It ranks at the very top of potential tax nightmares, especially if you invest internationally.

This nightmare could become a reality if you happen to invest in what the IRS deems a Passive Foreign Investment Company (PFIC), which are taxed at exorbitant rates and have highly complex reporting rules. Most foreign mutual funds are PFICs, as are certain foreign stocks.

It's not illegal to invest in a PFIC, but practically speaking, the costs of doing it are so incredibly onerous that it's prohibitively expensive in the vast majority of cases.

PFIC rules amount to unofficial restrictions on investing in certain foreign assets and are yet another indicator of the disturbing trend of creeping capital controls in the US.

Capital controls are used by many countries and come in all sorts of shapes, sizes, and labels. The purpose, however, is always the same: to restrict and control the free flow of money into and out of a country so that the politicians have more wealth at their disposal to plunder.

What Is a PFIC Investment?

As always, it's important to first define our terms.

As far as the IRS is concerned, passive income includes income from interest, dividends, annuities, and certain rents and royalties.

If a foreign corporation or investment vehicle meets either of the two conditions below, it will be deemed to be a PFIC.

1) If passive income accounts for 75% or more of gross income, or

2) 50% or more of its assets are assets that produce passive income.

If you own a foreign mutual fund -- even a cash management fund -- it probably qualifies as a PFIC. But it's not just foreign mutual funds; it can be any foreign stock that meets either of the above conditions as well.

Bottom line: even the simplest international investments can create significant tax problems.

(Clarification: an offshore LLC that makes an election to be classified as a disregarded entity or a partnership is not a PFIC.)

What Are the PFIC Rules?

To say the consequences of owning a share in a PFIC are severe would be an understatement.

First, the complexity of the PFIC rules are way out of league for TurboTax or your average tax preparer. You'll need the assistance of a specialist, and lots of it. The IRS estimates it takes up to a stunning 30 hours of tax preparation time to complete Form 8621, which needs to be filed for each PFIC every year. It's an incomprehensible waste of human and financial capital that could otherwise go to productive use.

Regardless of whether or not it proves to be a good investment, it's hard to imagine a situation where the benefit of holding a PFIC outweighs even the cost of reporting it.

But let's say an investor is willing to pay the ridiculous cost of reporting and the PFIC does prove to be a good investment. In this case, unless the investor makes one of the elections explained below, he suffers the following punitive tax rates and special rules:

• For any year in which you receive a dividend or sell any PFIC shares, you face a complex calculation that involves prorating the PFIC's return over your entire holding period and applying an interest charge. In contrast to the bizarrely complicated PFIC rules, capital gains tax for other investments are relatively simple to calculate and are only due when the gain is realized through a sale.

• Most capital gains are taxed at a top federal rate of 20%, plus the Obamacare surcharge of 3.8%, for a total of 23.8%, which is favorable compared to the top ordinary federal income tax rate of 39.6%. Capital gains in PFICs, however, are effectively taxed at the highest ordinary income rate plus the interest charge mentioned above. The tax and interest due can eat up 70% or more of your gain.

• A capital loss on a PFIC can't be used to offset capital gains on other investments.

Until recently, PFIC rules were weakly enforced.

But that's all changed now, thanks to the Foreign Account Tax Compliance Act (FATCA), which forces every single financial institution on the planet to submit information on their American clients to the IRS. This puts more information at the US government's fingertips than ever before, including information about PFICs.

Fortunately, there are a couple of ways out, though they aren't ideal.

First, if the PFIC meets certain accounting and reporting requirements, the US investor can elect to treat the PFIC as a Qualified Electing Fund (QEF), which eliminates the punitive tax rates. In practice, you can't count on a PFIC to provide the information you would need. And even if it does, you would be taxed on your share of its income and gains year by year, even if you didn't receive any dividends.

Second, generally speaking, there is an exemption from PFIC reporting if PFIC holdings do not exceed $25,000 ($50,000 for married couples filing jointly).

Third, if you hold a PFIC through an IRA or other certain retirement accounts, you may be exempt from Form 8621 filing requirements.

With the complexity and unfavorable tax rates that come with them, it is clearly better to avoid owning PFICs over the exempt amount in non-retirement accounts when looking to invest offshore.

(This is not to be construed as tax, investment, or legal advice. As always, discuss your situation with a qualified advisor.)

Conclusion

Taking a step back and looking at the big picture, it's clear the PFIC rules are part of the long-term trend of the US government using burdensome regulations to effectively shrink the number of options available for those seeking to diversify internationally. These roadblocks are a clue as to how desperate and bankrupt it really is.

You shouldn't be deterred, as that is exactly what the politicians want to happen. They prefer your savings remain within their immediate reach so that it's easier to fleece. Instead of being deterred, you should be emboldened to act to protect yourself before the window of opportunity fully shuts. You do not want to be like a sheep that has been penned in for a shearing. If you consult with a tax professional and comply with all of your obligations, you should have nothing to worry about.

Fortunately, there are still many practical international diversification strategies available to you, including some that you can do from your own living room. You'll find the latest information on the best of these proven strategies -- including how to avoid common pitfalls, like running afoul of the PFIC rules, and trusted professionals to assist with your tax filings -- in our Going Global publication.

The article was originally published at internationalman.com.