Investment Constraints 3: Equity

60% of Australians own equity based investments (listed or non-listed) outside of institutional superannuation accounts, and 37% of Australians own listed shares (2017 ASX Australian Investor Study). There are two main ways to invest in equity – purchase shares directly on the share market or purchase a slice of a portfolio managed by a professional portfolio manager. For Australian investors who are claimed by the US, the US tax implications of these two choices are quite different.

This is the third instalment in our series of posts discussing the ways US tax laws constrain the investment choices of US taxpayers living in Australia. These are the areas we will be covering:

  1. Superannuation
  2. Homeownership
  3. Real Estate
  4. Australian Managed Funds
  5. Australian Shares
  6. Business Ownership Structures
  7. Investing in the US
  8. Record keeping

This series (and everything on this website) is general information only. I am not a lawyer, tax professional, or financial planner, just someone who has learned about US tax and wants to pass on general knowledge. Many areas of tax law are interdependent, so changes in one area may have unintended consequences in another. You should consult a professional who can consider your own personal circumstances before taking any action.

4. Australian Managed Funds

If you get advice from a financial planner, chances are that managed funds will be a significant portion of the recommended portfolio. A managed fund is a slice of a larger portfolio of shares, bonds, real estate, or other investments. The fund may be actively managed, with analysts selecting specific investments based on some proprietary investment criteria; or passively managed, meaning the portfolio is invested in the companies in some broad market index. Managed funds are a cost-effective choice for small investors as they provide diversification and the transaction costs are spread across all investors in the fund. Unfortunately for US-taxpayers, Australian managed funds are classified as PFICs.

Passive Foreign Investment Companies (PFICs) are foreign (non-US) corporations meeting either of two conditions:

  1. 75% of the company’s income is passive income (interest, dividends, etc.) or
  2. 50% of the company’s assets produce, or could produce, passive income.

The PFIC rules were added to the US tax code by the Tax Reform Act of 1986. Non-US mutual funds are not all subject to rules that require current distribution of realised income, and this was seen by US mutual funds as an unfair advantage. However, many countries, such as Australia, have income distribution requirements that are similar to those in the US. By imposing a “one-size-fits-all” approach to taxing “foreign” investments, the PFIC rules are excessively punitive to investments in countries with tax systems that are roughly equivalent to the US.

If you own an investment classified as a PFIC, you have two choices: either include all increases in market value in ordinary income every year, or apply an extremely punitive anti-deferral regime that taxes all gains at the highest possible marginal rate (currently 39.5%) and charges daily compounded interest on the deemed deferral of tax. (There’s actually a third choice, but it requires an election and reporting by the foreign mutual fund directly to the IRS, which is very unlikely to happen). The record keeping and reporting is outrageously complex, and the net effect is a denial of capital gains treatment and a high effective tax rate on gains that can easily exceed the tax paid in Australia. Before FATCA and the push for “offshore” enforcement by the IRS, many taxpayers had no idea that their non-US mutual funds were taxed punitively in the US.

To get an idea of the complexity of US tax compliance for PFICs, take a look at this flowchart for those making the mark to market election to include all increases in value as taxable income on an annual basis. Note that the IRS estimates that the annual information return required for all PFICs, Form 8621, has an estimated time burden of:

Recordkeeping……………………………………………….. 16 hr. 58 min.
Learning about the law or the form…………………. 11 hr. 24 min.
Preparing and sending the form to the IRS……… 20 hr. 34 min.

No wonder this is one of the most expensive forms to have professionally prepared! Most US tax professionals advise clients to stay away from non-US managed funds to avoid both the compliance and punitive taxes associated with PFICs.

5. Australian Shares

To avoid owning PFICs, investors can buy shares directly on the ASX. It is important to note that some investments traded on the exchange may be PFICs, so if you’re investing in direct shares in order to avoid the PFIC rules, you should also be avoiding Exchange Traded Funds (ETFs), Listed Investment Companies (LICs), Real Estate Investment Companies (REITs), early stage start-up companies with no operating revenue, and any company whose assets are mainly investments in other companies.  If you stick to operating companies, the applicable US tax rules will be similar to the rules applied to US-listed companies.  Dividends received from a company incorporated in Australia (or any of the countries listed in this table) are considered “Qualified Dividends” and taxed at capital gains rates as long as certain holding period rules are met. Gain on shares held for more than a year also qualifies for capital gains tax rates, which are lower than ordinary tax rates. Any US tax on dividends or capital gains can be offset by Australian tax paid on investment income under the Foreign Tax Credit (FTC) rules (claimed on form 1116).

Of course, if you’re living in Australia, you are also paying Australian tax on this income, and the Australian tax benefits of owning shares may mean that you have little Australian tax available for FTC. When an Australian company pays dividends out of income that has already been taxed in Australia, the company tax attributable to that dividend is passed out to the shareholder as a “franking credit”. A numerical example may help illustrate these rules. Say a company has a net profit of $100 before tax. Australian company tax is a flat 30%, so the company will pay $30 in tax and have $70 of net income. If we assume the company pays all of this out as a dividend, the shareholder will receive $70 in cash. The $30 tax paid by the company is passed to the shareholder as a franking credit. The shareholder then reports $70+$30=$100 in dividend income on her Australian tax return and takes a tax credit of $30 against her total tax liability. If her marginal Australian tax rate is 19%, the $100 of dividend income will increase her tax by $19, but the $30 credit means that her net tax bill is $11 less with the dividend than without it. The franking credit is refundable, so investors with only dividend income can actually get a refund.

So, how does this affect US tax on Australian dividends? The US will tax only the cash dividend, and not the franking credit. However, the franking credit will reduce Australian tax available for FTC. Given relative tax rates between the two countries, and the reduced US tax rate paid on qualified dividends, it is quite possible that no US tax will be due. However, it is worth planning carefully to be sure.


Well, I’ve topped 1000 words again, and only barely scratched the surface. The PFIC rules are particularly complex. As always, you should consult a professional advisor before entering into any significant transaction. Next week we’ll wrap up this series with a post on business structures and investing in the US.

12 thoughts on “Investment Constraints 3: Equity”

  1. Karen, another great post which should be understandable by all. (This is also a good post for people in Canada where the taxation of Canadian dividends includes the concept of a “franking credit” (called the “dividend tax credit” in Canada)).

    The simple and (bottom line) message from your post is very simple:

    Those Australians who attempt to be U.S. tax compliant will have investing options that are SEVERELY LIMITED! They are severely disadvantaged when it comes to retirement planning and day-to-day investing. And all because they may have been born in the United States. Think of it! These are Australian residents who can’t plan for retirement because they are subject to a foreign tax system!

    As you point out, even the avoidance of Australian mutual funds may lead to PFIC problems.

    If I may add something to the non-U.S. mutual fund discussion:

    When people first hear about “PFIC/Mutual fund problems” their initial response is to simply sell the mutual funds. Selling the mutual funds can often lead to confiscatory taxation and the significant erosion of capital. Therefore, the message for those with mutual funds should be:

    1. Do NOT buy any more non-U.S. mutual funds; and

    2. If you have non-U.S. mutual funds they should NOT be sold until a review of the tax consequences has been undertaken!

    This is explained here, where the message is:

    “The world of PFICs is extremely complicated and confiscatory. The message for U.S. citizens abroad who have purchased mutual funds (and similar investment vehicles) in their country of residence is:

    Do NOT buy more and get professional advice for how to deal with the ones you have.”

    How can all of this be?

    The U.S. tax system is based on three principles of punishment:

    1. The U.S. hates ALL things foreign. (Non-U.S. mutual funds are foreign)

    2. The U.S. hates ALL forms of deferral unless it is specifically allowed in the Internal Revenue Code (The U.S. imagines that non-U.S. funds are opportunities for deferral when in reality they are often not. Of course U.S. based funds do NOT like competition from foreign funds)

    3. The U.S. hates the leakage of capital from the USA. (Australians who are claimed by the USA should be investing in American products and NOT committing “personal finance abroad”).

    The solution to all of this for those who wish to CONTINUE TO BE U.S. CITIZENS (there are good reasons to renounce U.S. citizenship) is to buy ONLY U.S. based financial planning and retirement products! But, this may be difficult because of the U.S. regulations.

    Of course, the real solution is for the United States to stop imposing taxation on the residents and citizens of other nations (which they call “citizenship-based taxation”)!

    Today is July 3. Tomorrow is the fourth of July. I strongly suggest that those of you who are Americans abroad should consider what it means to be an American living outside the United States. Homelanders will celebrate “Independence Day” and the breaking of ties to a tyrannical King. On the fourth of July, I will be meeting with Americans in Canada who plan to renounce U.S. citizenship in order to achieve their own independence and freedom from a rather tyrannical regime.

    1. Thanks for your comment, John.

      One of the big problems with PFICs is that many people may have bought local mutual funds years/decades ago and are just now realising that these are PFICs. They may have been reporting these investments on their US tax returns all along as if they were equivalent to US mutual funds. I know that some have had to start reporting these as PFICs (and perhaps file amended returns) due to the insistence of their tax preparer or through one of the IRS voluntary disclosure programs. I was wondering, though, whether there were many instances of the IRS sending out notices to expats who had incorrectly reported a foreign mutual fund on an otherwise complete return. Or is this another area where those who try to do the right thing are the ones who are hurt the worst?

      For me the 4th of July is a special day, it is the day we arrived in Australia 22 years ago.

      1. Karen:

        First, this comment should NOT be interpreted to mean that non-U.S. mutual funds are NOT PFICs. I am NOT taking a specific position on whether they are or not PFICs (or whether they same classification applies to ALL mutual funds).

        With that caveat and disclaimer …

        I am not aware of any statement that comes from the IRS directly that says that non-U.S. mutual funds are PFICs. It is not immediately apparent by reading the Internal Revenue Code that the PFIC Regime is aimed at capturing non-U.S. mutual funds. There is NO DOUBT that the tax “professionals” are preaching the “Foreign Mutual Funds are PFICs Gospel”. This is one more example of “the tax professionals reinforcing/creating the law”. There is also no doubt that few have analyzed the issue in terms of the law. But, what else is new …

        This is a complicated issue that requires (as a necessary but not sufficient condition) that the “mutual fund” be a corporation for U.S. tax purposes. This was a problem that was absolutely UNKNOWN until 2010. In Canada the whole thing started with an IRS Counsel ruling in conjunction with a completely unrelated issue which is described in the following IRS Chief Counsel Memorandum.

        Amazingly on the basis of the above IRS ruling (that HAD NOTHING TO DO WITH THE PFIC ISSUE), tax professionals (on the basis of this ruling) have begun preaching the “Mutual Funds Are PFICs Gospel”.

        It’s also important to understand what this kind of IRS technical memorandum actually is. You can read about the different kinds of IRS “guidance” here:

        What it says about technical memorandums is this:

        “Technical Advice Memorandum

        A technical advice memorandum, or TAM, is guidance furnished by the Office of Chief Counsel upon the request of an IRS director or an area director, appeals, in response to technical or procedural questions that develop during a proceeding. A request for a TAM generally stems from an examination of a taxpayer’s return, a consideration of a taxpayer’s claim for a refund or credit, or any other matter involving a specific taxpayer under the jurisdiction of the territory manager or the area director, appeals. Technical Advice Memoranda are issued only on closed transactions and provide the interpretation of proper application of tax laws, tax treaties, regulations, revenue rulings or other precedents. The advice rendered represents a final determination of the position of the IRS, but only with respect to the specific issue in the specific case in which the advice is issued. Technical Advice Memoranda are generally made public after all information has been removed that could identify the taxpayer whose circumstances triggered a specific memorandum.”

        PFIC was NOT the issue in the particular case.

        In addition, some have taken the position that NOT all non-U.S. mutual funds are PFICs …

        You write:

        “I was wondering, though, whether there were many instances of the IRS sending out notices to expats who had incorrectly reported a foreign mutual fund on an otherwise complete return. Or is this another area where those who try to do the right thing are the ones who are hurt the worst?”

        When it comes to the U.S. taxation of Americans abroad, those who assume the interpretation that is most favourable to the IRS, are absolutely hurt the worst. In fact, U.S. tax compliance is now the first step to renunciation (by necessity) for anybody who needs to plan for retirement.

        I am aware of no “hearsay” describing the IRS sending out notices to expats claiming that they had incorrectly reported a “foreign mutual fund”. Assuming a non-U.S. mutual fund is a PFIC, then reporting it on Form 8621 (which would then be correlated with Form 8938) would flag it as a PFIC.

        For people who bought mutual funds years ago …

        The simple fact is that if those mutual funds are PFICs the taxation of the gain can come close to 100% of the gain. This is why in my previous comment I warned against simply selling mutual funds that had been identified as PFICs. Compounding the problem is that only a small part of the gain will be treated as capital gain. The rest of the gain is a punitive tax based on Americans notions of “tax deferral”.

        In any case, those in this situation should be very careful.

        The PFIC problem is one more reason why …

        “All roads lead to renunciation!”

        Nobody can live as a “U.S. tax compliant” American citizen abroad.

      2. Continuing this topic and repeating my disclaimer that this is NOT tax or legal advice and I am NOT taking a position on whether non-U.S. mutual funds are PFICs.

        I thought it would be interesting to check IRS Publication 54 which is the IRS Publication for Americans Abroad (the Bible for Americans Abroad) which is found here:

        Although I recognize that this is NOT binding, it is interesting that there is no mention of non-U.S. mutual funds being subject to special reporting (Form 8621) or a special tax regime (Internal Rev. Code 1291). There is a link at the end of Chapter 1 to “other forms to file”. Here is what it says:

        “Other Forms You May Have To File

        FinCEN Form 114. You must file Form 114, Report of Foreign Bank and Financial Accounts (FBAR), if you had any financial interest in, or signature or other authority over a bank, securities, or other financial account in a foreign country. You do not need to file the report if the assets are with a U.S. military banking facility operated by a financial institution or if the combined assets in the account(s) are $10,000 or less during the entire year.

        Form 114 is filed electronically with the Financial Crimes Enforcement Network (FinCEN). See the filing instructions at
        FinCEN Form 105. You must file Form 105, Report of International Transportation of Currency or Monetary Instruments, if you physically transport, mail, ship, or cause to be physically transported, mailed, or shipped into or out of the United States, currency or other monetary instruments totaling more than $10,000 at one time. Certain recipients of currency or monetary instruments also must file Form 105.

        More information about the filing of Form 105 can be found in the instructions on the back of the form available at

        Form 8938. You must file Form 8938 to report the ownership of specified foreign financial assets if the total value of those assets exceeds an applicable threshold amount (the “reporting threshold”). The reporting threshold varies depending on whether you live in the United States, are married, or file a joint income tax return with your spouse. Specified foreign financial assets include any financial account maintained by a foreign financial institution and, to the extent held for investment, any stock, securities, or any other interest in a foreign entity and any financial instrument or contract with an issuer or counterparty that is not a U.S. person.

        You may have to pay penalties if you are required to file Form 8938 and fail to do so, or if you have an understatement of tax due to any transaction involving an undisclosed foreign financial asset

        More information about the filing of Form 8938 can be found in the separate instructions for Form 8938.”

        No mention of Form 8621. No mention of a PFIC. No mention of the dangers of a “non-U.S. mutual fund”.

        Moving over to Form 8938 (because it is mentioned):

        We see a reference to Form 8621 but no mention of what Form 8621 would be for.

        “Part IV. Excepted Specified Foreign Financial Assets

        If you reported a specified foreign financial asset on certain other forms listed below for the same tax year, you may not have to report it on Form 8938. However, you must identify the form where you reported the asset by indicating how many forms you filed.

        For more information, see Duplicative reporting, earlier. If you reported a specified foreign financial asset on one or more of the following forms, enter the number of forms filed.

        Form 3520.

        Form 3520-A.

        Form 5471.

        Form 8621.

        Form 8865.”

        Okay moving over to Form 8621:

        This a lot of reading and I am not reading this too carefully. But, what I am NOT saying is a clear statement that a “non-U.S. mutual fund” is a PFIC. I do see a discussion of the coordination of the CFC and PFIC rules (a small business corporation can and often is a PFIC).

        So, my point is this:

        I do NOT think that there is any chance that any normal person reading this stuff (starting with Publication 54) could possibly decide that their local non-U.S. mutual fund is a PFIC and subject to all this insanity. The IRS clearly is NOT going out of its way to alert people to this possible problem.

        In order to learn the true “status” of your mutual fund you would have to consult a “tax professional”.

        Caveat: I am reading this quickly and if I have missed a reference please advise in a reply comment. What I am not interested in is some kind of comment that goes upside down and sideways through a bunch of regs. My point is a simple one:

        No normal person would have the slightest suspicion that their “non-U.S. mutual fund” (down the street from where they live) would be subject to the PFIC regime. To get this kind of knowledge, you would need “specialized advice”.

        I do think that this observation is of some relevance to the discussion (particularly if you have owned “non-U.S. mutual funds” for many years).

        Obviously though:

        If you do NOT own “non-U.S. mutual funds” you should not buy them.

        If you DO own “non-U.S. mutual funds” you should NOT sell them without understanding the possible PFIC consequences.

      3. Let’s now consider the text of the Internal Revenue Code.

        First (continuing on), this comment should NOT be interpreted to mean that non-U.S. mutual funds are NOT PFICs. I am NOT taking a specific position on whether they are or not PFICs (or whether the same classification applies to ALL mutual funds).

        With that caveat and disclaimer …

        In my last comment I considered the information that the IRS provides directly to Americans abroad. I argued that there is nothing coming form the IRS that would directly suggest that “non-U.S. mutual funds” are PFICs. This unpleasant conclusion (it’s a PFIC) can be known only through a consultation with a “tax professional”.

        In this comment, I will consider the actual text of the Internal Revenue Code (the Bible of American life and required reading for ALL Americans Abroad).

        The question is whether (according to the text of the Internal Revenue Code) a “non-U.S. mutual fund” is a PFIC. Let’s look to the definition of a PFIC which is found in Internal Revenue Code 1297.

        “26 U.S. Code § 1297 – Passive foreign investment company

        (a) In general For purposes of this part, except as otherwise provided in this subpart, the term “passive foreign investment company” means any FOREIGN CORPORATION if—
        (1) 75 percent or more of the gross income of such corporation for the taxable year is passive income, or
        (2) the average percentage of assets (as determined in accordance with subsection (e)) held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50 percent.”

        Note, the necessary condition is that the mutual fund be a “corporation”. Let’s make a distinction between the mutual fund entity that owns the assets on behalf of the investors and the assets owned by the fund. Mutual funds are businesses that specialize in investing people’s assets. Anybody can create a mutual fund. So, the first question to ask is what is the “foreign corporation” that the “United States person” is a shareholder in (that might be subject to an PFIC”excess distribution” as per 1291)? Well, a mutual fund investor is NOT a shareholder of the mutual fund company. Therefore, the question becomes:

        Are the shares that the mutual fund company buys on behalf of the investors the shares of a corporation that is owned by the investors in the mutual fund? (Note that this is distinct from the shares of the mutual fund company per se.)

        Let’s look to the definition of “corporation” in S. 7701:

        “(3) Corporation
        The term “corporation” includes associations, joint-stock companies, and insurance companies.
        (4) Domestic
        The term “domestic” when applied to a corporation or partnership means created or organized in the United States or under the law of the United States or of any State unless, in the case of a partnership, the Secretary provides otherwise by regulations.
        (5) Foreign
        The term “foreign” when applied to a corporation or partnership means a corporation or partnership which is not domestic.”

        Again, it’s not clear (or at least would not be clear to the average person) that an investment in shares owned by a mutual fund on behalf of investors (remember that the investors do NOT own shares in the mutual fund company) are a corporation. Are the pooled shares in a mutual fund an “association” or “joint stock company”?

        Perhaps there is a regulation that speaks to this. You can check here:

        Possible conclusion:

        I see no way that the average person could read Internal Revenue Code 1297 and reach the immediate conclusion that a “non-U.S. mutual fund” is a PFIC because it is NOT clear that the pooled assets are owned by a corporation that is owned by a “United States Person”.

        Now, I am sure that there must be a way to reach the conclusion that “non-U.S. mutual funds” may (depending) on the fund be a corporation that is a “foreign corporation” (and therefore meets one of the prerequisites for PFICness).

        But, it could NOT be clear to the average person based on the plain text of the statute (at least it seems to me).

        What does all this suggest?

        Neither the information from the IRS nor the text of the Internal Revenue Code can easily be read to conclude that a “non-U.S. mutual fund” is a PFIC. You need ask your “tax professional” to learn this!

        Again, I do think that this is of some significance (particularly for those who have held “non-U.S. mutual funds” for many years.

      4. Finally (continuing on), this comment should NOT be interpreted to mean that non-U.S. mutual funds are NOT PFICs. I am NOT taking a specific position on whether they are or not PFICs (or whether the same classification applies to ALL mutual funds).

        With that caveat and disclaimer …

        And finally, some analysis on whether Australian mutual funds are or are not “foreign corporations”

        The answer does not seem to be clear.


        1. Thanks again for your comments, John.

          The absence of any reference to “foreign” mutual funds as PFICs in IRS publications has been mentioned to me before – I probably should have included this in my post. For someone without the “benefit” of a professional US tax preparer, there’s no indication in IRS publications that these investments should be treated any differently than an investment in a US-based fund. Here in Australia there are many funds run by Australian subsidiaries of US fund managers, and the end of the year tax statement contains the same information you would see on a US 1099, but keyed to Australian tax returns (and the Australian tax year which ends on 30 June). Why would you think to treat your Australian Vanguard fund any differently to your US Vanguard fund?

          The issue of whether fund units constitute investment in a corporation or some other type of entity raises one of my main concerns in the area of US taxation of Australian individuals – US tax rules often turn around interpreting local law through the lens of the Internal Revenue Code. US tax experts may know the Internal Revenue Code inside out, but they are not experts in Australian law. Where are the Australian-trained tax lawyers who are fighting for interpretations of the Internal Revenue Code that respect the actual reality of Australian legal structures, laws and regulations?

      5. Okay, have turned the comments to this post into a “story” at “Storify”. Learn how through a combination of U.S. legislation and regulations (read ONLY by “tax professionals”) converted the lowly “every day mutual fund” into (possibly) a wealth destroying PFIC.

        Your wealth and lives are being destroyed NOT by laws that you did NOT know existed, but rather by laws (and interpretation through regulation) that you couldn’t even imagine existed!

  2. Continuing the discussion of PFICs “Passive Foreign Investment Companies”:

    The PFIC legislation is found in Part VI of Subchapter P of the Internal Revenue Code which is the section dealing with “Capital Gains and Losses”.

    “26 U.S. Code Subchapter P – Capital Gains and Losses

    PART I – TREATMENT OF CAPITAL GAINS (§§ 1201 to 1202)

    Only part of the PFIC Regime is related to “capital gains”. The more natural place to include this would have been Part III of Subchapter N which (includes the Controlled Foreign Corporation rules) and deals with:

    “26 U.S. Code Subchapter N – Tax Based on Income From Sources Within or Without the United States


    This makes me wonder if Congress really understood what it was doing when enacting the PFIC rules.

  3. Thank you for this awesome post and website. Very helpful and also very scary for us dual citizens.

    Could you please point me in the right direction with this question? THANK YOU!!!

    I’m an AUS/US dual citizen. I just moved back to AUS a few months ago and I need to choose/identify a super account in the next few days for my employer to contribute to. My understanding is to avoid PFICs (i.e. avoid Non-US mutual funds). But it seems that a self-managed fund will also create many compliance issues? I’m looking for a super fund with the least amount of US compliance issues!! Thank you for your help!!!

    Obviously, it’s a much more complicated question than that. I’m just trying to sort out that first step and then get professional help with all my finances.

  4. Hi Daniel,
    Glad you found us. I think the key is finding a US tax professional who will report your super as being equivalent to Social Security, and talking to them about exactly what types of super accounts will qualify as Social Security on your US return.

    If you’re not treating super as social security, then an SMSF will definitely be a nightmare.

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