Wednesday, October 1, 2014

PFICs in the Keren Hishtalmut

In my non-expert assessment, I’m inclined to say that the Keren Hishtalmut and the Israeli pension are both employees’ trusts. This brings us to the question of what happens if the money inside of the Keren Hishtalmut or pension is invested in a PFIC.

Escaping the PFIC?

On the one hand, I would like say that the structure of the Keren Hishtalmut or pension shelters the investments inside of the account in such a way that it longer matters what the investments are.

The conceptual support for this approach comes from the way we are reporting the investment gains for tax purposes. We are taking the gains as income each year (and not as passive income), regardless of what the gain was from (interest, capital gains or dividends). It is almost as if the “trust” obfuscates the investments such that we no longer care if the underlying invest is a PFIC.

This is a nice line of thinking and it makes me happy to think about the world this way. However, does it have a basis in the tax regulations?

I think until recently this was the case. However, since December 2013, we can no longer use this reasoning.

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IRS Regulations on PFIC Ownership
Last December, the IRS published temporary regulations to specify exactly when the underlying investments in a trust require PFIC treatment and when they do not. 

Here is what it says about foreign pensions:

Foreign pension funds. A United States person that is treated as the owner of any portion of a trust … that owns, directly or indirectly, any interest in a PFIC is not required under section 1298(f) and these regulations to file Form 8621 (or successor form) with respect to the PFIC if the foreign trust is a foreign pension fund … operated principally to provide pension or retirement benefits, and, pursuant to an income tax convention to which the United States is a party, income earned by the pension fund may be taxed as the income of the owner of the trust only when and to the extent the income is paid to, or for the benefit of, the owner.

I really want this to mean that an Israeli pension which holds a foreign mutual fund would not have to deal with a PFIC. However, that is not what it says. The get-out-of-PFIC-free card only works for a foreign pension that is treated like a qualified plan according to a tax treaty. In that case, the foreign pension would have the same status as a U.S. qualified plan in which any PFICs held within the plan are obfuscated by the trust and do not require any special treatment.

The Israeli pension is not covered in a tax treaty. Instead, like a Keren Hishtalmut, it is an employees’ trust. This is a type of nongrantor trust. You know this is the right term because you eat potato berukas.
In that case, the following paragraph applies to the Keren Hishtalmut and to the Israeli pension:

Estates and nongrantor trusts. If a foreign or domestic estate or nongrantor trust … directly or indirectly owns stock, each beneficiary of the estate or trust is considered to own a proportionate amount of such stock.

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When you have a Keren Hishtalmut or the Israeli pension, you are the “beneficiary” of the trust. The IRS regulations published in December 2013 state that in this case you are “considered to own a proportionate amount” of any of the stock in the trust. If the stock is a foreign mutual fund, it means you have ownership in a PFIC and are required to file form 8621.

What Now?

The bad news is that in my non-expert opinion, you cannot escape a PFIC with a Keren Hishtalmut or an Israeli pension.

However, the good news is that since this PFIC is inside of an employees’ trust, its impact will be minimized. Next week, I explain the options for dealing with this PFIC.

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