Global Tax Forum: Tax Laws Make Foreign Funds a Bad Investment - TheStreet

Apparently, investors want to do business in their bathing suits.

U.S. citizens, in their continuing search for ways to get their money beyond the reach of the

Internal Revenue Service

and into some tropical foreign locale, inevitably will come across passive foreign investment companies.

Well, here's a travel tip: Stay away from them. The tax rules are so onerous that you might be left with little more than your swim trunks once the IRS is through with you.

"There is no benefit to a PFIC. This is something to avoid like the plague," warns Bruce Reynolds, an international tax-services partner at

Deloitte & Touche

in Washington.

PFICs once were a good way to get assets out of the U.S. and simultaneously defer paying any tax on gains until the money was withdrawn. But those benefits were stripped away in 1986, and for some reason, that news has yet to disseminate throughout the investment community. Though it's hard to quantify how many U.S. investors continue to put money in PFICs, tax experts say the problem continues to crop up 13 years after the law was changed.

What's a PFIC? For U.S. tax purposes, it's any foreign company that gets at least 75% of its gross income from passive activities or that gets passive income from at least 50% of its assets, according to the

Research Institute of America

, a tax-research group. Since a mutual fund generates passive income, a foreign mutual fund almost always qualifies as a PFIC.

U.S. expatriates are the likeliest to invest in PFICs, notes Reynolds. That's because people typically invest where they live. So if an American is stationed in a foreign country for a few years, odds are good that he will end up visiting a local broker. And the brokerage will try to sell him mutual funds, unaware of the burdensome U.S. tax laws.

"So we get a lot of expats coming back from their foreign assignments with a bag of investment problems," says Reynolds.

In addition, a growing number of U.S. residents believe there are serious problems with the economy and are looking at foreign mutual funds as a defensive measure, says Vernon Jacobs, editor of the newsletter,

Offshore Tax Strategies

, in Kansas City, Mo.

Three Ways to Tax PFICs

But U.S. tax laws exact a severe penalty to discourage any temptation to use PFICs as a tax dodge. A PFIC shareholder can choose to be taxed in one of three ways:

The excessive distribution method is the default. This method says you don't pay a dime until you sell out. Then your capital gains are taxed at the highest ordinary income rate, regardless of your income tax bracket. You also must assume that your gains are earned "ratably" over your investment years. (More on that below.) Even worse, you're smacked with a 9% to 10% interest charge, compounded annually, starting on the day you first invest.

Watch how ugly this gets. Let's say you invested $100,000 in a PFIC on Jan. 1, 1990 and sell out on Dec. 31, 1999. After meager returns for the first eight years, your nest egg rockets to $800,000 over the last two.

The tax laws require that you assume your $700,000 gain was generated in equal portions over the 10 years. So one-tenth was earned in 1990, one-tenth in 1991 and so on. For each year, you'll pay the highest tax rate, plus compounded interest on those gains as if you earned the money and avoided the tax in earlier years.

"It's the worst method of all," says Mark Merric, head of the tax and compliance department at

Engel Reiman & Lockwood

, an Englewood, Colo., law firm.

He calculated some effective tax rates for all this compounding and interest: If you put your money in a PFIC and leave it there for four years, you'll be taxed at a 46% effective tax rate. Leave the money for eight years, and the rate jumps to 56%. If you park your money in a PFIC for 15 years, you'll return 84% to Uncle Sam.

"It's the most punitive tax method of any in the tax code," says Merric.

The second tax computation option is a bit better. You can elect to "mark-to-market" your gains at year-end. That means that at the end of the year, you pay tax on the difference between the fair market value of your shares at the beginning and at the end of the year. Again, your gains and losses are taxed at the ordinary income tax rates, not the preferential capital gains rates. So gains have to be huge to make this method worth it.

The third option is the only way to avoid the tax entanglements described above.

You can elect to treat the PFIC as a "qualified electing fund." Tax jargon aside, this QEF election allows you to pay tax on your offshore mutual fund income just like it was a U.S. mutual fund. Each year, you'll pay the appropriate tax on your long-term capital gains, interest and dividends.

Of course, there's a catch.

To do this, the fund's management must keep two sets of accounting records: one for the local government and one for the U.S. tax system. Typically, foreign funds have no U.S. reporting requirements so "you'll find very few managers that want to do this for you," says Merric.

Complicated Tax Forms

Regardless of your option, IRS

Form 8621 --

Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund

-- must be filed by all U.S. citizens with PFIC investments. But it's so complicated that certified public accountants like Jacobs can make a good living just filling them out. He charges anywhere from $900 to $3,000 and passes the completed form on to the client's regular accountants. If you opt not to file this monster form, expect to pay a $10,000 fine.

Many PFICs require a $250,000 minimum investment, "so they're not for the $5,000 investor," says Merric.

"So before you jump into 'Dimitri's Mutual Fund,' educate yourself," says Bill Fleming, director of personal financial services for

PricewaterhouseCoopers

in Hartford, Conn.

And if you can't get the QEF election, then seriously consider bathing in a U.S. swimming pool.

Global Tax Forum aims to provide general tax information. It cannot and does not attempt to provide individual tax advice. All readers are urged to consult with an accountant as needed about their individual circumstances.