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Originally Posted On: https://www.intl-tax.com/what-is-a-passive-foreign-investment-company-pfic/

 

More than two-thirds of individuals worth more than $30 million are considered “self-made” millionaires. There are many ways to make money, and one that holds a huge amount of potential is investing.

With that in mind, it’s not simple. There are all kinds of ways to invest, and you need to have a good understanding of what you’re doing if you want to be successful. Of the many types of companies you could invest in, passive foreign investment companies are some of the least understood.

You’re likely asking “What is a passive foreign investment company (PFIC)?”. In this guide, we’ll answer that question and explain some of the complexities involved with these types of investments. Keep reading for more.

What Is a Passive Foreign Investment Company (PFIC)?

A PFIC is a company that decides to make one or more investments outside of the US. A typical example of this would be a company that invests in international mutual funds.

There is, however, a much wider range of investments that this can cover. Other popular investment types include hedge funds, pension funds, and insurance companies based in other countries. A company is only considered a PFIC if it meets one of two specific conditions.

The first is that the majority of the income (at least 75%) of the company must be passive. This means that the income from these investments and any other sources cannot be in any way related to a business’s regular operations.

The second condition is that at least 50% of the assets a company owns must be investments that generate income through dividends, interest, or capital gains.

Understanding a PFIC

PFICs were first officially recognized in 1986 with the passing of tax reforms. Changes were made to eliminate a loophole that some US taxpayers were taking advantage of.

This loophole allowed individuals to shelter offshore investments so they wouldn’t have to pay tax on them. The reforms not only made this impossible but also made it so that such investments would have very high tax rates. This discouraged people from continuing to follow this practice.

Foreign-based mutual funds are an example of what might be typically classified as a PFIC. Any investment that is determined to be a PFIC is subject to very strict and complicated tax guidelines. The IRS details these in Sections 1291 through 1298 of the U.S. Income Tax Code.

The PFIC and ant shareholders must maintain accurate and detailed records of any transactions related to the PFIC. This includes things like dividends received, share cost basis, and any undistributed income that the PFIC earns.

The cost basis guidelines are a good example of the strict tax rules in place regarding PFICs. When it comes to almost any other security or asset, the IRS allows more control. Anyone who inherits shares can step up the cost basis for the shares to the fair market value as it was at the time of their inheritance.

This isn’t the case, however, with shares in a PFIC. On top of this, it can be incredibly difficult and confusing to determine the acceptable cost basis for PFIC shares.

PFICs and Tax Strategies

To this day, PFICs remain complicated and the IRS works to discourage them. Despite that, many Americans still own shares of PFICs. Any investor who does must file IRS Form 8621.

This form relates to reporting actual distribution and gains. It also involves income and increases in QEF elections.

People often consider all tax forms to be long and complicated, but in this case, it’s a bit more arduous than most. The IRS estimates that it should take upwards of 40 hours to complete, highlighting how difficult the whole process can be. It’s strongly recommended that PFIC investors work with a tax professional to ensure they get everything right with this form.

PFIC shareholders need to be aware of what’s required of them. It may seem normal to assume that you don’t need to do anything in a year when there’s no income to report, but this isn’t the case. You won’t need to worry about specific tax penalties for such a year, but you still need to register or your entire tax return may be considered incomplete.

As an investor in a PFIC, there may be some ways that you can reduce the tax rate for your shares. You may be able to have a PFIC investment recognized as a QEF (qualified electing fund), for example.

Before taking steps like this, however, make sure you know how things work. Doing this could cause problems for other shareholders, so might not be the best choice. This is another reason to work with a professional who specializes in international business taxes.

PFICs and the Tax Cuts and Jobs Act

In 2017, the Tax Cuts and Jobs Act modified the rules for PFICs. One of the key changes was an exception regarding the insurance industry. This exception was effective for tax years from December 31, 2017 onwards.

It stipulates that any income a foreign corporation makes from an insurance business is passive income. This is unless the applicable insurance liabilities constitute over 25% of its total assets (based on the corporation’s applicable financial statement report).

More changes were then proposed by the U.S. Treasury Department and the IRS in December 2018. If these changes get approved, some taxing rules from the FATCA (Foreign Account Tax Compliance Act) will be reduced. They’ll also provide a more precise definition of an investment entity.

More changes were then proposed in July 2019. The purpose of these was to clarify the insurance exemption mentioned above.

PFIC Questions

With all of the above in mind, there’s still a lot more to understand about PFICs. We’ve answered some of the key questions you might have below.

What Is Officially Considered a PFIC for U.S. Tax Purposes?

People are often unaware that they have PFIC shares. It can be difficult to confirm, but with the right details, you can determine whether or not you own PFIC shares. The exact definition for a PFIC in the eyes of the IRS is a non-US entity that passes either the income test or asset test.

• It earns 75% or more of your total income from non-business activities (income test)
• 50% or more of the assets generate money through passive income (asset test)

An entity only needs to meet one of these criteria. If it meets neither, then it’s not considered a PFIC.

Is PFIC Income Taxable?

Absolutely. Any gains and distributions that you get from a PFIC are regarded as ordinary income. You need to declare this on IRS Form 8621.

How Can I Avoid PFIC Status?

Global diversification is a goal for many investors. Changes in PFIC rules over the years have made them less appealing, so investors often want to avoid PFIC status.

One way that people often achieve this is by investing in domestic ETFs and mutual funds that already hold foreign assets. This can give you exposure to foreign assets without having to pay taxes as a PFIC shareholder.

What Are Examples of Passive Income?

People throw the term “passive income” around a lot, but it’s often used incorrectly. Some use it online to appeal to people looking to make money.

Many people consider a YouTube channel, for example, to be passive income. This isn’t the case, as someone will only earn money from YouTube if they’re actively creating and promoting videos.

The IRS defines passive income as any income that comes from trade or business that you don’t materially participate in. This means that if you’re involved in operations on a significant and continual basis, it isn’t seen as passive income.

Some of the most common types of passive income include rental properties, dividends, royalties, interest, and capital gains. This means that gains and distributions earned through PFICs are classified as passive income.

How Are PFICs Taxed?

PFICs can be taxed in three different ways.

Excess distribution is the default method. Going down this route means you get taxed on excess distributions and achieve gains through the disposition or sale of stock holdings.

Mark-to-market (MTM) is an election in which your yearly PFIC value increase is taxed as ordinary gains. The marketable stock you hold at the end of the tax year is treated as if you sold and repurchased it at the fair market value. You need to make an election in the first year if you want to use this method, otherwise, your PFIC will default to excess distribution.

Qualified electing fund (QEF) involves taxes on both the long-term capital gain and the undistributed earnings of your PFIC. Note that this method requires specific documentation and is harder to implement.

Dealing with PFICs

So you no longer need to ask “What is a passive foreign investment company (PFIC)?”, but you still might have some questions. If you own PFIC shares, it’s important to handle your taxes correctly. Unless you have a very good understanding of how these taxes work, it’s not something that you’ll be able to deal with on your own.

If you need help working out the complexities of PFICs, the team at International Tax Consultants can help. Not many companies specialize in international tax planning and analysis, but we do. Don’t hesitate to contact us today to find out more about how we can help you.