On Warren Buffett, Berkshire Hathaway and PFICs

We have spoken before about passive foreign investment companies, or PFICs (pronounced pea-fick). There was a time when I saw these on a regular basis, and I remember wondering why the IRS made the rules so complicated.

I am thinking about PFICs because yesterday I read a release for IRS Notice 2014-28. The IRS is amending Regulations concerning the tax consequences of U.S. persons owning a passive foreign investment company through an account or organization which is tax-exempt. Think a hospital, pension plan or IRA, for example. 

Granted, this is not as interesting as Game of Thrones or Sons of Anarchy.

Could you walk unknowingly into a PFIC? It is not likely for the average person, but it is not as difficult as you might think.

PFICs came into the tax Code in 1986. They were intended to address what Congress saw as a loophole. I agree that there was a loophole, but whether the tax fly required the sledgehammer response it received is debatable.

There were a couple of ways to get to the loophole. One way would be to form a foreign corporation and have the corporation invest in stocks and bonds. This means you are forming a foreign mutual fund. There are a couple of issues with this, the key one being that it would require a large number of investors in order to avoid the rules for a controlled foreign corporation. To the extent that 10%-or-more U.S. shareholders owned more than 50% of the foreign corporation, for example, one would have a controlled foreign corporation (CFC) and would be back into the orbit of U.S. taxation.

The second way is to invest in an existing foreign mutual fund. Say that you invested in a German fund sponsored by Deutsche Bank, for example.

And the average person would say: so what? You invested in mutual fund.

Here s what the IRS did not like: the mutual fund could skirt the taxman by not paying dividends or distributions.  The value of the fund would increase, as it would accumulate its earnings.  When you sold that foreign mutual fund, you would have capital gains and you would pay U.S. tax.

Well, the IRS was unhappy with that, as you did not pay tax on dividends every year and, when you did pay, you paid capital gains rather than ordinary income tax. How dare you?

Why the sarcasm? Because you can get the same tax result from owning Berkshire Hathaway. Warren Buffet does not pay a dividend, and never has. You hold onto your shares for a few years and pay capital gains tax when you sell. The IRS never receives its tax on annual dividends, and you pay capital gains rather than ordinary tax on the sale.

Why the difference between the Berkshire Hathaway and Deutsche Bank? Exactly my point. Why is there a difference?

So we have PFIC taxation. Its sole purpose is to deny the deferral of tax to Americans investing in foreign mutual funds.

There are three ways to tax a PFIC.

The default scheme is found in Code Section 1291. You are allowed to defer taxation on a PFIC until the PFIC makes an “excess” distribution. An excess distribution is defined as one of two events:

(1)   The PFIC distributes an amount in excess of 125% of the average distribution for its preceding three years; or

(2)   You sell the PFIC stock.

Let’s say that we use the default taxation on the PFIC. What does your preparer (say me) have to do next?

(1)   I have to calculate your additional tax per year had the distribution been equally paid over the period you owned it (this part is relatively easy: it is the highest tax rate for that year); and

(2)   I have to calculate interest on the above annual tax amounts.

You can imagine my thrill in anticipation of this magical, career-fulfilling tax opportunity. There are severe biases in this calculation, such as presuming that any income or gain was earned pro rata over your holding period. I have seen calculations where - using 15 to 20 year holding periods - the tax and interest charge can approach 100%. This is not taxation. This is theft.

The second option is to annually calculate a "mark to market" on the PFIC. This works if there is a published trading or exchange price. You subtract the beginning-of-year value from the end-of-year value and pay tax on it. I have never seen a tax professional use this option, and frankly it strikes me as tax madness. With extremely limited exceptions, the tax Code does not consider asset appreciation to be an adequate trigger to impose tax. There would be no 401(k) industry, for example, if the IRS taxed 401(k)s like they tax PFICs.

The third option is what almost everyone does, assuming they recognize they have a PFIC and make the necessary election to be taxed as a “qualified election fund,” or QEF for short.

   OBSERVATION: Tax practitioners like their acronyms, as you can see.

There are two very important factors to a QEF:

           

(1)   You have to elect.

a.     No election, no QEF.

(2)   The foreign fund has to agree to provide you numbers, made up special just for its American investors. The fund has to tell you what your interest and dividends and capital gains would have been had it actually distributed income rather than accumulate.

You can fast forward why: because you are going to pay tax on income you did not receive.

What happens in the future when you sell the fund? Remember, you have been paying tax while the fund was accumulating. Don’t you get credit for all those taxes when you finally sell?

Yes, you do, and I have to track whichever of three calculations we decide on in a permanent file. For every fund you own.

BTW there had better be a specific form attached to your tax return: Form 8621. If you were required to disclose a foreign financial account (which a PFIC would be) and did not do so, either on Form 8621 or on another form intended for that purpose, the IRS might be able to "toll" the statute of limitations. Tolling means "suspend" in tax talk. This means the IRS could assess taxes, penalties and interest many years after the tax year should normally have closed. 

This applies only to rich people, right? Not so much, folks. This tax pollution has a way of dissolving down to affect very ordinary Americans.

How? Here are a couple of common ways:

(1)   You live abroad.

You live abroad. You invest abroad.

I intend to retire abroad, so some day this may affect me. Me and all the other tax CPA billionaires high-stepping it out of Cincinnati. Yep, we are a gang of tax-avoiding desperados, all right.

(2)   You work/worked in Canada.

And you have a RSSP. The RRSP is invested in Canadian mutual funds. How likely is this to happen? How about “extremely likely.”

There you have two ordinary as rain ways that someone can walk into a PFIC.

Keep in mind that the IRS is convinced that anyone with a nickel overseas is hiding money. We have already gone through the FBAR and OVDI fiascos, and tax literature is thick with stories of ordinary people who were harassed if not near-bankrupted by obscure and never-before-enforced tax penalties. The IRS is unabashed and wonders why you – the average person – cannot possibly keep up with its increasingly frenetic schedule of publishing tax rules, required disclosures, Star Trek parodies, bonuses to deadbeat employees and Fifth Amendment-pleading crooks.

Beginning in 2014, FATCA legislation requires all “foreign financial institutions” to report to the IRS all assets held by U.S. citizens and permanent residents. The U.S. citizen and permanent resident in turn will disclose all this information on new forms the IRS has created for this purpose – assuming one can find a qualified U.S. tax practitioner in Thailand, Argentina or wherever else an American may work or retire. Shouldn’t be a problem for that overseas practitioner to spot your PFIC – and all the related tax baggage that it draws in its wake - right?

What happens if one doesn’t know to file the PFIC form, or files the form incorrectly? I think we have already seen the velvet fist of the IRS with FBARs and OVDI. Why is this going to be any different?

A Surprise for US Persons With Undeclared Canadian Retirement Plans

We have a few clients who are Canadian or lived in Canada. We have two who lived in Toronto through last year before moving to Wisconsin. Nothing like that warmer weather!

Anyway…

There is a very specific tax issue if you are Canadian and emigrating to the U.S. It has to do with Canada’s version of IRAs and 401(k)s. Canada calls them Registered Retirement Savings Plans (RSSP) or Registered Retirement Income Funds (RRIF).

In Canada these accounts are tax deferred (just like IRAs and 401(k)s in the US). In the US they are not UNLESS you make certain tax elections. The IRS otherwise considers these accounts to be just another broker’s account and will tax you annually on the interest, dividends and capital gains.

Rev Proc 2002-23 states the procedures to make an election on your US tax return. You have to make a separate election for each plan. The form you use is Form 8833 Treaty Based Return Position Disclosure. You state that you are claiming the benefit of Article XVIII(7) of the US-Canada Income Tax Convention. You’ll have to include the name of the financial institution where the account is kept, the account number of the plan, and the account balance at the beginning of the year.

If somewhere down the road you finally draw on the Canadian plan, you will owe Canadian tax. If you truly have emigrated, then Canada will consider you a nonresident and withhold – at 25%, I believe.

If you paid tax annually to the US, the US tax calculation at that moment could be hair-pulling. You would have “basis” in some of the account – to the extent you paid tax – and not have “basis” in the rest.

If this is you, please get professional advice.