So let’s say you are a wealthy U.S. citizen living in Singapore (I am not an advisor of Eduardo Saverin and I have no information about his situation). You have $100,000 to invest over the next two years. You want to keep your life as simple as possible, so you decide that you will invest the funds in a single Singapore mutual fund. The mutual fund invests in stocks and securities in the Southeast Asian region, an area that is familiar to you.
On January 1, 2011 you invest the $100,000 in the Singapore mutual fund. It pays dividends at an annual rate of 4%. Thus, you receive dividends in 2011 of $4,000 and dividends in 2012 of $4,000. On December 31, 2012 you sell the shares in the Singapore mutual fund for $110,000.
You file your U.S. tax returns for 2011 and 2012 and pay tax on the $4,000 of dividends for each year. You are not really sure if the dividends qualify for the maximum 15% tax rate so you conservatively include them on your tax returns as non-qualified dividend income, paying tax at ordinary income rates.
You include the $10,000 gain on the sale of the Singapore mutual funds shares on your 2012 and pay long-term capital gains tax at a U.S. federal rate of 15%.
You know that there are some U.S. forms to file to report / disclose your interest in the Singapore mutual fund, but you want to keep your life simple and you decide you don’t want to deal with any of these additional reporting requirements --- you have paid your U.S. tax --- what else could the I.R.S. want?
Is your tax situation really as simple as you hoped? Absolutely not!
You unwittingly invested in a “passive foreign investment company.” Okay, the name sounds a bit ominous, but is it really that bad? Passive foreign investment companies (“PFICs”) were created by Congress in 1986. The Internal Revenue Code sections dealing with PFICs are 20 or so pages long and if you look in the regulations you will only see about 40 pages of regulations.
However, you need to look further. In 1991, twenty-one years ago, the I.R.S. published proposed regulations on PFICs which have never been finalized. The proposed regulations are not binding on taxpayers. They are considered a body of informed judgment but accorded no more weight than the I.R.S.’s litigation position. The proposed regulations are where the bulk of the rules related to PFICs are located.
Forty pages of proposed regulations doesn’t sound that bad. The proposed regulations begin with the following:
A U.S. person that is a shareholder (within the meaning of paragraph (b)(7) of this section) of a section 1291 fund (as defined in paragraph (b)(2)(v) of this section) is subject to the special rules under section 1291 and these regulations with respect to gain recognized on direct and indirect dispositions of stock of the section 1291 fund and upon certain direct and indirect distributions by the section 1291 fund.
Maybe a little dense. What is a section 1291 fund? Are there various types of PFICs? Why, yes. Some of the types include “QEFs,” “pedigreed QEFs,” and “unpedigreed QEFs” (I am not joking --- see Prop. Treas. Reg. §1.1291-1(b)(2)).
Some of the other arcane terminology includes “nonqualified funds,” “prePFIC years and days,” “prior PFIC years and days,” “excess distributions,” “nonexcess distributions,” “deferred tax amounts,” and much more. Just paging through the proposed regulations I see sexy tax things like “section 304 transactions,” “nonrecognition transfers,” and all sorts of good stuff for a tax advisor.
You correctly reported the dividend income as ordinary income on your U.S. tax return. The one mistake in computing your U.S. tax liability for 2012 is that the gain on the sale of the shares of the Singapore mutual fund did not qualify for long-term capital gains treatment. Instead, put simply, the gain must be spread over the years in which you held the shares (god forbid that you owned the shares for 15 years), you must calculate a hypothetical tax at the U.S. highest ordinary income tax rate for the applicable year, and then compute an interest charge (using variable interest rates), and complete a separate I.R.S. form regardless of whether these special rules apply to you.
So you started with $100,000, received earnings and gains from the Singapore mutual fund of $18,000, paid U.S. tax of say $6,000 (approximately 35% of $18,000), for next cash remaining of $112,000.
Enough with the complexity. You live outside the U.S., You paid your U.S. tax. What can the I.R.S. do?
This post does not discuss the potential criminal penalties for not telling the I.R.S. about your Singapore mutual fund.
On the civil side, the I.R.S. can impose monetary penalties. First and foremost, for choosing not to file the FBAR (i.e., Form TD F 90-22.1), the IRS can impose a penalty of half of the account balance per year. Thus, the penalty for 2011 would be $50,000 and the penalty for 2012 would be $50,000. [The penalty may be less if you did not intentionally fail to file.]
Also, starting in 2011, there is a new I.R.S. form, Form 8938, that imposes a penalty of $10,000 (and can be greater) for failing to tell the I.R.S. about the foreign financial asset.
Thus, the penalties for the two years add up to $120,000.
In summary, the $112,000 of cash remaining from the Singapore mutual fund goes to the I.R.S. and you still owe the I.R.S. $8,000. You have been a loyal U.S. citizen all of your life and you want to remain a U.S. citizen and pay your U.S. taxes. But when you begin to understand the complexity of the rules (the PFIC rules mentioned above are merely one of many complex tax situations for U.S. citizens living abroad) backstopped with the potentially bankrupting penalties, you start to wonder whether your life might be better off not being a U.S. citizen.
Maybe, just maybe, if the I.R.S. agent that you are dealing with is having a good day, you won’t owe all the penalties. Of course, it is not the I.R.S.’ fault. They didn’t make these rules --- Congress did. Congress should really make it less onerous for U.S. citizens living outside the U.S.