QUESTION: Please clarify for me the tax ramifications for an
American citizen of purchasing mutual funds in a European bank account
through a pension plan or an IRA. What comprises a mutual fund in this
context? Would an ETF be considered a mutual fund? Would a
money-market type fund that guarantees 1-2% over daily rates be
considered a mutual fund? What questions do I need to ask?

REPLY: A brief explanation of the U.S. tax treatment of foreign
mutual funds owned by U.S. persons is difficult, but I'll try to keep
it from turning into a book.

First, the applicable tax law refers to passive foreign investment
companies (PFIC) rather than to foreign mutual funds, but they
basically mean the same thing if the mutual fund is a corporation.

Second, there are two elements that define a PFIC. First, it is a
foreign corporation. Second, it receives either (1) 75% or more of its
income from passive investments or (2) 50% or more of its assets are
held to produce passive investment income. A foreign partnership can't
be a PFIC even if its only purpose is investing -- such as a
partnership hedge fund. In most cases, an investment trust will not be
a PFIC unless it has shares that can be transferred like shares of a
corporation.

There is no tax or reporting obligation by U.S. owners of a PFIC until
there is a distribution of income or until there is a disposition of
any shares. A disposition can include a sale, exchange, gift or
bequest. At that time, the U.S. owner must make a tax calculation that
is too complicated to describe briefly. However, if there has been any
accumulation of income over a period of years, the tax could become
punitive. Where there are both gains and losses within the PFIC, only
the gains are recognized and the losses are ignored. If the income is
distributed each year, the tax on accumulations does not apply but the
income is taxed as ordinary income.

This punitive tax can be mitigated with an election to pay tax on the
shareholder's portion of the PFIC income each year. (This is referred
to as a "qualified electing fund" or QEF) But that means the PFIC must
be willing to provide the shareholders with the type of information
that is usually provided by a U.S. mutual fund or partnership.
However, that imposes a significant additional cost on the operations
of the PFIC and most of them are not willing to provide that kind of
detailed information to the U.S. shareholders and the IRS.

If the PFIC is a mutual fund that is traded on a national stock
exchange similar to the NYSE or ASE or NASDAQ, the U.S. owner can
elect to compute income and pay annual taxes on the gain in value of
the shares from year to year. (This is referred to as the
mark-to-market election.)

If the PFIC is owned by a tax exempt entity like a charity or a tax
qualified retirement savings plan, any income will not be subject to
tax by the charity or retirement plan.

I have not seen any information from the IRS regarding the treatment
of exchange traded fund shares (ETF) in relation to the PFIC rules. If
the ETF shares are available on a U.S. exchange, I presume they would
be subject to U.S. information reporting requirements and would not be
treated as PFICs. If the ETF is only available on a foreign exchange,
it would appear to meet the definition of a PFIC as described earlier
but it should be eligible for the mark-to-market method of computing
income and taxes on an annual basis.

As for a money market fund managed by a non U.S. bank or financial
institution, it seems to me that it meets the definition of a PFIC. It
is very unlikely that it would be eligible for either the QEF annual
reporting method or the mark-to-market method. However, an argument
can be made that the income is distributed each year when it is added
to the account balance. Therefore, the gains would be treated as
ordinary income while any losses are ignored. With a lot of trading
activity, that could become a costly situation. For example, if there
were $10,000 of gains and $11,000 of losses, the $10,000 would be
reported as income by the U.S. shareholder and the losses would be
ignored. But if the money market fund only invests in time deposits
like bonds, the amount of gain or loss should be minimal and the
interest income would be taxable.

As for what questions should be asked, the first is whether the
investment entity is a corporation or a trust that permits the
transfer of investment units. The second is whether the fund is traded
on a major national stock exchange. The third is whether the fund is
willing to provide the information needed to make a QEF election. A
fourth question is whether a foreign bank money market fund invests in
time deposits or bonds or whether it engages in active trading of
securities and/or currencies.

Speaking of currencies, when computing the gains and losses of a PFIC
held in a foreign currency, they must be converted into U.S. dollars
with each transaction.

Additional details are included in the 3rd Edition of the Controlled
Foreign Corporation Tax Guide and will be discussed at the CFC Tax
Boot Camp in Las Vegas on Dec. 7th. For details on the book see
http://www.offshorepress.com/cfc-ibc-tax.htm For details on the
Seminar "Boot Camp" see http://www.offshorepress.com/cfcworkshop.htm

Vern Jacobs

The comments in this memorandum are not intended to constitute an
opinion regarding any specific tax issues because additional tax
issues may exist that could affect the tax treatment of the tax issues
addressed in this memo. This memorandum does not consider or reach a
conclusion with respect to those additional issues and was not written
and cannot be used for the purpose of avoiding penalties under code
section 6662(d). For further details see
http://www.offshorepress.com/vkjcpa/disclosurerules.htm