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Passive Foreign Investment Company (PFIC)

Investment in collective investment vehicles will usually be caught by rules on Passive Foreign Investment Companies (PFIC). For example, investing in non-US based collective investments such as investment trusts or unit trusts can lead to adverse US income tax consequences and complex annual US reporting requirements. 

This problem arises because all non-US collective investments are caught under the Passive Foreign Investment Company (PFIC) regime.
A Passive Foreign Investment Company is a corporation which meets either an income or an asset test. Under the income test, at least 75 percent of the corporation’s income must be “passive” income – such as dividends, interest and rents. Under the asset test a corporation is classified as a PFIC if at least 50% of the corporation’s assets are held for the production of passive income.

Basically, the existence of all such investments must be disclosed when income is distributed or when an investment is sold.

"Excess distributions” are taxed at the highest rate for individuals (currently 39.6% percent) and an interest charge is added as if growth had been reported on an annual basis and tax paid over the period of growth.

To avoid these negative consequences for a qualified electing fund (QEF) an election may be made.  However, in most cases the PFIC will not be prepared to meet the requirements proposed by the IRS  and so the QEF  election is usually not a possibility.
Another alternative, for regularly traded funds, is to make a mark to market election recognising either gain or loss annually. However PFIC inclusions are not eligible for the 15% rate on qualified dividends available to individuals.

The key point to note is that an investment made in an ISA in the UK which escapes from UK tax on both capital gains and income tax on the dividends may result in unpleasant US tax consequences if the investment is made into PFIC.