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The Potential Tax Trap of PFIC Investments

There are many times when a passive foreign investment company (PFIC) investment is made unknowingly and the tax consequences can be adverse.

Certain elections should be considered that can lessen the tax implications, but it can be difficult obtaining the financial information necessary to determine whether or not the investment is a PFIC. 

What is a PFIC?

If a foreign corporation or investment vehicle (not characterized as a disregarded entity or partnership for U.S. tax purposes) meets either of the two conditions below, it will be deemed a PFIC:

  • Passive income accounts for 75 percent or more of gross income. Passive income for a PFIC is cross-referenced to the Subpart F provisions, which include, for example, income from interest, dividends, annuities, and certain rents and royalties.
  • 50 percent or more of its assets produce passive income.

All corporations owned by an investment vehicle must be tested for PFIC status. And once a PFIC, always a PFIC.

The U.S. Treasury Department and the IRS issued final PFIC regulations that allow income that would normally be considered passive Subpart F rent or royalty income to be active non-PFIC, whereby the activity to make the income active can be performed anywhere in the group of related companies, including from the United States, rather than requiring that activity to be within the corporation being tested. Those same regulations also permit a working capital exception for cash that earns interest income.

Further, if a PFIC is a controlled foreign corporation solely by the repeal of Internal Revenue Code Section 958(b)(4), the asset test can continue to use fair market value rather than historic cost basis. Any subsidiary or partnership is considered passive per se if the ownership of that entity is less than 25 percent. There is a helpful look-through rule if 25 percent or more of a subsidiary corporation or partnership is owned by an investment vehicle where its assets can be treated as active assets to the extent they produce active income.

Implications of PFIC Rules

Unless a PFIC investor makes one of the elections below, the following punitive tax rates and special rules apply:

  • For any year a dividend is paid by the PFIC or any PFIC shares are sold, a complex calculation is used that involves prorating the PFIC’s return over the entire holding period, applying an interest charge on the tax deferred on what is considered an excess distribution.
  • Most capital gains are taxed for individuals at a top federal rate of 20 percent, plus the Affordable Care Act (ACA) surcharge of 3.8 percent, for a total of 23.8 percent. This is favorable compared to the top ordinary federal individual income tax rate of 39.6 percent (including the ACA surcharge). Capital gains from PFICs, however, are effectively taxed at the highest ordinary income rate plus the interest charge mentioned above.

Form 8621 needs to be completed and filed for each PFIC every year. There is no monetary penalty for failure to file the form, but a U.S. shareholder/owner’s statute of limitations remains open for when the IRS can commence auditing the tax return and does not begin to toll until the form is completed and filed.

Be aware that the Foreign Account Tax Compliance Act (FATCA) requires foreign financial institutions to disclose to the IRS information on their American investors. The IRS will have knowledge of U.S. investors in PFICs.

Other Considerations

There are a few election options and other matters that U.S. investors can and should consider.

If a PFIC meets certain accounting and reporting requirements, the U.S. investor can elect to treat the PFIC as a qualified electing fund (QEF), which eliminates the punitive tax rates. The QEF election basically treats the PFIC like a U.S. mutual fund, taxing the income annually (irrespective of whether it is distributed) but retaining favorable capital gains rates and eliminating the interest tax deferral on excess distributions.

This QEF election must be made for the first year of an investment in a PFIC (commonly referred to as a “pedigreed QEF”). In limited situations, late filing for IRC Section 9100 relief may be available.

If the taxpayer does not make a pedigreed QEF election and does not qualify for late relief, the taxpayer may in a later year make a purging election to recognize gain (but not loss) subject to the excess distribution interest charge provisions.

If the PFIC is “marketable,” the U.S. owner can make a mark-to-market election that marks that stock to market at year-end, which forces the U.S. shareholder to include the stock’s unrealized appreciation in income each year as ordinary income. Additionally, that shareholder can recognize depreciation in value as an ordinary deduction to the lesser of the depreciation in value or the unreversed appreciation previously recognized.

There is an exemption from PFIC reporting if PFIC holdings do not exceed $25,000 ($50,000 for married couples filing jointly). Also, holding a PFIC through an IRA or other certain retirement accounts may be exempt from Form 8621 filing requirements.

A special rule may prevent a corporation from being a PFIC in its first year if its gross income meets three provisions (which, in practice, are difficult to meet):

  • No predecessor of the corporation may have been a PFIC.
  • The taxpayer must demonstrate to the IRS’s satisfaction that the corporation will not be a PFIC for the first two years following the year in which the corporation first has gross income.
  • The corporation must not actually be a PFIC for either of the first two years following the year in which the corporation first has gross income. If it is a PFIC in any of those two following years, then it fails retroactively.

Congress created an important exception in 1997 commonly referred to as the controlled foreign corporation (CFC)/PFIC overlap rule. If a U.S. person is a 10 percent or greater shareholder of a foreign corporation and the foreign corporation is both a CFC and a PFIC, then the entity is only a CFC for those 10 percent or greater U.S. shareholders. For U.S. shareholders who own less than 10 percent, the PFIC provisions still apply. When a foreign corporation is both a CFC and a PFIC, the asset test to the PFIC shareholders must be computed under historic tax book value – fair market value cannot be used.

A protective statement is a statement, executed under penalty of perjury, by the shareholder (or a person authorized to sign a federal income tax return on behalf of the shareholder) that preserves the shareholder’s ability to make a retroactive QEF election. To file a protective statement that applies to a taxable year of the shareholder, the shareholder must reasonably believe as of the election due date that the foreign corporation was not a PFIC for the foreign corporation’s taxable year that ended during the retroactive election years.

The protective statement must contain the following:

  • The shareholder’s explanation as to why the foreign corporation was not a PFIC, and what information has been relied upon to make this statement
  • The shareholder’s agreement extending the period of limitations on the assessment of PFIC-related taxes for all taxable years to which the protective statement applies
  • Certain information and representations

Practical Considerations

The hardest aspect of making a PFIC determination is obtaining the financial information to make the income and asset test calculations. U.S. shareholders typically do not control the foreign corporations they invest in, nor do they have the ability to compel them to provide the information. Here are some ideas and suggestions to get this information:

  • Obtain a copy of the investment prospectus and read it. Often, the prospectus will indicate whether the investment is a PFIC and may also outline a mechanism for requesting the information for PFIC testing.
  • Talk to other investors you know who have invested in this same investment and their advisors about how they are getting the information to do the PFIC testing. There can be strength in numbers when investors band together and request this information.
  • If you do not have access to it, talk to an investment adviser about getting this information.
  • Use the internet to see what financial information exists. Many countries have statutory disclosure provisions, and the needed information may be publicly available. Care needs to be exercised when using the internet: not all online information is correct.
  • Check to see if there are SEC filings for the investment. If so, there can be a wealth of financial information in those filings, including discussions of the PFIC status.

The original article appeared in the Fall 2021 issue of the Pennsylvania CPA Journal.