A PFIC, or Passive Foreign Investment Company, is a non-US corporation whose gross income is predominantly passive. Additionally, approximately 50% of the corporation's assets are investments that generate passive income. Passive income includes interests, dividends, royalties, capital gains, and rents from the disposition of securities.
In this guide, we provide a detailed overview of PFIC, including its identification, taxation, exemptions, and other key information that U.S. taxpayers should be aware of.
Key Takeaway
- A PFIC stands for a passive foreign investment company that is established outside the United States, generating passive income or holding passive assets that work towards generating passive income.
- The taxation methods related to PFICs are excess distribution, mark-to-market, and QEF election.
- The investors from the United States are required to file Form 8621 annually for each PFIC.
- PFICs with a valuation of less than $25,000 are exempt from filing.
What is a PFIC (Passive Foreign Investment Company)?
A PFIC is a foreign company that predominantly generates passive income such as capital gains, interest, or dividends. Apart from this, the company holds passive assets that contribute to generating such income.
The regulatory framework of the PFIC was set up by the Internal Revenue Service (US) to prevent the taxpayers of the United States from deferring taxes on the passive income that is earned from an offshore investment (s).
How to Identify the Passive Foreign Investment Company (PFIC)?
Any foreign company is considered a PFIC for any financial year if it meets either of the two tests applied annually:
- Income Test: At least 75% of the total gross income should be passive.
- Asset Test: Approximately 50% of the corporation's assets are allocated to generating passive income.
Why Do The Rules of PFIC Matter?
As a footnote, the rules established for PFIC were designed to prevent U.S. taxpayers from deferring taxes on passive income earned through investments made in a foreign entity or other similar arrangements.
Once an investment falls under the classification of PFIC, it triggers a set of complex rules and regulations for reporting, and can also result in high taxes.
A US investor with a PFIC holding is required to report the investment holding using IRS Form 8621, which is an information return by a shareholder of a passive foreign Investment company or Qualified Electing Fund (QEF). Heavy penalties will be imposed if the taxpayer fails to comply with the reporting requirements.
What Are The Common Examples of PFICs?
There are thousands of PFICs registered worldwide, covering various investment types, including mutual funds, index funds, ETFs, pension plans, and more.
Passive foreign investment companies (PFICs) include:
- Foreign Mutual Funds
- Certain Hedge Funds
- Pooled Investment Vehicles
- Startups with Cash Reserves.
Such entities often generate passive income, which makes them subject to the PFIC rules. Furthermore, foreign exchange-traded funds (ETFs) and foreign investment trusts are a few common examples.
Moreover, active businesses, such as an offshore manufacturing company or an overseas retail chain, are not eligible to become a PFIC because their gross income is primarily generated through business operations rather than passive income.
What is The Taxation Method of PFIC?
The PFIC taxation can be closed by using any one of the three methods mentioned below:
The Excess Distribution Method
The excess distribution method is considered the default method for taxing the PFICs (Passive foreign Investment Companies).
With respect to this taxation approach, any distribution that exceeds the threshold of 125% of the average distributions received over the last three years is viewed as an "Excess distribution."
These excess distributions are then allocated over the holding periods of the taxpayer. They are taxed at the highest ordinary income rate for each financial year, with additional interest charges also applicable.
Let us illustrate this with an example: Suppose Mr. Earl receives an excess distribution of approximately $5,000 in the first year of owning a passive foreign investment company. The distributions will be divided among the royalties three years ago, and then they will be taxed accordingly.
In a nutshell, the longer you hold the PFIC, the more interest you are going to stockpile over time.
Mark-to-Market (MTM) Election
The mark-to-market election allows the taxpayer to recognize annual gains from passive foreign investment company (PFIC) shares as ordinary income, regardless of whether the shares are sold or not.
The gains are based on the valuation of the PFIC at the end of the fiscal year and are compared to the value of the PFIC at the beginning of the year. In this case, where the value is decreased, the taxpayer can claim the losses.
However, the claim of losses can only be to the extent that it offsets the previously reported gains.
Note: The mark-to-market methods are only available if the PFI shares are publicly traded on a qualified exchange. It eliminates the interest charged, which is part of the excessive distribution method. This method might not be the best choice for the PFICs that have unpredictable or volatile annual returns.
Qualified Electing Fund (QEF) Election
The qualified electing fund election permits you to be taxed annually on the pro rata shares of the passive foreign investment company (PFICs) earnings, regardless of whether the distribution is received or not.
With this method, the gains from the PFIC share sales are considered as the capital gains, and you avoid the charges of interest on the excess distributions.
The QEF election method is only applicable if the PFIC agrees to provide detailed financial information every year; however, this is not always the case. Ensure that without this detailed financial information, you will be caught up with the default excess distribution methods.
What Are The Reporting Requirements for PFICs
One of the major reporting requirements for PFICs is that if you hold a share in a passive foreign investment company, then you must file Form 8621 with the Internal Revenue Service annually for each investment. The form must be filed regardless of whether you have received a distribution or not.
The form also requires reporting any excess distributions, gains from the sale of PFIC shares, and any elections made, such as the MTM or QEF.
Additionally, with Form 8621, the PFIC might also need to be reported on Form 8938, which is a statement of specific foreign financial assets under FATCA regulations. Additionally, on the Foreign Bank & Financial Account Report (FBAR), if foreign financial assets exceed the $10,000 threshold at any point during the financial year.
Note: It is always in your best interest to maintain a detailed record of your PFIC holding, as determining the income and cost basis can become somewhat complicated.
PFIC Filing Requirements Exceptions
Everything comes with exceptions, and hence, the standard PFIC filing requirements too:
Low Value Exemption: If the total valuations of your passive foreign investment company holdings are less than $25,000 ($50,000 if married filing jointly), then you are exempt from filing Form 8621.
Foreign Pension Plans: Passive foreign investment companies that are part of foreign pension plans, such as the UK SIPP, are generally exempt from filing requirements unless they meet specific criteria.
Controlled Foreign Corporation (CFC) status: If your PFIC qualifies as a controlled foreign corporation, then you are only required to file Form 5471 instead of Form 8621.
How To Reduce the PFIC Tax Liability?
Here are some of the strategies mentioned to minimize the tax liability of your passive foreign investment company holdings.
Timely QEF Elections: By making a timely QEF election, you can easily avoid the internet charges imposed on the excess distributions.
US-based EFTs and Mutual Funds: When you invest in US-based mutual funds or ETFs, it is not subject to the PFIC rules.
Analyze the Holding Period: If the holding periods are long, they may result in a significant interest change, so it is always advisable to review your holdings and consider either selling them or making an election whenever it benefits you.
Take An Expert's Assistance Before You Invest
The complexities surrounding passive foreign investment companies extend beyond the investment itself, encompassing tax implications and long-term financial obligations.
As a taxpayer, if you are not sure about your PFIC filing or how you should handle the tax obligations associated with that, you must consult an investment tax expert, Savetaxs.
Savetaxs is a leading tax consultancy firm that helps US citizens and NRIs with their tax concerns. We have been helping for over a decade, and our satisfied clientele base speaks for itself.
For unmatched expert guidance regarding PFIC investments and how to file Form 8621 or other related forms, connect with us!
Note: This guide is for informational purposes only. The views expressed in this guide are personal and do not constitute the views of Savetaxs. Savetaxs or the author will not be responsible for any direct or indirect loss incurred by the reader for taking any decision based on the information or the contents. It is advisable to consult with either a Chartered Accountant (CA) or a professional Company Secretary (CS) from the Savetaxs team, as they are familiar with the current regulations and help you make accurate decisions and maintain accuracy throughout the whole process.
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