PFIC - QEF or Mark to Market – Is There a Huge Difference?

As the broader acknowledgement and understanding of the US tax obligations of New Zealand based US citizens continues to grow, we’re seeing a frequent debate arise as to the most beneficial (or least punitive) approach to dealing with Passive Foreign Investment Companies (PFICs).

In particular, there seems to be a growing view that where possible, a US citizen should always seek to have a PFIC treated as a Qualified Electing Fund (QEF), rather than using the Mark-to-Market (M2M) regime.

There is indeed good logic to this, but is the necessity of QEF treatment overstated?

In practice, the difference between QEF and Mark-to-Market is not necessarily as vast as it may appear.

What is a PFIC?

Whilst we’ve frequently covered this across our other articles, it doesn’t do any harm to reclarify for first time readers.

A PFIC is a foreign company which derives most of its income from passive investments, or which holds a substantial proportion of its assets in passive investments.

Specifically, it is a foreign company which:

-       Generates at least 75% of its income passively

-       Holds at least 50% of its assets for the generation of passive income.

It is important to note at this stage, that unit trusts broadly fall under this categorisation.

For US citizens living in New Zealand, PFICs are particularly common. They usually arise through KiwiSaver, managed funds, PIE funds, Australian unit trusts, foreign ETFs and mutual funds.

Whilst PIE investments are frequently marketed as tax-advantegeous, the US treatment can be significantly more complex. A little like New Zealand has the FIF tax regime, the US also has its own (PFIC), which applies to foreign (non-US investments).

The default PFIC regime, under Section 1291, is particularly unattractive. Gains can effectively be allocated over the period the investment was held, with tax and interest charges applied to amounts allocated to prior years.

Fortunately, the default treatment can be prevented by making an alternative election.

Our alternative methods of reporting a PFIC to the IRS are the Qualified Electing Fund (QEF) treatment and Mark-to-Market (M2M) treatment.

What is the US tax on a PFIC?

The answer to this is broad, as we do have multiple elections which can be made, whereby a US citizen can elect to report income from the investment in different ways.

Some of these methods can be fairly punitive and group all income from a fund as being from a single source and taxed at punitive rates. Others can split out the income from the fund into its respective types, and thus taxed at the varying rates the IRS offers.

What is QEF treatment?

Under the QEF regime, the US taxpayer generally includes their share of the PFIC's income each year, as reportable income in their US tax return. This does result in unrealised gains being taxable (assuming no income is actually paid out from the fund).

There are two components:

• ordinary earnings are treated as ordinary income; and

• net capital gain is treated as long-term capital gain.

  
  

This is the major attraction of QEF, as the US tax rate for long term capital gains is (usually) lower than ordinary income tax rates.

When compared to the other methods of PFIC taxation, which can bulk all income together at a single tax rate, QEF allows us to take advantage of lower long term capital gains tax rates in the US.

By reporting this fund income each year, the US citizen taxpayer can be in a position whereby no tax is due upon the eventual sale of the fund.

However, there’s a little more to this.

Understandably, foreign (ie non-US funds) want to assist their US citizen investors with a QEF election.

Whilst the QEF election is made by the taxpayer on their US tax return, it requires a complaint fund to co-operate on the reporting.

This involves supplying a PFIC Annual Information statement to the taxpayer each year, detailing and calculating the shareholder's share of ordinary earnings and net capital gain.

However, what is frequently misunderstood, is that this requires the fund to calculate their income according to US tax law.

I’ve been asked in the past if the fund can just give the taxpayer a statement each year showing their share of income, however this is insufficient.

Rather, to determine the shareholder’s share of income, the fund itself must first prepare financial statements according to US tax law. Specifically, US tax code §1.1295-1(g)(1)(iv)(A) specifies the US law under which the PFIC’s income must be determined.

By providing a statement to the taxpayer according to NZ tax law, we’re missing out on a key requirement for the individual to make a QEF election on their US tax return.

This is an important distinction which can be frequently misunderstood, and when a fund advertises that it is QEF ready, it is important to ensure that the financial reporting made by the fund adheres to US principles.

What is the Mark to Market alternative?

Mark-to-Market is somewhat different.

Where the election applies, the taxpayer essentially calculates the increase in value of the PFIC each year.

For example:

You purchase a PFIC for NZ$50,000.

At the end of the year, it is worth NZ$60,000.

You have a NZ$10,000 Mark-to-Market gain, which will be converted to USD and reportable as ordinary income on your US tax return.

When the value falls, a deduction can be available also (subject to limitations)..

The result is quite similar in this case to QEF, the taxpayer is reporting income (ie fund value growth), that they may not have actually realised yet.

Is QEF actually better?

The main advantage is the treatment of capital gains.

Imagine that a fund produces the following return during a year:

• NZ$5,000 of ordinary earnings; and

• NZ$15,000 of net capital gain.

  
  

Under QEF treatment, the taxpayer would generally report the NZ$5,000 as ordinary income and the NZ$15,000 as long-term capital gain.

As a reminder, long term capital gains are generally taxed at lower US tax rates than Ordinary income.

Under Mark-to-Market, the entire $20,000 increase is likely to be treated as ordinary income, meaning we’d likely be looking at a higher tax rate on the $15,000 of gain, than we would for a QEF fund.

Fund Differences

Whether QEF is worthwhile, given the compliance obligation, can very much depend on how the fund operates and what returns it expects to provide to shareholders.

When we have a fund (which would usually be considered a growth fund), QEF treatment of course can certainly help to lower the US tax burden. This is especially relevant for the AIP Growth Category currently available by Immigration New Zealand.

This is also relevant for investments where a significant proportion of the return comes from the sale of investments inside the fund.

In the above situation, we can say with some certainty that QEF is likely to result in a better US tax outcome.

On the other hand, we have many investment funds in New Zealand which class themselves as “income funds”, which usually produce a mixture of dividends, interest, other ordinary income and capital gains.

In this example:

• NZ$18,000 of ordinary earnings (ie dividends, interest etc); and

• NZ$2,000 of net capital gain.

  
  

We’d be looking at only a marginal difference in the overall US tax between Mark to Market and QEF. Under Mark to Market, the full $20,000 would likely be considered “ordinary income”. Under QEF only a minority of the income is subject to (generally) more beneficial long term capital gains treatment.

So the actual benefit of QEF depends heavily upon what the fund is investing in and what type of income it generates.

We do frequently see two thing:

-       An understanding that QEF must be obtained at all costs

-       The benefits of QEF or Mark to Market not fully understood

US tax rates on ordinary income can vary from 0%-37%, and for lower income earners, it is possible that their ordinary income tax rate can be equal to (or even lower than) their long term capital gains tax rate (between 0-20% in most cases).  

Summary

We do sometimes field worried calls from both investors and wealth managers, concerned that without QEF treatment, a fund is going to be punitively taxed by the IRS.

As you’ll see above, this isn’t necessarily the case, and it is highly dependent on:

-       The overall earnings of the investor

-       The earnings mix of the fund

It is also important not to understate the requirements placed on the fund itself, should it wish to offer QEF treatment to its shareholders.

The US Tax Team New Zealand specialises in US tax advice for both new US citizen migrants to New Zealand, and those who’ve lived here for a generation. If you’d like to discuss further, reach out to us today – info@usatax.nz