The Tax Perils of Foreign Mutual Funds -- and How to Avoid Them

By Wendy Connick Markets Fool.com

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Back in the early '80s, U.S. investors loved taking advantage of a loophole in the tax laws related to foreign mutual funds. They could invest in these funds tax-free, and the funds themselves were never taxed by the U.S. because they were foreign entities. But the party ended with the Tax Reform Act of 1986. Today, U.S. taxpayers investing in foreign mutual funds are in for a world of hurt.

If you choose to buy shares in, say, a British mutual fund, you will be placed by default in the "excess distribution regime." Under this regime, investors aren't taxed until the mutual fund makes an excess distribution (for example, when you sell the shares). At that time, you pay tax at your marginal income tax rate (not your capital gains tax rate), allocate your gains and dividends over the entire period during which you held the shares, and then pay interest on those gains. Your tax rate on the investment could be as high as 50% -- or even higher.

The good news is that the excess distribution regime is not the only option for investors in foreign mutual funds. You can elect to use the QEF, or qualified electing fund, tax scheme instead. Under this system, instead of waiting for an excess distribution to pay tax, you'd pay tax on a pro-rata basis. Income you receive from the fund is taxed as ordinary income, while gains are taxed under the capital gains rate. In other words, QEF is very close to the tax outcome you'd have with a domestic mutual fund.

The bad news? You have to make the QEF choice during the first year in which you own shares in the fund. If you miss that window of opportunity, you're stuck with the excess distribution regime. And in order to elect QEF treatment, you must receive a signed annual information statement from the fund each and every year.

If the fund refuses to send you the required statement, there's a plan B you can fall back on: use the mark-to-market (MTM) rules instead. This system isn't as good as the QEF one from the taxpayer's perspective, but it's better than the default regime. Under mark-to-market, you pay taxes on your gains at the end of every year at ordinary income tax rates, whether or not you sell the shares. But guess what? As with QEF, you have to elect mark-to-market treatment during the first year.

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If you missed the first-year election window for either option, there is a ray of hope. You can use what's called a purging election to switch over to the QEF or MTM rules as of the current year. You'll still be stuck paying excess distribution taxes on the past years' gains, but at least you'll be in a much better tax situation for the future.

The purging election works like a kind of fake sale. In the eyes of the IRS, you're selling your shares and paying the relevant taxes using the excess distribution rules, then immediately buying the exact same shares and making a QEF or MTM election on the investment. You make a purging election by filling out and turning in Form 8621 to the IRS.

In the above scenario, where you own shares in a foreign mutual fund and are late electing a new tax scheme, you can elect QEF by checking the "Election To Treat the PFIC as a QEF" and the "Deemed Sale Election" checkboxes in Part II of the form. If you're making a mark-to-market election, check the "Election To Mark-to-Market PFIC Stock" box instead of the "Election To Treat the PFIC as a QEF" box. Form 8621 is quite lengthy and complex, so it's best to hire a tax professional to fill it out. After all, you don't want to dig yourself into a whole new tax catastrophe while trying to get out of the last one.

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