Wednesday, March 12, 2014

Getting Eaten by a PFIC

As a U.S. tax payer, it will not be feasible for you to invest in an Israeli mutual funds in your taxable accounts. Previously, I have asked you to trust me about this, promising that I would write fully about this in a future blog. As a thank you for trusting me, here it is:

If you buy a mutual fund outside of the U.S., you will first be sorry. And then, you will be very sorry.

I can explain why the easy way, or I could explain it the hard way. I’ll assume that because you made aliyah, you prefer to do everything the hard way. On the off chance that this was a one-time lapse of judgment, I am proud to introduce Investing by Accident’s patent-conceivable “Skipping” tags to show you exactly which parts you can skip and not miss anything too important.

אזרחי ארה"ב לדוברי עברית

It was recently brought to my attention that an increasingly large number of non-American Israelis are interested in my blog. By “increasingly large,” I mean specifically, Yael, who is my fearless pension agent. I say, “fearless,” because basically that is what it takes to be my agent for anything, especially for anything relating to investing.

In our last meeting, Yael mentioned to me that the question came to her recently on whether American citizens can invest in Israeli mutual funds. This blog is for everyone and I want to make sure that the word gets out on this. Also, I think it would be really cool if Investing by Accident was the #1 search result for “השקעה קרן נאמנות אזרח ארה"ב”. Therefore, I include the following statement for the vernacularly inclined local readership:

שימו לב, אזרחי ארה"ב! אל תשקיעו בקרנות נאמנות, בקרנות סל או בקרנות המשקיעות בהן. מבחינת החוק, זה מותר לגמרי, אבל מבחינת המיסוי בארה"ב זה ממש לא כדאי.

כל אזרח ארה"ב חייב לדווח ולשלם מיסים לארה"ב בלי קשר למקום מגוריו בעולם. המוצרים האלה נחשבים בארה"ב כחברות שמרוויחות רק על ידי השקעות, וארה"ב מחייבת מיסים עליהם ברמה הכי גבוהה שאפשר.

או שתאמינו לי, או שתקראו את הבלוג הזה ובו אסביר.

במקום להשקיע במוצרים אלו, אתם יכולים להשקיע ישירות במניות של חברות רגילות או ישירות באג"חים. אל תדאגו. זה לא יהיה לכם קשה מדי. אני אתן לכם רשימה מלאה של חברות שאתם יכולים להשקיע בהן באופן ישיר. רק תצטרכו לקרוא את הבלוג שלי באנגלית. 

כל מה שאמרתי הוא נכון לכספים רגילים שמחויבים במס רווחי הון. השקעות מסוג גמל (פנסיה, ביטוח מנהלים, קרן השתלמות) נחשבות בצורה אחרת מבחינת מיסוי. הן בדרך כלל בסדר, אבל כדאי לכם לקרוא את בלוגים שלי על הנושא זה (תתחיל פה).

Ok, then. Here’s what you never wanted to know.

[Begin Skipping]

Why will you be sorry?

A mutual fund outside of the U.S. is one of the forms that is taken by a PFIC. Most people have been fortunate enough to never have encountered one of these which is why they have never heard of it.

A PFIC is a semi-mythological creature that roams the earth outside of the United States of America. It seeks out American taxpayers wherever they may be living, watches carefully to see if they invest their money outside of the United States, and then eats them. It does this by levying the highest possible tax calculation on the earnings from these investments.

It tends to eat them slowly, so that at first they may not feel all that much pain. After time, they experience extreme agony.

How can you avoid the PFIC?
  
It’s simple! Just don’t buy shares in any investment which would be classified as a “Passive Foreign Income Corporation.” I think that is fairly self-explanatory already, but just to make sure you really understand, I’ll copy and paste how the IRS defines it:

1. At least 75% of the corporation's income is considered “passive,” which is based on investments rather than standard operating business; or,

2. At least 50% of the company's assets are investments that produce interest, dividends and/or capital gains

The PFIC was created by an act of Congress to attack wealthy people (probably not you) who were attempting to avoid U.S. taxes by hiding investments in foreign corporations (probably not you again) which were not actually doing any real business (like “making widgets”) but were instead just holding investments. Sadly, the PFIC is not a discriminate eater and doesn’t check your net worth before pouncing. Even poor little you can get eaten.

What does this mean for you?

The PFIC makes investing in Israel for an American much like keeping kosher in the U.S. You can still do it, but it will be harder for you than it is for everyone else around you.

That’s because an ordinary Israeli mutual fund traded on the Tel Aviv Stock Exchange falls squarely in the jaws of the PFIC. There is some real basis for this. Although you were not intending to hide from U.S. tax obligations by investing in one of these funds, inadvertently that would start happening because Israel does not collect any taxes on money you invest in one of these fund until you take your money out. This allows all of the gains that you have in the fund from interest and dividends to grow tax free for years and years. This is great for the Israeli side of you, but it you carry that U.S. passport, you have to pay taxes on these earnings every year that you earn them.

Can the PFIC be defeated?

No, not really.

The PFIC attacks investments into foreign mutual funds in such a way that you are either forced to somehow figure out exactly how much interest and dividends you personally earned (mostly impossible with an Israeli mutual fund), or make a “simple” calculation designed to tax the highest possible amount that the investment may have increased in value.

If you have money in a PFIC, at the end of each year, you will have one of several simple options to choose from when filing your tax return:

1. Fake your own death. This can be a bit tricky, but I see it in movies all the time. I would suggest starting a car chase that ends with you driving your car into a frozen river. You would then survive by breathing in the air from the tires. Even better would be if you somehow get out of the car earlier and leave a fake stuffed version of yourself in the car instead.

2. Chose “Qualified Electing Fund” and report the dividends and capital gains for your shares in the mutual fund. To do this, you simply need the mutual fund to tell you all of this information. It’s funny that you would even think such a thing is possible. However, because we have a good imagination, let’s just imagine what this would be like:

“Hi. This is an American. I’m about to get eaten by a PFIC. By any chance, could you just tell me the dividends and capital gains that were earned during the year for my portion of the fund? Also, if you could just tell me which of the dividends are ‘ordinary’ and which are ‘qualified’ that would be great because I simply don’t know whether I can eat this avocado yet.”

“I will call you back.”

3. Do nothing. In this case, you would use the IRS’s default method which will apply a sensible tax assessment whenever it is that you decide to sell. By “sensible,” I mean that you simply calculate the total gains that you need to pay tax on. Because it isn’t clear when the gain was made, we will just assume by default that they were made during the entire time you held the fund. Since you didn’t pay taxes on it back then, you can make it up now by paying an interest penalty. Also, because we don’t know what the gains were from, we’ll just assume the worst and you will pay tax at the rate of ordinary income.

4. Choose “Mark to Market” and pay taxes on the gains during the current year. This is the only real viable option that you would have. The way it works is that you calculate the fair market value of your mutual fund holdings on January 1 and December 31. Then you pay tax on any gain at the rate of ordinary income.

If you are still reading this, you may be thinking: Why didn’t I skip when I had the chance? And also, what’s wrong with option #4? It sounds fine.

That it “sounds fine” is to be expected, as the PFIC is very hungry and tries to lure you in with seemingly viable ways in which you could invest in foreign mutual funds. If you choose option #4, you will pay tax on the entire gain as ordinary income even if some of the gains came from long term capital gains and dividends that would have been taxed at a lower rate.

If your income places you in one of the lower tax brackets in the U.S., this may turn out to be ok. However, as soon as you are in the 25% bracket or higher, you will find that achieving the Tax Equilibrium will become very difficult. What this means is that you will start paying much more tax than you otherwise would have, had you invested in individual stocks and bonds.

Also, with Option #4, while you can offset losses from a PFIC with gains from another PFIC, you cannot take any loses as a deduction of any sort anywhere else on your U.S. tax return. This may not sound bad at first, but keep in mind that this means that if you had any gains from investments in the U.S., you would not be able to offset them with loses from investments that you had in Israeli mutual funds.

What about other insanely clever workarounds?

I have tried many different approaches to defeat the PFIC. My most clever attempt was a strategy I devised in which I would buy an Israeli mutual fund on January 1 and sell it on December 31 of every year. When I would do this, I would pay 25% tax on the gain to Israel which I could then credit against whatever taxes I owe on my U.S. return for investment income. Although, the U.S. tax would be calculated as “ordinary income,” I figured that the difference may not be all that significant.

This clever strategy is not so clever when you consider that U.S. taxes on gains are assessed in dollars, by comparing the buy and sell prices as they appear on January 1 and December 31 in dollars. This means that the mutual fund could actually lose money in shekel, but you would still owe taxes on gains to the U.S. due to a fluctuation in the exchange rate.

To calculate how much of an impact the fluctuation in currency could have, all you would need to do is model the price of the dollar and shekel from year-start to year-end against the estimated returns on your investments. I am quite ashamed to say that I did just this using the historical exchange rates from 1995-2012.

While there are years in which fluctuation between the dollar and shekel could cause you to owe no taxes at all to the U.S., in my model, there was not a single 4-year period in which the effective tax rate on the gains for someone in the 25% tax bracket would be at least 40%. In other words, you will get eaten by a PFIC.

Why you will be very sorry

Of course, there was no need to think about it this much anyway. One of the reasons you want to invest in Israel in the first place is to avoid fluctuations in currency. Using Option #4 (which is the only viable option) essentially re-assumes a good part of the risk that we were trying to avoid in the first place!

[Stop Skipping]

So, loyal readers, in conclusion: do not buy an Israeli mutual fund if you have to pay taxes in America. To be clear on this, by “mutual fund,” I mean anything that is a mutual fund or acts like one. For example, any companies in Israel whose business looks mostly like a mutual fund would also be included. The most common case would be companies who make money by investing in other companies instead of selling actual goods and services.

The PFIC is also a problem for Israeli “ETFs” (קרנות סל) because these are just mutual funds that are traded on the stock exchange. Regarding “ETNs” (תעודות סל), the story is more complicated. You should read about them in Running Away from a PFIC.

The PFIC could possibly also attack non-taxable retirement accounts, like your pension or Keren Hishtalmut. However, it does this in a way that generally doesn't matter. If you enjoy skipping tags, you will definitely enjoy reading all about this in Investing by Accident's series of logs on the Keren Hishtalmut as a PFIC, starting with Running Away from a Keren Hishtalmut.

But, have no fear! You can invest in Investing by Accident’s Israel Price Asset Yield index, or I-PRAY. It has been pre-screened to eliminate any companies that looks or feels like a mutual fund. At least I hope so. I don’t want to get eaten.

18 comments:

  1. I think it is time to go the other way! With the shekel being so strong against the struggling dollar due to Obamacare, it is a great time to by $$$ with all your NIS!

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    1. I agree that the dollar is cheap right now and it's a good time to buy. The only caution is not to do that with all of your money. For example, let's say you normally want to allocate your money to have 50% in dollar and 50% shekel. Considering that the dollar is cheap right now, maybe you would adjust this somewhat and have 55% in dollar and 45% in shekel right now.

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    2. Danny - do you think the dollar will get worse since Obamacare continues to fail and we should wait as the dollar will get weaker?

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    3. There have been a lot of questions about this and I'm going to devote the next two weeks of blog postings to this topic; namely: how to allocate your money when the dollar is weak.

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    4. Cool - is it critical to determine the effect of ObamaCare on the dollar when tradiding between the shekel and the dollar?

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  2. How do you think the war in the Ukraine will affect the Israel stock market? It seems to be hurting the US market. Is it safer to keep our money in Israel?

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  3. Just came across this blog. Very cool and informative.

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    1. Thanks!! Happy to have you on board!

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  4. Have you considered posting on Twitter as well?

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    1. I'm very impressed with the people that have so much "thoughts" that they can post them all time. I barely have enough to update my Facebook status.

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  5. I wanted to ask you regarding the last point - תעודות סל. Since in Israel, they are really ETN's (obligate to give you a certain return of an index) and not ETFs. Meaning, they aren't real funds (the way I understand it). Are you sure they fall under the definition of a PFIC? Thanks.

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    1. WOW! This is a fantastic point that I completely missed. Thank you for pointing this out. ETN's would not be not considered PFIC's, and this just may be the answer on how not to get eaten. I am going to investigate this thoroughly and post a complete update it.

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    2. Thanks for the informative and humorous post. I will be curious to read about your findings regarding teudot sal.

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    3. Read all about it on Running Away from a PFIC: http://www.investingbyaccident.com/2014/04/running-away-from-pfic.html. I also updated this posting accordingly so that everyone will know exactly what will (and will not) eat them.

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  6. What makes non-taxable retirement accounts different from all other accounts (for IRS taxation purposes)?

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    1. This is a terrific accidental question. I'm adding it to the backlog for a future blog posting.

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    2. Update: the answer is that these are PFICs, but it doesn't really matter. Here are the blog postings on this: http://www.investingbyaccident.com/2014/09/keren-hishtalmut-us-tax-treatment-part-i.html and http://www.investingbyaccident.com/2014/11/how-to-run-away-from-keren-hishtalmut.html

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