Making investments is the best way to help you with your finances that will provide you and your family with a better future. That’s why many people always find new opportunities to make more investments and earn more profit. The most popular investment today is the one that can generate income even if you’re not doing anything with it. It means that you’re growing your profits or assets in a passive way, which seems to be very attractive to most investors, not just those residing in the United States but also those U.S. citizens living offshore.
Because of that, the U.S. government has enacted the Passive Foreign Investment Company or PFIC legislation. It aims to discourage those U.S.-citizen investors from taking advantage of the foreign corporations to reduce or delay their taxes on their financial assets, which has the potential to provide tax benefits to investing in foreign mutual funds instead of doing it in the domestic ones.
Besides that, if the foreign corporations or funds trade or hold in cryptocurrencies, there’s also a tendency that it’ll become a PFIC that will usually trigger the federal income tax consequences in the U.S. with strict reporting requirements and obligations. Hence, if you want to know more about PFIC, please read the entire PFIC authoritative guide below.
What is a Passive Foreign Investment Company (PFIC)?
U.S. citizens and domestic trusts and corporations are required to pay their legal taxes from the income they earn worldwide. The said income is from the subsidiaries abroad of the corporations in the United States, but it won’t be subject to taxes unless it becomes repatriated to the U.S. Because of that, the Passive Foreign Investment Company or PFIC was enacted in 1986. It prevents taxpayers in the United States from avoiding or deferring their legal taxes on passive investments or even converting the ordinary income they’re earning to capital gains through different entities abroad. It’s usually via investing in mutual funds.
Moreover, the enactment of PFIC aims to solve the problems in the U.S. related to taxes. First is the fact that the government didn’t have an effective method to track investments offshore. Hence, many taxpayers were able to take advantage of it and didn’t include their income from foreign investments when filing their tax returns.
Besides that, another issue was that every dollar invested in mutual funds offshore, for example, didn’t go to the IRS that could have been used for various government projects. It’s because every investment in mutual funds across the country has a mandatory payout schedule, resulting in more taxable income to be collected by the IRS. Hence, to solve these problems, the U.S. government successfully enacted PFIC in 1986. Since then, citizens in the United States who have foreign investments have been taxed at high rates as a way to discourage them from following any practices mentioned above.
How do you determine if a company is a PFIC?
To determine if the company is a PFIC, it should meet at least one of the criteria.
- In the total gross income of the company, at least 75% of it should be considered a passive income. It’ll be a passive income if it’s generating a profit, even if you’re not actively participating in it or working on it to make your investment grow. For instance, selling properties or offering services to your clients or customers is an active income. But if you’re earning money every month from your rental property on a regular basis, it’s what we call a passive income. So the same thing goes for foreign investments where the U.S. citizens are still earning even without doing anything.
- The second criterion that a company should meet to be considered as a PFIC is the asset test. It can be a Passive Foreign Investment Company if at least 50% of its total assets are held as investments. The assets could be stocks, savings accounts, or mutual funds, and it could also be an income generated from capital gains, dividends, or interests.
With these criteria, the rules may be applied to your investments this year but not in the following year. It’s because the assets and income of the company may not remain the same all the time. So if you have this type of investment, you may have decreased your total taxable income for a particular tax year and may have increased it in the following year.
Example of a Passive Foreign Investment Company (PFIC)
The Passive Foreign Investment Companies are companies that make offshore investments. A good example of that is when a company invests in non-U.S. mutual funds. It may also include hedge funds, pension funds, and even offshore insurance companies. Besides that, PFIC investment can also be in an Open-Ended Investment Company, Exchange-Traded Funds, unit trust, and many other investment vehicles that are incorporated as a foreign company.
The revenue that these investments and sources generate are not related to the regular business operation that a company is running, but the gross income has to be earned passively. That’s why some people don’t know that they have a PFIC due to the fact that the investments they make are in control of a mutual fund. In fact, many U.S. taxpayers residing outside the United States may have been investing their assets into mutual funds, for example, in the particular country they live in today without enough knowledge about the rules of Passive Foreign Investment Company.
Qualified Electing Fund
The Qualified Electing Fund or QEF is a strategy that you can employ to help you decrease the taxes you have to pay from the income you’ve earned on PFICs. With this QEF, you can pay your taxes following the tax rates and the same rules applied to domestic investments. It’ll allow you to have part of your income taxed with the capital gains tax rates, and another part of it is taxed with the personal income tax rate. Besides that, QEF will also let you defer your unrealized gains without worrying about any penalty while enjoying a favorable income tax rate.
Moreover, most owners of PFIC shares prefer using a timely Qualified Electing Fund election because they are only taxed based on the income they’ve earned throughout the entire duration when they own the PFIC shares. So they can avoid paying the accrued interest charges on their taxes that are deemed to be incurred from the previous years. Besides that, taxpayers with PFIC shares are subject to the excess distribution regime when the PFIC shares they’ve sold have realized gains and to the Qualified Electing Fund income inclusions throughout the PFIC shares holding period.
Also, the basis of the taxpayers in the United States in their PFIC shares will increase when the income has been recognized from yearly Qualified Electing Fund inclusions in the entire taxpayer’s holding period. Then, the said basis tends to decrease in their PFIC shares due to the actual distributions they received throughout the entire holding period of the taxpayer.
Mark to Market
Another strategy you can employ to decrease your taxes from the income on PFICs is the market-to-market method. Using it will allow your investments to be valued at the existing fair market price. Moreover, you will also be taxed for your gains from PFICs according to your income level at the marginal tax rate. So both of your unrealized and realized gains, you will also be taxed at the marginal tax rate. As a result, you can offset taxes with your loss claims, and even the daily interest generated from deferrals will also be eliminated.
Moreover, MTM will also have an effect when you treat your dispositions and actual distributions as ordinary gains or income if you make a market to market election on your PFIC shares. So if you want to sell your PFIC shares in the future, the gains will be reduced. That’s why a deemed disposal may be a requirement to be in this particular tax regime.
Hence, if you want to elect to have the rules in the market-to-market method be applied to your PFIC taxes, you need to submit all relevant information for PFIC, including your federal income tax return, and you also have to file Form 8621 for you to make the MTM election. As a taxpayer who has PFIC, remember that you need to repeat all of these steps on a yearly basis for you to have this treatment applied to your PFIC.
How are PFICs taxed?
With the new law in the United States, those who have been earning an income from PHICs will no longer enjoy the tax rates of lower capital gains. It’s because the income they’re now generating will be taxed not just with the ordinary rates of taxes but at the highest one. In fact, those who are the highest earners from these foreign investments will be paying taxes with the maximum tax rates.
In some circumstances, taxpayers can elect to defer their capital gains from PFICs. But if they do, the IRS will assess their income with a non-deductible penalty of interest. It means that the interest will increase on a daily basis for the entire time of deferring their capital gains. As a result, the interest will automatically add up to a large amount of money. Hence, investing in PFICs is legal, but many people find it not attractive with this new law.
U.S. Taxation of Passive Foreign Investment Company Shareholder
The statutory provisions in the United States include three different tax regimes that can be applied to the citizens of the country who own stock assets on PFIC.
- IRC section 1291 or Interest on Tax Deferral
It allows the shareholders to defer their income on PFIC, but it’ll require them to pay their taxes, including the deferral interest when there’s a PFIC stock disposition or when they have an excess distribution. Besides that, the PFIC shareholders are considered shareholders in the 1291 fund when they haven’t elected to treat the investments they have as a QEF investment.
- IRC Section 1293 or the Current Taxation of Income from Qualified Electing Fund
When the shareholders elect to treat their investments on PFIC as an investment in a QEF, this particular tax regime applies to them. Besides that, it also requires the shareholders on PFIC to pay their taxes from their undistributed income on PFIC as they have earned it.
- IRC Section 1296 or the Market to Market for Marketable Stock
This particular tax regime applies to all shareholders of PFIC who have elected to recognize losses and capital gains from their marketable stock when filing their returns during a specific tax year when they occur.
Who needs to file PFIC?
Citizens in the United States need to file if they’re passively earning an interest from their investments in a foreign corporation. PFIC requires U.S. persons to include their aggregate taxable income when filing their returns to the IRS and comply with all of the reporting requirements.
Keep in mind that the IRS and the Treasury finally released the complete guidelines to determine reporting legal obligations of the shareholders of PFIC as well as PFIC investment ownership. That’s why all employers and other entities should conduct an annual review to see if their partners or employees own an indirect or direct investment in foreign corporations that can trigger the rules under PFIC.
How do I report PFIC income?
You should file your income tax return, including your PFIC income, in the IRS center. But if you’re not required to process your tax return, you need to send filled-out copies of Form 8621 to the IRS center in your area. Remember that Form 8621 only has two pages, but it contains complete instructions, consisting of seven pages in total with complicated details that you need to understand. The complexity basically comes from the election to pay your taxes based on the shareholders’ pro-rata share in the generated income on PFIC.
However, there are two different ways of doing it, and there’s also a default taxation method if you don’t want to make an election for your taxes. Also, don’t forget to fill out the correct form completely with your income tax return for each separate PFIC as a shareholder. The time required by the IRS for doing that will usually be about seven hours. But it may also vary depending on the election you want to make.
You may finish filing the forms a little bit longer, especially when you report taxable income using the QEF method. However, it won’t take that long if you’re using a market-to-market method. Also, it may take seven hours or more to complete the form if you have an excess distribution to compute for the taxes.
Pitfalls of Passive Foreign Investment Company Ownership
The tax requirements for recognition and reporting can be very stressful to prepare, especially if the initial investment in PFIC is not identified as PFIC. Besides that, if you don’t elect to treat your investment under QEF or MTM, you have to report your interest in PFIC under the method of excess distribution. However, in the perspective of tax compliance, many taxpayers find the methodology of excess distribution daunting.
It’s because, in most cases, it’ll require you as an investor to allocate the distribution you get from PFIC for the entire holding duration of your investment. As a result, you are now required to impute your interest and taxes associated with your excess distribution to know your existing tax obligations. Also, these allocations aim to simulate the consequences of your taxes if your excess distribution had been recognized annually.
Moreover, there may be an impact on you as an investor who has de minimis or direct PFIC holdings with the new guidelines from the IRS. With regard to the reporting of your interests in foreign assets, corporations, partnerships, and even foreign bank accounts, you have to be mindful of changing legislation as a taxpayer in the U.S. It’s because dealing with the regulatory and statutory environment in the country can be very complicated, and, on top of that, noncompliance will surely make you face large monetary penalties and other consequences.
What is PFIC testing?
A corporation needs to satisfy at least one of the tests to be considered a PFIC. It’s the asset test where 50% or more of the total assets of the corporation are generating a passive income. On the other hand, the income test will be satisfied if 75% or more of the gross income of the corporation is a passive income.
What is considered a PFIC?
A company will be considered as a PFIC if it satisfies one of the criteria. First, 75% of the total gross income of the company is passive income. Secondly, it can be a PFIC if at least 50% of its total assets are held as investments and able to produce passive income. Keep in mind that an income is considered passive if it’s generating a profit even if you’re not actively participating in it or working on it to make your investment grow.
Can you hold a PFIC in an IRA?
If you are a citizen in the United States and own a stock of a PFIC through an IRA or Individual Retirement Account, you are not subject to the rules under PFIC. It means that you don’t need to process and file the reporting requirements in Form 8621.
How are PFICs taxed?
Those who have been earning an income from PHICs will no longer enjoy the tax rates of lower capital gains with the new law in the United States. It’s because they’re now taxed not just with the ordinary rates of taxes but at the highest one. Besides that, paying taxes with the maximum tax rates will be reserved for those with the highest earners from these foreign investments.
Can a publicly-traded company be a PFIC?
A publicly-traded company will be considered as PFIC if it satisfies one of the criteria. As mentioned earlier, if 75% of its gross income is able to produce passive income and 50% of its total assets are invested and earning a passive income, the company will become a PFIC.
What is form 8621
Form 8621 is a particular form that taxpayers need to prepare and submit when filing their returns to the IRS under the following guidelines. If you are a U.S. citizen and you’re getting actual distributions directly or indirectly from a PFIC, recognizing gains on PFIC stock dispositions, and reporting details with QEF or Market-to-Market election, you are required to fill out Form 8621 completely and include it in your tax returns upon filing.
For the purpose of U.S. income taxes, all legal citizens in the country who have shares in PFIC or Passive Foreign Investment Company may have the chance to choose between deferral of their income subject to the interest regime and deemed taxes and the existing taxation on the PFIC income. The PFIC legislation was passed as part of the Act of 1986 of the Tax Reform to position those offshore investment fund owners the same as the owners of investment funds in the United States.
Moreover, all foreign corporations were under the original provisions satisfying either the asset test or the income test. But, with the amendments created in 1997, shareholders of controlled foreign corporations in the United States have been given a limited application.
Hence, if you plan to make investments in Passive Foreign Investment Companies in the future, make sure you have a complete understanding of your tax obligations and all of the consequences for noncompliance. Besides that, you can always come back to this page whenever you have questions regarding Passive Foreign Investment Company, or you can also get in touch with one of the financial professionals in your area to provide you with the help and assistance you need.