PFIC UK Funds: Why Americans Should Check Their ISA

PFIC UK funds: an introduction

The PFIC UK funds problem is simple to state: most UK collective investment funds count as passive foreign investment companies for US tax, so Americans who hold them face harsh default rules and an extra form. That applies even inside a stocks and shares ISA, which the US does not treat as tax-free. If you are a US person in Britain with UK funds, check them before your next US return.

This article explains what makes a UK fund a PFIC, how the default tax works and what the elections change. Our full guide to the US-UK double taxation treaty explains where the treaty helps and where it does not.

Why PFIC UK funds catch so many Americans

UK savers are encouraged to hold funds rather than single shares, and most ISA platforms are built around them. Meanwhile, the US rules were written to stop Americans deferring tax through offshore funds. Consequently, an ordinary UK index fund, bought for sensible reasons, sits squarely inside rules aimed at tax avoidance. Few UK advisers mention it, because the issue only exists for US taxpayers.

What a PFIC is

A passive foreign investment company, or PFIC, is a non-US company that mainly earns or holds passive investment income. Under section 1297 of the Internal Revenue Code, a foreign corporation is a PFIC if 75% or more of its gross income is passive. Alternatively, it is a PFIC if at least 50% of its assets produce passive income. A fund that holds shares and bonds usually meets both tests.

Which UK investments are PFICs?

Most UK pooled funds are PFICs, including unit trusts, OEICs, UK-listed ETFs and investment trusts. Shares in an ordinary UK trading company generally are not, because a trading company's income is mostly active.

Unit trusts, OEICs and ETFs

An OEIC is an open-ended investment company, and a unit trust is a similar pooled fund set up as a trust. Both are usually classified as corporations for US tax purposes, and both hold passive investments. Similarly, ETFs listed in London or domiciled in Ireland or Luxembourg are generally PFICs. Therefore, the PFIC UK funds question covers most of what a typical ISA platform sells.

Investment trusts

An investment trust is a listed UK company whose business is holding investments. Despite the name, it is a company, and its income is mostly passive. As a result, investment trusts are usually PFICs too. Real estate investment trusts and some specialist trusts need a closer look at their income and assets.

Shares in UK trading companies

Shares in a company such as a UK bank, retailer or manufacturer are generally not PFICs. Their income comes mainly from trading, so they fail both passive tests. Even so, the tests are applied each year, so a company that changes its business can change status. Dividends and gains on these shares go on your US return in the normal way.

Money market and bond funds

Funds that hold only bonds or cash deposits are PFICs too. Their income is interest, which is passive. Many people assume a cautious fund is a simple one. For US purposes, it is not. The same forms and default rules apply as for an equity fund.

How does the default PFIC tax work?

Unless you make an election, gains and large distributions are spread back over your holding period, taxed at the highest rate for each earlier year, and charged interest. That default regime is set out in section 1291.

Excess distributions

An excess distribution is the part of a year's distributions that exceeds 125% of the average received in the previous three years. Normal, steady distributions fall outside it. However, the excess is allocated evenly across each day you held the fund. The amount allocated to the current year is taxed as ordinary income.

Accumulation units

Many UK funds offer accumulation units, which reinvest income instead of paying it out. In that case, you receive no distribution. Under the default rules, there is then nothing to tax until you sell. That sounds helpful. However, the deferral is exactly what the interest charge targets. The longer you hold, the larger the charge on sale.

Gains on sale

A gain on selling a PFIC is treated in the same way as an excess distribution. That means no capital gains rate, even on a fund held for years. The portion allocated to earlier years is taxed at the highest rate in force for each of those years. On top of that, an interest charge applies as if the tax had been paid late.

Why the result is so harsh

The default rules ignore the lower capital gains rates and add interest on top. For someone in a modest tax bracket, that can mean US tax far above what the gain would normally attract. Furthermore, UK tax on the same gain may be nil inside an ISA. Consequently, there may be no UK tax to credit against the US charge.

What do the QEF and mark-to-market elections change?

Both elections replace the default regime with yearly taxation. The QEF election taxes your share of the fund's income each year; the mark-to-market election taxes the annual rise in value. Each has conditions, and neither is always available.

The qualified electing fund election

A qualified electing fund, or QEF, is a PFIC whose US shareholders elect to include their share of its ordinary earnings and net capital gain each year. The election sits in section 1295. However, it needs the fund to provide a PFIC Annual Information Statement, as Treasury Regulation 1.1295-1 requires. Most UK funds do not produce one. Therefore, the QEF route is often closed for PFIC UK funds.

UK reporting fund status is not the same

HMRC keeps a list of approved offshore reporting funds. Reporting fund status is a UK concept that affects how UK investors are taxed on offshore funds. It is not a US election, and it does not supply the IRS statement a QEF needs. Nevertheless, reporting funds publish annual income figures, which can help with US calculations.

The mark-to-market election

Under section 1296, you can elect to mark marketable PFIC stock to market each year. Marketable stock includes shares regularly traded on qualifying exchanges. Each year's increase in value is taxed as ordinary income, and some decreases are deductible. Listed ETFs and investment trusts may qualify; open-ended funds often need closer analysis. Making the election late, after years of holding, brings its own complications.

When must you file Form 8621?

You generally file Form 8621 for each PFIC you hold, with your US return. A small-holdings exception applies in some years, and pensions have their own exception.

The $25,000 exception

The Form 8621 instructions relieve you from the main part of the form for default-regime funds in some years. The exception applies where all your PFIC stock is worth $25,000 or less at year end, or $50,000 for joint filers. You must also have had no excess distribution and no gain on disposal that year. Therefore, a small ISA may need no form in a quiet year, but a sale changes that.

Funds inside a UK pension

Funds held inside a UK pension scheme are treated differently. Article 18(1) of the US-UK income tax treaty defers US tax on income built up inside a pension until it is paid out. Treasury Regulation 1.1298-1(c)(4) then removes the Form 8621 requirement for PFICs held through such a pension arrangement. Whether a particular SIPP qualifies under the treaty is a question practitioners treat with care, so we check each scheme's terms.

The open statute of limitations

Missing Form 8621 has a serious side effect. Under section 6501(c)(8), the time for the IRS to assess tax does not end until three years after the missing information is supplied. As a result, a return without a required Form 8621 can stay open indefinitely. That alone is a reason to deal with PFIC UK funds properly, even when little tax is at stake.

Catching up on missed years

Many Americans discover PFIC UK funds only after years of holding them. The fix is usually to file the missing forms with amended or late returns. Where other filings were also missed, the streamlined procedures can bring everything up to date at once. Before filing, we work out the tax under each regime. That shows whether a late election is worth pursuing.

What about ISAs in particular?

The US does not follow the UK's tax-free treatment of ISAs. The US-UK income tax treaty does not mention them, and the saving clause lets the US tax its citizens as if the treaty did not apply. Consequently, ISA income and gains usually go on your US return.

Cash ISAs

A cash ISA holds bank deposits, not funds, so it raises no PFIC issue. However, the interest is still taxable in the US each year. The account also counts towards your FBAR total. GOV.UK explains the ISA rules and the £20,000 allowance for 2026 to 2027 on its individual savings accounts page.

Stocks and shares ISAs

A stocks and shares ISA is where the PFIC UK funds issue bites hardest. The UK ignores the income and gains, but the US taxes them, often under the default PFIC rules. Furthermore, there is no UK tax to credit. In our experience, a long-held stocks and shares ISA is the commonest source of unexpected US tax for Americans in Britain.

Lifetime ISAs and junior ISAs follow the same logic. If they hold funds, the funds are usually PFICs. A junior ISA held for an American child can therefore raise Form 8621 questions for the child. Similarly, the US treatment of the government bonus on a Lifetime ISA is not settled, so we take a cautious approach. These are points we check for every family with ISAs on both sides.

An illustrative example

Consider a typical case. Olivia is a US citizen who has lived in Leeds for nine years. She has paid into a stocks and shares ISA every year, holding a UK-domiciled global index fund that reinvests its income. Her ISA is now worth well over $25,000. Nobody has ever filed Form 8621 for it.

Olivia has not sold anything, so no excess distribution or gain has arisen yet. However, her holdings are above the $25,000 threshold, so Form 8621 is required each year. When she eventually sells, the default rules will spread the gain over nine years and add interest. We would prepare the missing forms, check whether an election can still be made and work out the figures both ways.

How US UK Tax Experts can help

We prepare Form 8621 for PFIC UK funds held directly, in ISAs and in general investment accounts. First, we list every fund you hold and test whether it is a PFIC. Next, we work out the tax under each available regime and prepare the forms, using the same figures as your UK return. Our PFIC reporting service covers this work, and our guide to FBAR and FATCA reporting covers the account forms.

We do not give investment advice or recommend what to buy or sell. For that, you need an adviser authorised by the Financial Conduct Authority. What we can do is show you the US tax effect of what you already hold, so you and your adviser decide with the full picture.

Conclusion

In summary, most PFIC UK funds are caught by harsh US default rules, and an ISA does not shelter them from US tax. The QEF election is rarely available, while mark-to-market can help with listed holdings. Form 8621 is usually due each year unless the small-holdings or pension exception applies. Above all, an unfiled form leaves your return open, so it pays to deal with UK funds early.

Contact us

Do you hold UK funds in an ISA or investment account and want to know where you stand on PFIC UK funds? Email us at hello@usuktaxexperts.com, or tell us about your holdings through our contact page. We reply within one working day with the forms that apply.