The Passive Foreign Investment Company (PFIC) rules are designed to prevent United States investors (1) from deferring United States tax on passive income earned through foreign corporations, or (2) from converting such income into capital gains that are taxed at preferential rates.

The PFIC rules are just one set of several anti-deferral rules that international taxpayers should keep in mind. Previous blog posts from GHJ’s International Tax Services team have discussed U.S. tax rules, namely subpart F and GILTI rules, which are intended to prevent the deferral of U.S. tax on income earned by certain foreign corporations owned by U.S. persons. But the PFIC rules are especially notable because they are applicable to a wider range of taxpayers than the name suggests.

The original purpose of the PFIC rules was to prevent the so-called “foreign pocketbook” for passive investments by U.S. individuals — but today they have a much wider application. Taxation under the PFIC regime is exceptionally punitive, and many individuals who become U.S. tax residents are unpleasantly surprised to find out that their investments are PFICs for U.S. income tax purposes.

This blog breaks down the PFIC rules and how to determine whether investments fall under this category.

WHAT IS A PFIC?

To determine what investments fall under PFIC rules, one must first understand what a PFIC is. The Internal Revenue Code (IRC) defines a PFIC as a foreign corporation that meets either of the following two tests for a particular tax year, known collectively as the PFIC Tests:

(1) at least 75 percent of the foreign corporation’s gross income is passive income (known as the Income Test); or

(2) the average percentage of assets that are held by the foreign corporation during the tax year and that produce (or are held to produce) passive income is at least 50 percent (known as the Asset Test).

There are no threshold ownership requirements for PFIC investments, so even a 1 percent investment in a PFIC may have consequences for the shareholder. The IRC uses the rules for foreign personal holding company income (“FPHCI”) under the Subpart F rules to define what constitutes passive income for purposes of the Income Test. More specifically, passive income is defined as income that “is of a kind [that] would be FPHCI.” Passive assets for purposes of the Asset Test are defined as assets that produce passive income.

For purposes of the Asset Test, assets are measured through one of the following ways (depending on the status of the relevant foreign corporation):

1. Fair market value for publicly-traded corporations
2. Adjusted basis for controlled foreign corporations (CFCs)
3. Fair market value, unless an election is made to measure assets by adjusted basis, for other foreign corporations

PFIC RULES TO KNOW

In addition to the qualifiers outlined above, it is important to note several “look-through” rules that apply to a foreign corporation’s subsidiaries and related parties for the purposes of the PFIC Tests:

• The General Look-Through Rule treats the relevant foreign corporation as if it held its proportionate share of the assets and directly received its proportionate share of the income of any corporation (foreign or domestic) for which it owns (directly or indirectly) at least 25 percent by value (through what is known as a look-through subsidiary).
• The Related-Party Look-Through Rule provides that passive income does not include interest, dividends, rents or royalties received or accrued from a related person to the extent that amount is properly allocable to the related person’s non-passive income.
• The Domestic Look-Through Rule treats certain stock that the relevant foreign corporation indirectly owns through a 25-percent-owned second-tier domestic corporation as an asset generating non-passive income for purposes of the PFIC Tests, provided that the foreign corporation is subject to the accumulated earnings tax or waives any treaty protections against the imposition of that tax.
• Additional look-through rules, which are beyond the scope of this article, also exist for foreign corporations owned through foreign partnerships.

One of the most punitive provisions is that once an entity qualifies as a PFIC, it will remain a PFIC regardless of whether the tests are met in the future. It is interesting to note that if an entity is both a CFC and a PFIC, the CFC rules override the PFIC rules for those who qualify as U.S. shareholders, but other U.S. owners must still apply the PFIC rules.

A U.S. person that owns, or is treated as owning, stock in a PFIC and either sells the stock or receives a so-called “extraordinary” dividend from the PFIC is subject to the following rules:

1. The “extraordinary” portion of the dividend (or gain treated as an extraordinary distribution) is allocated ratably over the U.S. person’s holding period. Amounts allocable to the current year and amounts allocable to any prior year during which the foreign corporation was not a PFIC are treated as ordinary income in the current year.
2. Amounts allocable to any prior year during which the foreign corporation was a PFIC are excluded from current-year gross income. Instead, they are subject to an add-on tax at the highest rate applicable to ordinary income for that year, plus an interest charge.

For these purposes, an extraordinary dividend is essentially a distribution in the current year, which exceeds 125 percent of the average of the three prior years.

POTENTIAL PFIC ELECTIONS

Once your PFIC status is determined, there are several elections that may be available. An alternative treatment to the one described above is available to the extent that a Qualified Electing Fund (QEF) election is made. The QEF election is an optional method of taxation available for certain PFICs. This election allows for capital gains treatment of some of the income as long as any prior gain has been dealt with, and most closely mirrors the U.S. taxation of U.S. mutual funds.

Once the election has been made, Form 8621 — Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund — must be filed each year, and the election will remain in place for all subsequent years. The QEF election involves including the ordinary income and capital gains in the shareholder’s income each year — even if the money was not actually received. Making the election will allow for gains on the disposition of QEFs to be taxed as capital gains when they are sold. Being able to make this and other elections is dependent on certain reporting requirements for the PFIC, which are often not available.

Notwithstanding the QEF election, U.S. investors who own shares of a PFIC must file Form 8621. This form is used to report actual distributions and gains, along with income and increases in QEF elections. Form 8621 is required to be filed for each PFIC and is a lengthy, complicated form that the IRS estimates may take more than 40 hours to fill out. For this reason, PFIC investors are generally advised to have a tax professional handle completion of the form. In a year where there is no income to report, they do not need to worry about specific tax penalties. However, failure to file may render a tax return incomplete.

Overall, the PFIC rules are very complex and may create a trap for the unwary. For this reason, anyone unsure about his or her U.S. tax obligations with respect to ownership in foreign companies should contact GHJ’s International Tax Team for a more comprehensive discussion.