QEF or mark-to-market: PFIC elections for UK funds

What does the default PFIC regime do to a UK fund holder

Unless an election is made, the excess distribution regime in section 1291 applies. A gain on sale, and any distribution above a set proportion of the average of earlier years, is spread across the holding period. The part allocated to earlier years is taxed at the highest rate for each of those years, with an interest charge added.

The regime penalises long holding, which is the opposite of how most investors use funds. A fund held for many years and sold at a gain can produce a bill dominated by the top-rate allocation and the interest charge, with no capital gain rate available. Ordinary distributions within the limit are taxed in the year received. The Instructions for Form 8621 (opens the official IRS page in a new tab) set out the computation, and it is reported on Form 8621 for each fund.

The default regime is also the one that follows the shares. A fund bought years ago without an election carries its status into every later year, and any election made afterwards has to deal with the earlier years. For that reason the choice between the regimes is best made in the first year of ownership, before the first sale, and it is separate from the UK tax computation on the same fund, which follows UK rules.

When can you make a QEF election on a UK fund

A qualified electing fund election taxes the holder each year on a share of the fund's ordinary earnings and net capital gain, whether or not the fund pays anything out. It is available only if the fund provides the PFIC annual information statement, or enough information to compute the share, and most UK retail funds do not provide one.

The election is made on Form 8621 with a timely filed return and applies to that fund from then on. Sections 1293 and 1295 and the Form 8621 instructions (opens the official IRS page in a new tab) govern it. The statement the fund supplies has three core parts.

The benefit is that capital gain keeps its character and, where the election applies from the start of the holding, the interest charge does not arise. The cost is dependence on the manager for the figures every year, and tax on income the holder may not have received in cash. Some managers with US investors supply a statement on request and a few publish one, so a direct request to the manager settles the point.

• The ordinary earnings and net capital gain attributable to the holder's shares for the year
• The cash and property distributed to the holder during the year
• A statement that the fund will let the holder inspect its records to check the figures

Can you make a mark-to-market election on a UK fund

Only if the shares are marketable stock. For this purpose that broadly means stock regularly traded on a qualifying exchange, which can include certain foreign exchanges. Most UK OEICs and unit trusts are dealt directly with the manager at a price set by the fund, not traded on an exchange, so they usually do not qualify.

A listed investment trust or exchange traded fund can be different. The test is applied to the particular shares and the particular exchange, using the rules in the regulations on qualifying exchanges and regular trading, so a listing alone does not settle it. Our post on whether UK investment trusts are PFICs covers how these companies are tested in the first place.

Where the election is available, the holder includes as ordinary income the excess of fair market value over adjusted basis at the end of each year. A loss is allowed only to the extent of earlier net inclusions, and a gain on sale is ordinary income. The election is made on Form 8621 by the due date, including extensions, of the return for the first year the stock is marked to market. It suits a holder who can accept ordinary income treatment and has no statement to rely on, but it taxes unrealised growth with no cash to pay the bill.

How do you move a fund out of the default regime

A holder already in the default regime who wants to elect later can usually do so only with a purging election. It treats the shares as sold, or where the fund is also a controlled foreign corporation as paying a dividend, and brings the earlier gain into tax under the default rules so the new regime starts clean.

A timely purging election is made on Form 8621. A late one has its own procedure, which uses Form 8621-A, computes the tax as if the election had been timely and adds interest from the original due date of the return. The Instructions for Form 8621 (opens the official IRS page in a new tab) describe both, and the box references have changed between revisions, so the current form should be checked before filing.

The price of the purge is a tax charge on the accumulated gain, paid now, in return for a cleaner position later. That makes the size of the gain and the expected holding period the main inputs. A mark-to-market election made after the first year of holding also has to deal with the default regime for earlier years, and the instructions set out how.

• Deemed sale election: the shares are treated as sold at market value and the gain is taxed under the default rules
• Deemed dividend election: for a fund that is also a controlled foreign corporation, accumulated earnings are taxed as an excess distribution
• After a deemed sale, the holder generally has a new basis and a new holding period for the election to build on

Does UK reporting fund status count for US purposes

No. Reporting fund status is a UK tax label under the offshore funds rules. It decides whether a gain on the fund is taxed in the UK as capital gain or as income, and it has no effect on whether the fund is a PFIC or on whether a QEF election can be made.

A fund's UK reporting to HMRC and to investors rests on UK rules and is not a PFIC annual information statement unless the manager says it also meets the US requirements. Some managers produce both, and the two documents can sit side by side. A UK tax pack should not be used to complete a QEF election unless the manager confirms it carries the US statement items.

Wrappers do not change this. An ISA (opens the official GOV.UK page in a new tab) has no US tax protection, so funds inside one are taxed on the US return as if held directly, and our article on why a stocks and shares ISA worries the IRS explains the position. Credit for UK tax paid on the same income depends on category and timing, so the two returns should be prepared together.

How should a US person in the UK choose between the regimes

Start with what is available, because the fund often makes the choice. If the manager supplies a statement, QEF is open. If the shares trade on a qualifying exchange, mark-to-market is open. If neither applies, the default regime remains, and the aim becomes limiting its cost rather than avoiding it.

Take a US citizen employed in Manchester who holds a global equity OEIC bought through a platform, with no US statement from the manager and no exchange listing. Neither election is open, so the fund stays in the default regime and is reported on Form 8621, and a sale will usually produce an excess distribution. A review would ask whether similar exposure is available through a listed fund where mark-to-market might work, or through a US-domiciled fund, with the UK tax and platform consequences checked first.

Records matter in every case. The election, the basis, the holding period and any purging election have to be traceable from year to year, and Form 8938 (opens the official IRS page in a new tab) can apply alongside Form 8621 for the same holdings, as the page on Form 8938 explains. Our PFIC reporting service reviews holdings fund by fund, and our tax planning and international tax services model the choice before a sale. The wider position is in the guide to US-UK tax for founders, fund managers and executives, and you can contact US UK Tax Returns with a list of holdings.