If you’re a U.S. taxpayer with investments in foreign mutual funds, offshore companies, or overseas ETFs, you may unknowingly own a Passive Foreign Investment Company (PFIC) — one of the most complex and punitive regimes in U.S. international tax law.
The PFIC rules, found in Internal Revenue Code §§1291–1298, were enacted to prevent U.S. taxpayers from deferring tax through foreign corporations that generate passive income. The rules often ensnare regular investors who are unaware of the reporting and tax consequences.
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What Is a PFIC?
A PFIC is defined as any foreign corporation that meets either of the following tests:
- Income Test: At least 75% of its gross income is considered passive (e.g., dividends, interest, capital gains).
- Asset Test: At least 50% of its assets are held for the production of passive income.
Foreign mutual funds and ETFs, held directly, in a foreign brokerage account, or foreign retirement account, for example, will usually be PFIC investments.
Why PFICs Are So Punitive
The PFIC regime is intentionally strict. Under the default rules (known as the “Excess Distribution Regime” in §1291), any distribution exceeding 125% of the average distribution from the prior three years is taxed at the highest marginal rate, plus a non-deductible interest charge applied to each year the investment was held. This can result in effective tax rates exceeding 50% on otherwise routine gains.
PFIC Elections: QEF and MTM
To mitigate these harsh results, taxpayers may make one of two elections:
- Qualified Electing Fund (QEF) Election
Allows the taxpayer to include their share of the PFIC’s annual income and gains as if it were a pass-through entity. However, this requires timely elections and detailed annual statements from the foreign entity — which are often unavailable from non-U.S. funds. - Mark-to-Market (MTM) Election
Available for marketable securities. Instead of tracking distributions, the taxpayer includes annual unrealized gains/losses in income, similar to how publicly traded U.S. funds are taxed.
Both elections require timely elections and carry their own compliance burdens.
Reporting Requirements: Form 8621
U.S. taxpayers who are direct or indirect shareholders of a PFIC must file Form 8621 each year — one per PFIC. These forms are notoriously time-consuming and complex. None of the commercial tax prep software support Form 8621 filing, and few tax preparers know how to properly report a PFIC distribution.
Unlike other international forms (Form 8938, Form 5471, Form 3520, etc), there are no specific penalties for failure to file Form 8621. However, the failure to file:
- Can delay the statute of limitations on your entire tax return,
- May result in other penalties and interest.
De Minimis Exception
No Form 8621 is required if:
- No QEF election has been made
- There have been no distributions (dividends or sales) during the tax year AND the value of all PFIC stock is less than $25,000 (or $50,000 for taxpayers filing jointly).
foreign pension funds covered by a tax treaty
When a foreign pension plan contains PFICs, no Form 8621 is required if a tax treaty allows for the deferral of income tax on the foreign pension. Proper elections must be made, if necessary.
Common Examples of PFICs
- Foreign mutual funds (common in retirement accounts abroad)
- Foreign ETFs not registered with the SEC
- Foreign startup companies with significant cash holdings
- Certain foreign insurance products with investment components
Not sure if you have a PFIC, or do you have a PFIC and need to disclose it? Contact us.