What Is a Passive Foreign Investment Company (PFIC)?
A Passive Foreign Investment Company (PFIC) is a foreign corporation that meets either of these two conditions based on income or assets:
- At least 75% of the corporation’s gross income is “passive”—derived from investments or other non-operational sources.
- At least 50% of the company’s assets generate passive income in the form of earned interest, dividends, or capital gains.
Key Takeaways
- A foreign corporation is considered a PFIC if 75% or more of its gross income is from non-business operational activities (income test).
- It is also classified as a PFIC if at least 50% of its average percentage of assets are held for producing passive income (asset test).
- PFICs are subject to complex tax regulations by the Internal Revenue Service (IRS).
- U.S. investors holding shares in a PFIC must file IRS Form 8621.
- Holding PFIC investments helps close tax loopholes that allow avoidance of taxation on foreign income.
Understanding the PFIC Rules
The concept of PFIC was introduced through tax reforms in 1986 designed to close tax loopholes used by U.S. taxpayers to shelter offshore investments from taxation. The reforms aimed not only to close these tax avoidance loopholes but also to tax these investments at high rates to discourage such practices.
Common examples of PFICs include foreign-based mutual funds and startups that fall under the PFIC definition. These foreign mutual funds typically become PFICs when they generate over 75% of their income from passive sources, such as capital gains and dividends.
Investments categorized as PFICs follow strict IRC guidelines as outlined in sections 1291 through 1298 of the U.S. income tax code. Both the PFIC and its shareholders need to maintain precise records of transactions—including share cost basis, dividends received, and undistributed income of the PFIC.
The tax regulations are particularly stringent about the cost basis. Unlike most other marketable securities, inherited PFIC shares are usually not allowed a step-up in cost basis to fair market value at the time of inheritance, making determination of the acceptable cost basis a challenging task.
Tax Strategies and PFICs
U.S. investors who own shares of a PFIC are required to file IRS Form 8621, which reports actual distributions, gains, and increases in Qualified Electing Fund (QEF) elections. This form is intricate and time-consuming, often taking over 40 hours to complete, hence, consulting a tax professional is typically advisable.
In years with no income to report, specific tax penalties may not pose a problem, but disregarding the registration can render an entire tax return incomplete.
Some strategies can mitigate the tax impact, such as recognizing the PFIC investment as a QEF, although it may also introduce other tax ramifications for shareholders. Importantly, U.S. investors who acquired PFIC shares before 1997 are exempt from the subsequent tax interest regime on those shares.
PFICs and the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act (TCJA) of 2017 modified PFIC guidelines, specifically introducing an exception tied to the insurance industry. For tax years beginning after December 31, 2017, income connected to an insurance business won’t be treated as passive income, as long as insurance liabilities don’t exceed 25% of the company’s assets as detailed in the financial statements.
In December 2018 and July 2019, further refinements were proposed by the IRS and the U.S. Treasury, which seek to reduce some existing rules from the Foreign Account Tax Compliance Act (FATCA) and refine the definitions applicable to investment entities and insurance exceptions.
Expert Answers on PFIC
What constitutes a PFIC for U.S. tax purposes?
The IRS defines a PFIC as a non-U.S. entity that either earns 75% or more of its gross income from passive sources, or if at least 50% of its assets are held to generate passive income.
Is PFIC income taxable?
Yes, gains and distributions from a PFIC are taxable as ordinary income and must be declared on IRS Form 8621.
How can one avoid PFIC status?
U.S. investors can bypass PFIC’s complex status by considering domestic mutual funds and ETFs holding foreign assets, such as U.S.-based funds specializing in emerging markets or global sovereign debt.
What are examples of passive income?
Passive income includes earnings from sources like rental properties, limited partnerships, or other ventures where the individual does not actively participate, e.g., rents, royalties, interest, dividends, and capital gains.
The Bottom Line
Before the mid-1980s, American investors could evade taxation by investing in foreign entities that produced passive income, like rental real estate and global holding companies. Post-reform, the IRS mandates declaring such income in PFICs, consequently treating them as ordinary incomes requiring meticulous adherence to IRS regulations. To attain PFIC status, a firm must have at least 75% of gross income as passive or over half its assets dedicated to generating passive income.
Related Terms: qualified electing fund, IRS Form 8621, tax loophole, TCJA.
References
- Legal Information Institute, Cornell Law School. “26 U.S. Code Sec. 1297. Passive foreign investment company”.
- U.S. Congress. “H.R. 3838 - Tax Reform Act of 1986”, Pages 482-507.
- Legal Information Institute, Cornell Law School. “26 U.S. Code Part VI - Treatment of Certain Passive Foreign Investment Companies”.
- Internal Revenue Service. “Instructions for Form 8621”.
- U.S. Congress. “H.R.1 - An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018”, Page 433.
- Internal Revenue Service. “REG-132881-17: Regulations Reducing Burden under FATCA and Chapter 3”, Pages 12-14.
- Federal Register. “Guidance on Passive Foreign Investment Companies”.
