A Passive Foreign Investment Company (PFIC) is a foreign corporation with at least 75% of its income derived from passive activities, such as investments (e.g., dividends, interest, capital gains) rather than active business operations. Alternatively, a PFIC can also be defined as a company where at least 50% of its assets produce or are held for the production of passive income.
Criteria for Classification as a PFIC
Two main tests determine if a company qualifies as a PFIC under U.S. tax law:
Income Test
- A foreign corporation is considered a PFIC if 75% or more of its gross income for the taxable year is passive income. Examples of passive income include:
- Dividends
- Interest
- Rents
- Royalties
- Capital gains from the sale of securities
Asset Test
- A foreign corporation qualifies as a PFIC if 50% or more of the average percentage of its assets during the taxable year are assets that produce passive income or are held for the production of passive income.
Tax Implications for U.S. Investors
U.S. investors in PFICs face unique and often complicated tax rules designed to discourage the deferral of U.S. tax through investment in a PFIC. Key considerations include:
Excess Distribution Regime
- Distributions from a PFIC are treated as excess distributions if they exceed 125% of the average distributions received by the shareholder in the past three years. These distributions are subject to punitive tax rates and interest charges.
Qualified Electing Fund (QEF) Election
- Investors can elect to annually include their share of the PFIC’s income in their taxable income to mitigate the harsh tax treatment of excess distributions.
Mark-to-Market Election
- Shareholders in publicly traded PFICs may elect to recognize annually any gains or losses in the market value of their PFIC shares, treating the gains as ordinary income and losses as ordinary losses.
Historical Context
The concept of PFICs was established by the Tax Reform Act of 1986 to address the use of offshore corporations by U.S. taxpayers to defer tax on passive income. These rules aimed to align the treatment of passive investments in foreign and domestic contexts, reducing the tax deferral benefits achieved through foreign investments.
Comparison to Controlled Foreign Corporation (CFC)
While both PFICs and CFCs involve foreign entities, their classification criteria and tax treatments differ. A CFC requires U.S. shareholders to own more than 50% of the foreign corporation’s voting power or value, whereas PFIC classification is based on passive income and asset criteria irrespective of ownership.
Related Terms
- Controlled Foreign Corporation (CFC): A CFC is a foreign corporation in which U.S. shareholders own more than 50% of the corporation’s stock by vote or value.
- Passive Income: Income that comes from investments rather than from active business operations, such as dividends, interest, and capital gains.
FAQs
Can a PFIC election be revoked?
Are there any exceptions to PFIC classification?
What forms are required for PFIC reporting?
Summary
Passive Foreign Investment Companies (PFICs) represent foreign entities primarily engaged in passive income generation through investments. U.S. investors must navigate complex tax treatments and reporting obligations associated with PFICs to comply with IRS regulations. Understanding the criteria, implications, and available elections can help mitigate adverse tax consequences.
References
- Internal Revenue Service (IRS). “Passive Foreign Investment Company (PFIC).” IRS.gov
- Tax Reform Act of 1986. Pub. L. 99-514. U.S. Government Publishing Office.
