Section 1291-1297 is one of the most unfair and insidious parts of the U.S. Tax Code. It deals with taxing offshore mutual funds.

Naturally, the Treasury doesn’t call offshore funds “offshore funds.” That would be too simple. Instead, it calls them “passive foreign investment companies” (PFICs).

For purchases of U.S. mutual funds, the IRS receives a report of income or gain on Form 1099. However, offshore funds don’t file Form 1099, so the IRS requires investors to determine their share of the income and pay tax on it.

That’s often impossible for an investor to do. And if you can’t make the necessary calculations, using IRS-approved methods, the IRS imposes punitive taxes and interest payments on whatever taxes you defer.

These calculations are complex, but the bottom line is that after you hold offshore funds for many years, the tax and interest you owe the IRS can easily exceed your total gain. However, the law provides that the tax and interest charge shall not exceed the amount of the distribution. (Gee, thanks IRS!)

Some U.S. investors have tried to avoid these rules by purchasing offshore funds through an offshore trust. I do NOT recommend you do so, unless you receive enough information from the fund to use the IRS-approved methods to calculate your gains.

Let me explain why. Under the U.S. grantor trust rules (I.R.C. 691-697), the income or gain your foreign trust receives is treated as if it was received by the grantor (the person who funded the trust). Since most offshore trusts funded by U.S. persons are taxed as grantor trusts, most of the time, you shouldn’t own offshore funds.

Now, the IRS has published an even more extreme interpretation of the PFIC rules. In a recently released Technical Advice Memorandum (TAM #200733024), the IRS declared U.S. beneficiaries of a foreign trust are subject to the PFIC rules as well, even when non-U.S. persons established and funded the trust.

In this case, the foreign trust, established in 1981, five years before the PFIC rules came into effect, owned a foreign corporation (holding company). The holding company in turn owned the stock of some other foreign corporations.

The IRS decreed the holding company was a PFIC. When it was liquidated and its assets transferred to the foreign trust, the IRS ruled that it was a taxable event under the PFIC “excess distribution” rules. This subjected the U.S. beneficiaries not only to tax on the excess distribution, but to interest charges going back 12 years.

This result doesn’t seem to be fair. It also doesn’t seem to mesh to the rules for this type of trust (called a foreign non-grantor trust). The beneficiaries may well appeal the ruling. But it illustrates the extreme dangers of holding offshore funds in an offshore trust without a thorough analysis of the possible tax consequences.