Have a read of this -
http://www.deblislaw.com/understanding-the-pfic-rules-without-suffering-a-migraine.html
"A taxpayer who does not make a QEF election is taxed under the pure PFIC tax regime of Section 1291. Under this regime, taxpayers are permitted to defer taxation of a PFIC’s undistributed income until the PFIC makes an excess distribution. An excess distribution includes the following:
i. A gain realized on the sale of PFIC stock, and
ii. Any actual distribution made by the PFIC, but only to the extent that the total actual distributions received for the year exceed 125% of the average actual distribution received in the preceding three taxable years (or, if shorter, the taxpayer’s holding period before the current taxable year)."
Thanks, good to know. My understanding after reading up: the qualified electing fund (QEF) option is not available for UK funds. So the only options are the normal/delayed treatment you describe above, or mark-to-market (MTM) each year. The delayed method is free if I leave the US without selling up, but if I stayed it'd be taxed as an "excess distribution" at highest marginal rate - 39.6% - plus interest.
The alternative is to MTM every year, which would be taxed as ordinary income at my marginal rate with no interest penalty, but means the certainty of being taxed even if I later leave. Or just bite the bullet of less diversification and buy UK stocks directly to benefit from long term capital gains and qualified dividends.
I've worked through an example on a $100k portfolio. Assume 10% annual growth (4% dividends + 6% cap gain) over 3 years, then either stay in US or leave and become non-resident. 25% marginal income tax band for all three years. Gain of $33.1k in the PFIC; $12k dividends and $21.1k cap gains in UK stocks.
Option | Stay in US | Leave after 3 years |
PFIC Delayed | ~$14k | $0 |
PFIC MTM | $8.25k | $5.5k* |
UK stocks | ~$5k | $~1.8k* |
* Delay selling/capital gains until non-resident in final year
Of course, the difference will be larger/smaller if a greater/smaller return happens. And it assumes UK stocks will return the same as the PFIC fund, despite much less diversification.
Using the table I calculated the expected value of each option given a certain probability of deciding to remain indefinitely in the US after 3 years. PFIC MTM can be ruled out. I should pick PFIC delayed if I'm <18% likely to stay in the US beyond 3 years.
Can't help but feel that picking 20-25 UK stocks is hardly equivalent to a globally diversified portfolio, though. Plus there's all the hassle of reinvesting dividends, corporate actions...
Converting to $ and investing with Vanguard US isn't much better for the reasons outlined in original post.
I am leaning towards the "life's too short, just buy the PFIC fund and be done with it" option. Even with a potential $14k tax bill. Think I'll do it for year 1 at least, as it keeps me in the market with the lowest risk. I can re-evaluate in Dec 2015.
Thanks for your thoughts everyone (though feel free to chime in if you have anything to say about the above!)