PFIC Basics & Reporting You Should Know

So, your client had a strong month, quarter, or year and has excess funds to invest. After some analysis, they decided to invest in a foreign security that could give strong returns with potential exchange rate gains. If you’re lucky, they may even inform you about it. Years later, the IRS timely informs them of the requirements to file Form 8621, their returns are now open past the expected statute of limitations, and the tax on the distributions from the investment is significantly higher than expected.

Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company (PFIC) or Qualified Electing Fund (QEF), is a routine filing in the international tax realm and can often catch U.S. taxpayers by surprise. Similar to specified foreign assets, PFIC reporting can seem like a “gotcha”. By arming yourself (and your clients) with an understanding of what a PFIC is, what reporting is required, and the basic tax implications, you can avoid any surprises.

PFIC Basics & Form 8621

A PFIC, generally, is a non-U.S. company where either 1.) 75% of its income is considered as passive income (as defined under 1297(b)), or 2.) 50% of its assets are considered passive income-generating assets (as defined under 1297(e)). For the asset test, look-through rules apply to other shares owned over 25% by the potential PFIC. Assets are generally measured at fair market value. The adjusted basis can be used if the potential PFIC is a non-publicly traded controlled foreign corporation.

For U.S. taxpayers, there is no ownership threshold for reporting on Form 8621. Any amount of PFIC share that is either owned directly or indirectly through controlled PFICs, pass-throughs, or other entities requires the filing of Form 8621 for each year the shares are owned.

Additional reasons for filing Form 8621 by U.S. taxpayers include:

1. They receive direct or indirect distributions from the PFIC
2. They recognize gain on a direct or indirect disposition of PFIC stock
3. The PFIC in question needs to report information due to a QEF election or 1296 Mark-to-Market election, or
4. The PFIC is making an election among the list in Part II of Form 8621

Form 8621 is generally for reporting purposes. U.S. taxpayers typically don’t have an immediate tax liability unless they have reported distributions or have elected to treat the PFIC as a QEF. The form has six parts, each required depending on the facts and patterns of the PFIC. A separate 8621 is needed for each PFIC, which may present a significant compliance burden.

What about Other International Reporting?

Even if you report your client’s financial activity on another form, they may still be required to file Form 8621 for their PFIC, and that PFIC may be subject to additional foreign reporting. A controlled foreign corporation, a foreign disregarded entity, and foreign specified assets require Forms 5471, 8858, and 8938, respectively. All of these may be considered a PFIC. In these circumstances, do taxpayers need to file all of these forms or just one of them?

In the case of a controlled foreign corporation that is a PFIC, the taxpayer could be expected to file both Forms 5471 and 8621, depending on which category of 5471 filer the U.S. taxpayer represents. Generally, Category 1, 4, or 5 filers of Form 5471 would not need to file Form 8621, but a Category 2 or 3 filer would. Other international filing requirements may exist for PFICs, such as Form 8932 or Form 8865, depending on the circumstances. Determining a client’s exact filing requirements would demand specific context.

Taxation Options & Penalties

Taxation of PFICs can be punitive, as its main objective for U.S. tax purposes is to identify and discourage offshore deferral on investment income. It would be easier to apply an immediate inclusion of PFIC income, similar to GILTI. However, taxpayers who own only a small portion of a PFIC may have difficulty obtaining complete information on the PFIC’s income. The punitive tax on PFICs is typically applied to the “excess distributions,” which are distributions that are in excess of 125% of the average distributions the PFIC made during the prior three years. The rules regarding PFIC taxation and excess distribution taxation can be found in Section 1291.

There are methods of avoiding the punitive excess distributions by electing the PFIC to be a QEF or a 1296 Mark-to-Market. Both of these would accelerate the PFIC’s income on offshore investments by either recognizing its income or recognizing the gain or loss, respectively, in the U.S. taxpayer’s income. Currently, there is no penalty for failure to file Form 8621; however, doing so may leave taxpayers’ returns statute of limitations open.

The landscape of international business taxation comes with many complexities. Before your client makes any significant, or even minor, global investments, make sure to understand the tax implications. Contact our Global Business Services team for assistance and guidance.