1116 instructions). Investment income generally goes in the passive category, on its own Form 1116, separate from wages; passive income taxed abroad above the highest US rate moves to another category (Form 1116 instructions). Why the credit can come out smaller than the tax paid, and how carryovers work, is in foreign tax credit limits and carryovers.

The net investment income tax of 3.8% applies to US citizens abroad; it does not apply to nonresident aliens (26 U.S.C. 1411). It starts when modified adjusted gross income passes $200,000 for a single filer or head of household, $250,000 on a joint return ($250,000 for a qualifying surviving spouse), or $125,000 when married filing separately. Pay excluded under the foreign earned income exclusion is added back to that income figure (Form 8960 instructions). Whether the foreign tax credit reduces this tax is covered in foreign income on a US return.

Are dividends from foreign companies taxed at the lower qualified-dividend rates?

They can be, if the company is a qualified foreign corporation and you meet the holding period. Qualified dividends are taxed at the long-term capital gain rates of 0%, 15% or 20% (IRS Publication 550).

A foreign company is a qualified foreign corporation if any one of these holds (26 U.S.C. 1(h)(11)(C)):

A company that was a PFIC in the year of the dividend or the year before is never a qualified foreign corporation, so payouts from a foreign fund that is a PFIC are taxed as ordinary income. A company in a country without a listed treaty can pay qualified dividends only on shares that trade on a US exchange. You must also have held the share for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (IRS Publication 550).

Does a tax treaty protect my investments from US tax?

Usually not. US tax treaties contain a saving clause that lets the US tax its citizens as if the treaty did not exist (IRS Publication 54). The exceptions listed in the US–UK treaty, for example, include relief from double taxation, non-discrimination, mutual agreement and certain pension rules, not a citizen's ordinary savings and funds (US–UK treaty, Article 1(4)–(5)).

The exception that matters most for investment income is the relief-from-double-taxation article, which works alongside the foreign tax credit. Because of the saving clause, a treaty rarely changes the PFIC result for a fund held in a local account; check the articles of your own country's treaty.

Does keeping a US brokerage account while living abroad change my US tax or reporting?

A US brokerage account is taxed under the normal US rules and reported to you on Form 1099. US-domiciled funds in it are not PFICs. Accounts maintained by a US financial institution are not reported on Form 8938 (Form 8938 instructions), and the FBAR covers only accounts in a foreign country (IRS Publication 54).

Two traps. A foreign branch of a US financial institution is a foreign account for the FBAR, though not for Form 8938 (IRS comparison chart). And if a US payer withholds 30% from your dividends because of your foreign address, a US citizen can give the payer Form W-9; tax withheld in error that the payer does not refund can be claimed as a credit on your return (IRS Publication 54).

The country you live in may tax US-domiciled funds differently, sometimes heavily. That is a question of local law, to check under that country's rules.

What does each kind of holding add to my US return every year?

Each holding adds its income to Form 1040, and foreign accounts add the account reports. The table shows the usual filings; FBAR is due when your foreign accounts together pass $10,000 at any time in the year, and Form 8938 for a single filer who lives abroad (a bona fide resident of another country for a full tax year, or abroad at least 330 full days in 12 months) when foreign assets pass $200,000 at year-end or $300,000 at any time ($400,000 and $600,000 on a joint return) (Form 8938 instructions).

A fund reported on a timely Form 8621 does not need to be listed again on Form 8938, but Form 8938 must say how many Forms 8621 you filed, and the value of those funds still counts toward the Form 8938 threshold (Form 8938 instructions). Which accounts belong on the FBAR is covered in which accounts count.

Example

These are illustrative cases with round numbers, in the currency each one names.

A UK stocks and shares ISA with one fund

A US–UK dual citizen in London, filing as single, holds £20,000 in a stocks and shares ISA invested in one index fund organized in Ireland and treated as a corporation for US tax. The UK does not tax the ISA. On the US return that exemption does not carry over, and the fund is a PFIC.

• Years 1 to 4: the fund pays nothing out, but £20,000 converts to more than $25,000, so the small-holding exception does not apply and Form 8621 is due each year ($50,000 on a joint return).
• Year 5: the fund is sold for £28,000, an £8,000 gain in pounds. On the US return the gain is the dollar value at sale less the dollar cost at purchase, so it can be larger or smaller. With no election, about one fifth of the gain is ordinary income in Year 5. The other four fifths are taxed at the highest rate for Years 1 to 4, plus interest, even though the UK charged nothing. Form 8621 is due for Year 5 because of the sale.

Single shares at a broker in Spain

A US citizen in Spain holds €50,000 of shares in five listed European operating companies at a Spanish broker and receives €1,500 of dividends with €300 of Spanish tax withheld. If none of the companies meets a PFIC test, there is no Form 8621. The dividends can be qualified if each company is eligible for a listed treaty and the holding period is met. The €300 can be claimed as a foreign tax credit in the passive category, to the extent it is tax actually owed and not refundable under a treaty. The account is over the FBAR threshold; Form 8938 depends on the total of all foreign assets.

A US brokerage account from Germany

A US citizen in Germany keeps US$80,000 in US-listed index funds at a US brokerage account. The funds are not PFICs, the income comes on a normal Form 1099, and because the account is at a US institution, it is not a foreign account for the FBAR or Form 8938. How Germany taxes those funds is a German question to check separately.

Different for you?

• You hold several foreign funds, or sold some in years you never reported: see Form 8621 filing and missed years and get cross-border tax help.
• You are deciding on a QEF or mark-to-market election: see PFIC elections; a late or wrong election is hard to undo, so have it reviewed through cross-border tax help.
• You never reported your investment income while abroad: see the Streamlined Foreign Offshore Procedures.
• Your savings are in a pension, provident or retirement scheme abroad: see foreign pension reporting.
• You hold a life insurance or capitalisation contract sold as savings: see insurance policies bought abroad.
• You live in Canada with a TFSA or FHSA: see TFSA and FHSA for US citizens.
• You want to contribute to an IRA while using the exclusion: see exclusion or foreign tax credit.
• Your foreign tax credit is smaller than the tax you paid: see foreign tax credit limits and carryovers.
• You are moving to the US with foreign funds: see PFIC rules when moving to the US.