Surprise! Your client’s investment is actually a PFIC

What is PFIC?

Passive Foreign Investment Company (PFIC) is a notorious designation arising from the Internal Revenue Code that can seriously complicate a taxpayer’s journey into investing or expanding abroad. A “passive foreign investment company” is defined as any foreign corporation that has excessive passive assets, passive income, or both. A foreign corporation will be deemed a PFIC in a taxable year if in that year (1) at least 75 percent of its gross income is “passive income” or (2) at least 50 percent of its assets constitute passive assets (i.e., assets producing or held for the production of passive income). These PFIC rules are so broad that a U.S. person would find itself a shareholder of a PFIC if it owned shares of a foreign corporation that is inactive, but has $1,000 of cash and no other assets. Significantly, the ownership by U.S. persons, whether controlling or not, is irrelevant for PFIC classification.

The U.S. shareholder of a PFIC is, by default, subject under §1291 to an interest charge on the amount of income deferred, and subject to ordinary income treatment when it either disposes of its PFIC stock or receives other “excess distributions”. The determination of whether a foreign corporation will be a PFIC for a taxable year is based on the composition of that year’s income and assets. If a foreign corporation is a PFIC with respect to a shareholder for any taxable year, it continues to be a PFIC with respect to that shareholder for all subsequent taxable years even if it does not meet the gross income or asset test for those years; remember, “Once a PFIC, always a PFIC”.

What options do U.S. shareholders have?

However, the shareholder can make elections to avoid the more draconian aspects of these rules and make the PFIC a Qualified Electing Fund (“QEF”) or, make a mark-to-market election for the first taxable year in which the owner held shares and for which the foreign corporation was a PFIC. From there, the rules under §1293 state that an electing shareholder of a QEF will include (1) its pro rata share of the QEF’s “ordinary earnings,” in ordinary income, and (2) its pro rata share of the QEF’s “net capital gain,” as a long-term capital gain. Further, the old PFIC taint is removable if the U.S. owner elects under §1298(b)(1) to recognize gain (but not loss), as of the last day of the last taxable year for which the company was a PFIC, on a deemed disposition of the foreign corporation’s shares. An interest charge applies with respect to the amount of tax deferred to date, and the gain on the deemed sale is taxed as ordinary income.  The net effect of these elections is to begin recognizing income currently, eliminate the interest charge on deferred income, and secure long-term capital gains treatment.

Finally, the U.S. owner of PFIC shares must attach IRS Form 8621 annually to its U.S. federal income tax return if (1) the shareholder directly owned stock of the PFIC or (2) is an indirect shareholder that holds any interest in the PFIC through one or more foreign entities.

As you can see, the PFIC rules can easily spring a trap on the unwary. McGuire Sponsel’s Global Services Team can assist in getting your clients into compliance with the onerous PFIC statutes and help make the proper elections to get relief from stepping into one of those snares. We appreciate your continued trust in McGuire Sponsel as a technical resource to your firm. If you have any questions about this update or other international tax compliance issues, do not hesitate to reach out to our Global Business Services team.