Do you Invest in a Passive Foreign Investment Company?

Do you Invest in a Passive Foreign Investment Company?

Many taxpayers with overseas investments may unknowingly have one or more investments in a passive foreign investment company (PFIC). And chances are highly likely that these investments are not being reported correctly. Taxpayers don’t know what they are and even their CPAs may not be familiar with these investments.

History of PFICs

A US shareholder is taxed on his share of a US corporation’s net ordinary income (dividends and interest) and capital gains. US mutual funds are required to provide shareholders with an allocation of their ordinary income and capital gains. Additionally, this information is reported to the IRS on Form 1099-B.

Foreign mutual funds on the other hand usually do not provide such allocations to shareholders. Consequently, the income that would’ve been reported in the US as ordinary dividends or interest income can be tax deferred when the same type of income is earned through a foreign mutual fund. Not only is this income tax deferred, it’s also converted into capital gains which are taxed at a preferential rate.

In order to prevent massive capital outflow and protect US companies, Congress enacted the passive foreign investment company (PFIC) regime in 1986 and is codified in IRC § 1291 to 1298.

Do I have a PFIC?

A PFIC can be found in any non-US investment that contains foreign mutual funds. Such investments can include ownership in the following types of investments:

  • Non-US mutual funds
  • Hedge funds
  • Insurance products
  • Money market accounts
  • Retirement/pension accounts

Often taxpayers with such accounts will have several to dozens of PFICs within these investments.

Sections 1291 through 1297 of the tax code provide the rules for passive foreign investment companies.

Under Section 1297, a PFIC is any foreign corporation in which:

(1) 75 percent or more of the gross income of such corporation for the taxable year is passive income, or

(2) The average percentage of assets (as determined in accordance with subsection (e)) held by such corporation during the taxable years which produce passive income or which are held for the production of passive income is at least 50 percent.

Passive income test: A foreign corporation meets the passive income test if at least 75% of its gross income for the year includes dividends, interest, royalties, rents, and annuities, among other things.

Passive asset test: A foreign corporation meets the passive asset test if at least 50% of its assets produce passive income or are held for the production of passive income.

Determining whether a company meets the passive income or asset test will require looking through the company balance sheet and income statement. Generally a foreign mutual fund is a PFIC. Foreign stock may or may not be a PFIC.

De minimis exception: A PFIC shareholder is not required to complete the annual reporting requirement under IRC 1298(f) if the shareholder has not received any distribution or recognized gain and the aggregate value of all PFIC stock is less than $25,000 ($50,000 if married filing jointly).

Foreign pension funds: For any portion of a foreign pension fund that is considered a grantor trust, the taxpayer may be subject to the PFIC annual reporting requirements. The exception is if the tax treaty contains a provision that allows the deferral of foreign pension fund income until distribution.

How Does this Impact me Financially?

First, the PFIC taxing regime is highly punitive for such investments compared to similar types of investments in the US. For those in the highest marginal tax bracket with “excess distributions” could end up paying taxes in excess of 50% of their investment income.

A shareholder of a PFIC is required to annually report their interest in and any distribution from the PFIC.  This requirement is satisfied by reporting the PFIC on Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.

A PFIC distribution consists of two parts — an excess distribution and a non-excess distribution portion. Non-excess distribution is taxed under the same rules as other U.S. sourced income.

An excess distribution is the portion of the current distribution that exceeds 125% of the average of the preceding three years.

The excess distribution is then allocated ratably over each day of the shareholder’s holding period. Then these distributions are taxed at the highest graduated rate in effect for each previous tax year along with interest.

What should non-compliant taxpayers do?

If taxpayers are non-compliant with the foreign asset and income reporting requirements, they should consider applying to one of IRS’ voluntary disclosure programs:

We assist taxpayers who have undisclosed foreign financial assets. Schedule an appointment to see how we can help.