Protect Your Foreign Stock Gains from IRS PFIC Taxes

The Little-Known Tax Trap Every US Investor Needs to Avoid

“The best investment you can make is in yourself. The more you learn, the more you earn.”

— Warren Buffett

Did you know that investing in foreign stocks, including foreign stocks purchased on US stock exchanges, could cost you thousands in taxes, and you might not even realize it until it's too late? Welcome to the world of Passive Foreign Investment Companies (PFICs)—the lurking danger in your investment portfolio! For the unaware investor, they can be an expensive tax nightmare.

Taxes and tax planning aren’t exactly fun—at least not for me. But as an investor, it is not just about making big gains; it is also about keeping as much of those gains as possible. That is why being aware of taxes and planning for them is so critically important. I look at proactively learning about taxes and planning in the same way as I look at eating healthy or hitting the gym. It isn’t always fun, but the long-term cost of not doing it, is A LOT less fun.

When it comes to learning about taxes, there are really only two ways: the easy way and the hard way. The easy way is to educate yourself ahead of time by learning about tax rules and working with qualified tax professionals. (I’m not a tax professional—just an investor sharing my knowledge.) Or the hard way is to get surprised by a huge, unexpected tax bill and only learn your lesson after it’s too late.

This article focuses on the risk of inadvertently owning foreign stock classified by the IRS as a Passive Foreign Investment Company (PFIC). Owning a foreign fund or a certain foreign stock, if it is a PFIC, triggers nasty tax rules. If not filed correctly, the IRS taxes gains at the highest rates (up to 37%+) instead of the capital gains rates and slaps on retroactive interest charges, possibly resulting in an effective tax rate in excess of 50%.

I don’t want to be alarmist. There is no cause for alarm. But if you want to minimize your tax bill, this is something to be aware of, and plan accordingly.

You might tell yourself, "Nothing to worry about. I will never own a PFIC." Well, not so fast. They can sneak up on you. For example, the popular silver ETF PSLV (Sprott Physical Silver Trust) is a PFIC. In terms of silver ETFs, two popular ETFs are SLV (iShares Silver Trust) and PSLV (Sprott Physical Silver Trust). Many silver ETF investors, including me, prefer PSLV over SLV, as they deem the collateral position to be superior. Read more about both ETFs here.

The thing is, though, SLV, as a U.S. company, is not a PFIC. PSLV, as a foreign company (Canadian company), is a PFIC. Sprott, the sponsor of PSLV, confirms that PSLV is a PFIC here.

Before we dive into the PFIC risk (item 3), while we are discussing foreign taxes, let’s quickly hit two other less common but very significant tax risks.

1. Extended stay in a foreign country (accidental tax resident)

Let’s say you are fortunate enough to be geographically flexible and decide for the next 4 months to work and live in Switzerland – a country consistently voted as having the highest living standard. What could go wrong? Well, while the typical rule for tax residency and thus the requirement to file and pay taxes on one’s global income is 183+ days, in Switzerland, it is only 90 days. If you don’t know that, for that year, you would have to pay Swiss income tax on your global income. Yikes. You can read about this type of risk here.

2. You plan to return to your home country (exit tax)

If you unwittingly made the mistake of becoming an unintentional tax resident, you may tell yourself, “Oh man, what a disaster. I won’t do that again.” And you return to your home country. That works for most countries, but more and more countries (mostly in Europe, but also other countries) now have an exit tax. The exit tax (triggered by not being a tax resident anymore) assumes that you sold ALL your investments worldwide (whether you sold them or not), and now you have to pay capital gains taxes. The US has double-tax avoidance treaties with most countries, and that may provide some relief, but short of that, Double Yikes. More to come about this topic, in the coming months.

3. You invest in a foreign stock classified as a Passive Foreign Investment Company (PFIC)

Many legendary investors invest in foreign stocks either through foreign stocks trading on US stock exchanges (mostly ADRs) or through buying stocks on foreign stock exchanges through internationally minded US brokers like Interactive Brokers. While the US equity market is the largest equity market in the world, it is also one of the highest valued equity markets in the world in terms of P/E ratios, and it isn’t as easy to find overlooked investments as one finds in less busy foreign countries.

While the international return can be spectacular, it also introduces new risks. There is the political risk of the foreign country. In addition, starting about 10 years ago, there is now the political risk of the US government, as random US government-driven sanctions and de-listing of foreign companies have exploded exponentially. You can read about this here: “ADRs: Once a Gateway to Foreign Investments, Now a Potential Minefield.”

Now, you tell yourself, no problemo, I will just invest in close allies of the US. That will reduce my sanctions and de-listing risk (true), and I should be home free. Well, not so fast. Say you buy a Canadian company trading in the US as an ADR, keep it for a number of years, make a hefty profit, and when you sell it and file your taxes, you get a nice letter from the IRS essentially saying, “Hey, that Canadian company you owned was classified as a PFIC (Passive Foreign Investment Company), and you were required to file Form 8621 every year you owned it (even if you didn’t sell it). Now you owe back taxes and penalties.” How can that be? Well, congrats! You just discovered the wonderful world of Passive Foreign Investment Companies – another IRS special.

Table of Contents

1. In a Nutshell: How the IRS Can Take 50%+ of Your Foreign Stock Gains

2. A Simple Trick for Avoiding the Whole PFIC Tax Mess

3. Consequences for Not Filling the Required PFIC Tax Paperwork

4. What Is a Passive Foreign Investment Company (PFIC)?

5. How to Recognize a Passive Foreign Investment Company (PFIC)

6. PFIC IRS Filing Options

7. Summary

1. In a Nutshell: How the IRS Can Take 50%+ of Your Foreign Stock Gains

If you invest in foreign stocks—even those traded on U.S. exchanges—you could be walking straight into one of IRS’s most punishing tax traps: the Passive Foreign Investment Company (PFIC) regime. PFICs are foreign companies where at least 75% of income is passive (like dividends, interest, or rent), or 50% or more of the assets produce passive income. For example, Sprott’s silver ETF (PSLV) is considered a PFIC, while iShares’ SLV, a US fund, is not.

The IRS’s default approach to PFICs is a financial nightmare. Instead of the preferential long-term capital gains rates, all gains and distributions from a PFIC are taxed as ordinary income, which can mean rates as high as 37% or more. Worse, the IRS doesn’t just tax your gains for the current year. Under the “excess distribution” method, it retroactively allocates gains over your entire holding period and applies the highest marginal tax rate for each year. On top of that, interest is charged on the deferred taxes, often pushing your effective tax rate well above 50%. If you fail to file IRS Form 8621 for each PFIC investment, you could face additional penalties.

There are ways to avoid the worst of PFIC taxation. Holding PFICs inside tax-advantaged accounts like IRAs or 401(k)s sidesteps these rules entirely, as PFIC regulations do not apply to retirement accounts. Another workaround is to trade call options on PFICs rather than owning the shares directly—provided you never exercise the options, you avoid PFIC ownership. If you must hold PFICs in a non-retirement account, you can file Form 8621 annually and elect either the Qualified Electing Fund (QEF) or the Mark-to-Market (MTM) treatment, both of which can at least clarify your tax liability.

Due diligence is not optional. You must check a company’s financials to see if it meets the PFIC tests, and you should assume most foreign ETFs and trusts are PFICs unless you have clear evidence to the contrary. Given the complexity and punitive nature of these rules, consulting a tax professional is recommended.

The lesson is clear: the IRS won’t warn you before you fall into the PFIC trap. If you don’t plan ahead, you could lose more than half your gains to taxes and penalties. Here, ignorance isn’t bliss—it is a tax bill.

Let’s go a bit deeper into the details.

2. A Simple Trick for Avoiding the Whole PFIC Tax Mess

PFICs, or Passive Foreign Investment Companies, can create complicated tax headaches for US investors. Usually, owning PFICs means more paperwork and significantly higher taxes if not managed proactively and correctly. More about that below. But here’s the good news: there are two ways to avoid the PFIC tax mess:

1. Own PFICs inside a 401(k), IRA, or Roth IRA

If you keep PFICs inside certain retirement accounts—like a 401(k), traditional IRA, or Roth IRA—you can sidestep these issues entirely. The IRS does not apply PFIC rules to investments held inside these US retirement accounts. So, you don’t have to worry about filing extra tax forms or paying extra taxes on PFICs in your 401(k), IRA, or Roth IRA. Your investments can grow tax-deferred or even tax-free, depending on the account, without the usual PFIC tax problems.

2. Own Call Options on PFICs

If you are comfortable with options trading, you can purchase a call on a PFIC in either a retirement account or a regular non-retirement account. As long as you don’t exercise the call (which would result in you owning a PFIC), but only buy a call (buy to open) and sell that call later (sell to close), you never owned a PFIC, and PFIC reporting doesn’t apply to you.

The challenges here are threefold. First, you need to be comfortable with options trading. Second, there needs to be an active options market on the PFIC you are interested in. Third, this only works if you never end up owning the PFIC, but only close out the call.

However, if you own or are thinking about owning foreign companies—including ADRs (American Depositary Receipts) traded on US stock exchanges—in a regular non-retirement brokerage account, PFIC tax risk is something you really need to watch out for and plan accordingly. In either case, involving a tax expert before proceeding is recommended.

3. Consequences for Not Filling the Required PFIC Tax Paperwork

If you do nothing (maybe because you didn’t know you owned a PFIC), the IRS taxes your gains under a punitive retroactive system. When you eventually sell your PFIC or receive large distributions, the IRS calculates "excess" amounts—anything beyond 125% of your average distributions over the prior three years. This excess gets taxed at the highest ordinary income rates (not capital gains rates) and is spread retroactively across your entire holding period. On top of that, the IRS tacks on interest charges for each year’s "deferred" tax. And if you failed to file Form 8621 annually during your ownership, the IRS could pile on additional penalties.

Now, that sounds scary and complex. Let’s make that easier to understand:

Scenario:

Imagine you bought a PFIC for $100 four years ago, but you didn’t know it was a PFIC and didn’t file any PFIC IRS paperwork. Over the first three years, you received $10 in dividends annually. In year four, you sold it for $1,100, netting a $1,000 gain.

Here is how the IRS crunches the numbers:

• First, they calculate 125% of your three-year dividend average ($10 × 1.25 = $12.50). Then, they subtract that from your total gain ($1,000 - $12.50 = $987.50 "excess"). That $987.50 gets divided equally over your four-year holding period ($246.88 per year).

• Each yearly portion gets taxed at the highest ordinary income rate (currently 37%), plus interest (around 6-8%) for the "delay" in payment. The math adds up fast, and your total hit could easily exceed 50% of your gain.

The Brutal Truth

If you own and sell a PFIC without the proper PFIC tax filings (annual form 8621) expecting normal capital gains rates (0%, 15%, or 20%), you’re in for a shock. The IRS doesn’t just tax your profits (essentially at ordinary income rates) —it backdates the bill and adds interest. And if you failed to file IRS PFIC Form 8621 annually during your ownership, the IRS could pile on additional penalties.

This article assumes that you own PFICs through US brokers. If you own them through a foreign broker with foreign brokerage accounts, then beyond Form 8621, PFIC ownership often triggers additional reporting through FATCA (Form 8938) and FBAR (FinCEN 114). But if you are a US resident, if you own PFIC companies through a US broker, then FATCA and FBAR don’t come into play.

$25,000 and $5,000 PFIC Stock Value Exceptions

There is an exception for US shareholders of a Passive Foreign Investment Company (PFIC).

Source: https://patellawoffices.com/blog/planning-for-tax-minimization/small-pfic-exception-to-filing-form-8621/

You are not required to file Form 8621 for a PFIC in a tax year if:

1. You did not receive any payments (distributions) from any PFIC, and

2. You did not have any gains from selling or disposing of PFIC stock, and

3. One of these two conditions is also met:

   1. The total value of all your PFIC stock at the end of the tax year is $25,000 or less (or $50,000 or less if you file a joint return), OR

   2. If you own PFIC stock indirectly (for example, you own a PFIC 1 through another PFIC 2), your proportionate share in PFIC 1 is $5,000 or less.

4. What Is a Passive Foreign Investment Company (PFIC)?

A Passive Foreign Investment Company (PFIC) is any foreign corporation that meets one of two IRS tests:

• Income Test: If 75% or more of the company’s income comes from “passive” sources, like interest, dividends, or rent, it is a PFIC. This is called the income test.

• Asset Test: If 50% or more of the company’s assets (like stocks, bonds, or property) are used to make passive income, it is also a PFIC. This is called the asset test.

Source: https://www.irs.gov/instructions/i8621

In plain English? If a foreign company makes most of its money from investments rather than running an actual business (like manufacturing, retail, or services), the IRS considers it a PFIC.

The theory is simple. The actual practical application is not.

Some companies, like the popular silver ETF PSLV (Sprott Physical Silver Trust) mentioned above, are clearly PFICs. In the case of PSLV, it is confirmed as such by its sponsor Sprott here.

However, other companies may move in and out of PFIC status. For example, while gold mining is an active business, a gold mining company that also is engaged in gold royalties (earning money from investments) can move in and out of PFIC status based on where it stands in terms of the above-mentioned IRS criteria. However, it seems that the IRS has the rule, subject to some exceptions, "Once a PFIC, always a PFIC." According to that rule, if a company was ever a PFIC during your holding period, certain PFIC rules may continue to apply in later years, even if the company is no longer a PFIC in those years.

Source: https://www.jdsupra.com/legalnews/purging-the-pfic-taint-8784147/#:~:text=Section%201298(b)(1,no%20longer%20satisfies%20the%20PFIC

And to make it extra fun, more likely than not, your US broker won’t tell you either that you purchased a PFIC company, own a PFIC company, or sold a PFIC company.

So what to do?

5. How to Recognize a Passive Foreign Investment Company (PFIC)

Some companies are clear-cut PFICs. For example, foreign mutual funds, foreign ETFs, and companies like PSLV (a silver trust) are 100% PFIC—they exist mainly to hold investments and produce passive income.

But not all companies are so obvious. Some businesses, like a gold mining company that also does gold streaming (which involves buying and selling gold contracts), might be a PFIC one year and not the next. If a gold miner earns most of its money from mining (which is an active business), it might not be a PFIC. But if, in a certain year, most of its income comes from gold streaming (which is considered passive income), it could meet the PFIC test for that year. The same goes for companies that shift their business activities or asset mix from year to year.

Thorough due diligence is essential for US investors in foreign companies to determine and document whether a company is a Passive Foreign Investment Company (PFIC). To my knowledge, there is no broad “safe harbor” rule that automatically protects investors from PFIC status. Each company must be tested annually.

Steps for Effective Due Diligence

• Review annual financial statements and the company’s website on what it says about its PFIC status (if anything): Analyze the company’s audited financial statements each year. Focus on the breakdown of income sources (active vs. passive) and the composition of assets (operating assets vs. cash, securities, etc.).

• Apply the IRS tests: Calculate the percentage of passive income and passive assets using the IRS definitions and thresholds.

• Document calculations and sources: Keep detailed records of your calculations, the financial statements used, and any correspondence with the company or tax professionals. This documentation is crucial if the IRS ever questions your PFIC analysis.

• Consult tax professionals: Given the complexity, consult with tax advisors who are experienced in international tax and PFIC rules, especially if the company’s business model is mixed or changes year to year.

6. PFIC IRS Filing Options

When you own shares in a Passive Foreign Investment Company (PFIC), the IRS gives you three tax paths, each with distinct consequences. The default method (using “excess” distribution) acts as a penalty box for unprepared investors, while the Mark-to-Market and QEF elections offer more controlled – though complex – alternatives.

The Default PFIC Method: A Tax Trap

If you do nothing, the IRS taxes your gains under a punitive retroactive system. When you eventually sell your PFIC or receive large distributions, the IRS calculates "excess" amounts—anything beyond 125% of your average distributions over the prior three years.

This excess gets taxed at the highest ordinary income rates (not capital gains rates) and is spread retroactively across your entire holding period. On top of that, the IRS tacks on interest charges for each year’s "deferred" tax. And if you failed to file Form 8621 annually during your ownership, the IRS could pile on additional penalties. The net financial result of this IRS default result is explained in more detail above in section 3, “Consequences for Not Filling the Required PFIC Paperwork.”

Mark-to-Market: Annual Accountability

The Mark-to-Market (MTM) election for PFICs allows you to pay taxes on your investment gains each year instead of waiting until you sell. This means you calculate the increase in your PFIC’s value at the end of each year compared to your adjusted basis and pay ordinary income tax on that gain.

While this avoids the complicated and often costly retroactive tax rules, it does create some important cash flow challenges. Because you owe taxes on unrealized gains—profits that exist only on paper—you might have to come up with cash to pay taxes even if you haven’t sold any shares or received any dividends. This can be difficult if the investment doesn’t generate income or if you want to hold the shares long term.

If your PFIC increases in value one year and then decreases the next, the tax treatment can be tricky. For example, if your PFIC grows from $10,000 to $15,000 in the first year, you pay tax on the $5,000 gain as ordinary income, and your new tax basis adjusts to $15,000. If in the following year the value drops to $12,000, you can only claim the $3,000 loss against future gains from that same PFIC. Losses under the MTM election cannot offset other income or gains from different investments.

In other words, you cannot use a PFIC loss to offset past gains from that PFIC, gains from other PFICs, or gains from different types of investments.

In a similar example, if your investment goes from $10,000 to $15,000 to $12,000 when you sell, you have paid taxes on the $5,000 gain, whereas your actual gain was only $2,000. Yikes.

In another example, if the value of a Passive Foreign Investment Company (PFIC) falls below your original purchase price, you generally cannot claim a loss in that year for tax purposes. However, again, you can claim a loss against future gains from the same PFIC investment.

All gains under the MTM method are taxed at ordinary income rates, which are usually higher than capital gains rates.

Under the MTM (Mark-to-Market) method, there is a risk that you could owe more in taxes than your original investment if a stock’s price rises sharply (causing a large taxable gain), then falls and never recovers. While this scenario is rare for most stocks, it’s important to be aware of the possibility.

Overall, the MTM election works best for publicly traded, low-volatility PFICs where market values are easy to track and for investors who can handle paying taxes annually on paper gains. It simplifies PFIC tax rules but comes with cash flow considerations and limits on how losses can be used. Because this election is complex and irreversible, it’s wise to consult a tax professional before choosing this option.

QEF Election: Partnership-Style Taxation

The Qualified Electing Fund (QEF) election is a way for people who invest in Passive Foreign Investment Companies (PFICs) to report their income like people in a partnership. When you choose this option, you pay taxes every year on the money you earn from the PFIC. This includes regular income and capital gains. For example, if the PFIC sells stocks for more than their purchase price, the profit is called a capital gain. If you keep your investment for over a year, you might pay less tax on those profits.

When using this election, the PFIC has to give you a yearly paper called the Annual Information Statement (a requirement many PFICs struggle to meet) that shows your total share of earnings, including any dividends distributed to you and the profits that the PFIC retained or reinvested, even if they didn't pay them out as cash. This means you will be taxed on all of your share of the PFIC's earnings for that year, regardless of whether you actually received any money.

While the QEF method requires the PFIC to provide Annual Information Statements and demands rigorous annual reporting, it can be particularly attractive for seasoned investors working with experienced tax professionals. This is because, if the underlying company has accumulated losses on its path to profitability, the QEF election allows those losses to offset future gains, enabling tax harvesting that may result in little to no taxes owed for an extended period. However, due to the technical requirements and the need for precise compliance, the QEF election is generally only practical for sophisticated investors who have access to specialized tax expertise.

Once you decide to make the QEF election, you can’t change it; you have to keep following these tax rules for that investment forever.

Choosing Your Path

For short-term holdings under $25,000, the default method might suffice despite its flaws. Publicly traded PFICs with low-volatility prices often pair well with MTM elections, while long-term investors should push for QEF status if and whenever possible.

The catch? Both MTM and QEF elections require filing Form 8621 annually, a document notorious for its complexity. As mentioned above, if you do nothing and file nothing, the default method will be applied. Professional guidance becomes crucial here, as missteps can trigger audits or accidental default method treatment.

Special Case – Foreign Brokers

If you own PFIC through non-US brokers, then beyond Form 8621, PFIC ownership often triggers additional reporting through FATCA (Form 8938) and FBAR (FinCEN 114). But if you are a US resident, if you own PFIC companies through a US broker, then FATCA and FBAR don’t come into play.

Strategic Considerations

The QEF election generally provides the most favorable tax outcome for disciplined investors, particularly when paired with proper record-keeping. However, its viability depends entirely on the PFIC's willingness to provide compliant tax statements. For investors stuck with uncooperative foreign funds, the MTM election or even divestment might become necessary to avoid the default method catastrophe. Remember: once you enter PFIC territory, there are no perfectly simple solutions – only varying degrees of controlled complexity.

7. Summary

Navigating the complexities of foreign investments can feel like a minefield, especially with Passive Foreign Investment Companies (PFICs), which can surprise you and potentially rob you of much of your gain with a hefty unexpected tax bill.

Avoid falling into this tax trap by staying informed, doing your due diligence, and consulting with tax professionals.

As mentioned in the beginning, when it comes to learning about taxes, there are really only two ways: the easy way and the hard way. The easy way is to educate yourself ahead of time by learning about tax rules and working with qualified tax professionals. (I’m not a tax professional—just an investor sharing my knowledge.) Or the hard way is to get surprised by a huge, unexpected tax bill and only learn your lesson after it’s too late.

Let’s make it the easy way, so that you can enjoy your investment gains.

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Disclaimer

Neither the author nor Fringe Finance is a financial advisor or a tax professional. This article is for illustrative and educational purposes only and does not constitute a specific offer of any product or service.

Past performance of stocks and assets is not an indicator or guarantee of future performance of stocks and assets.

The information in this blog does not constitute an offer to buy or sell, or a solicitation of an offer to buy or sell, any of the securities mentioned herein.

We believe the information provided is accurate and current. However, we do not guarantee its accuracy and it should not be considered a complete analysis of the topics discussed.

Any opinions expressed reflect the author's judgment at the time of publication and are subject to change.

Seek guidance from qualified financial and tax experts before taking action.