Freeman Law frequently advises international business ventures. International operations often give rise to unique (and sometimes unanticipated) compliance obligations and complex reporting requirements. Recent tax reform rules and regulations have imposed a number of new requirements. This post focuses on, and provides a short introduction to, the Passive Foreign Investment Company (“PFIC”) rules.
U.S. taxpayers investing in foreign corporations may be subject to the passive foreign investment company (“PFIC”) tax regime. As explained below, the PFIC regime is triggered where a threshold amount of the income or assets held by the foreign corporation is “passive.” U.S. taxpayers with PFIC holdings have three possible reporting regimes: (1) the Excess Distribution (or Section 1291 fund) regime; (2) the Qualified Electing Fund regime; and (2) the Mark-to-Market regime.
The PFIC regime was enacted in 1986 in an effort to prevent U.S. taxpayers from deferring tax on passive income earned through foreign corporations. Along with the Controlled Foreign Corporation (“CFC”)/Subpart F income rules, it is one of the U.S. Tax Code’s primary anti-deferral regimes.
What is a PFIC?
A foreign corporation is a PFIC is it meets one of two tests: (1) the Passive Income Test or (2) the Passive Asset Test. Foreign mutual funds and exchange-traded funds frequently run afoul of the PFIC rules.
Passive Asset Test: A foreign corporation is a PFIC if 50 percent or more of its assets held during the tax year produce, or are held for the production of, passive income.
Passive Income Test: A foreign corporation is a PFIC if 75 percent or more of its gross income for the tax year is passive income.
Passive income is defined, with certain exceptions, as any income that would be foreign personal holding company income under section 954(c). This includes dividends, interest, rents, royalties, and certain property gains. Passive assets take on a similar definition, generally including assets that give rise to passive income.
The default rule is that a shareholder of a PFIC is subject to the section 1291 Excess Distribution regime. The Excess Distribution regime imposes a tax and interest charge on the portion of “excess distributions” that are received and treated as though they were subject to tax in a prior tax year (though the tax/interest is included in the shareholder’s tax return during the year the distribution is received).
An excess distribution is the excess, if any, of the total distributions received with respect to the PFIC stock over and above 125 percent of the average annual distributions from the PFIC stock during the three prior tax years (or, the shareholder’s holding period, if shorter).
The excess distribution is allocated pro rata across the taxpayer’s holding period of the PFIC stock. The excess distribution that is allocated to the current year and to pre-PFIC holding periods is included in ordinary income for the current year. The portion that is allocated to prior PFIC years is taxed at the highest marginal tax rates for each of those years, and interest is then added.
The portion of the actual distribution that is not classified as an excess distribution is treated as a section 301 distribution. Notably, under the excess distribution regime, any gain from the disposition of PFIC stock is taxed as ordinary income—even if it was held as a capital asset.
Qualified Electing Fund (“QEF”)
Alternatively, a taxpayer may elect to treat a PFIC as a Qualified Electing Fund (“QEF”). Taxpayers who make a valid and timely QEF election are taxed annually on income that is deemed to be received from the PFIC. The QEF election is made on Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. The first U.S. taxpayer in the chain of ownership is the party that must make the QEF election.
A shareholder who elects QEF treatment is required to include its share of ordinary earnings and net capital gain of the PFIC in income currently. Notably, QEF shareholders may treat the gain on the sale of PFIC stock under the ordinary rules, thus generally giving rise to capital gain.
Taxpayers should be careful to avoid “unpedigreed QEFs,” which may remain subject to the excess distribution regime. PFIC taint can be purged under certain circumstances.
Some shareholders may have another method for reporting income from their interest in a PFIC under section 1296. The Mark-to-Market rules are available for stocks that are “regularly “traded” on a “qualified exchange or other market.”
Under section 1296(a), a U.S. person that owns (or is treated as owning under section 1296(g)) marketable stock in a PFIC may be elect to include in gross income the excess of the fair market value of the stock over the stock’s adjusted basis or, if the adjusted basis exceeds the fair market value of the stock, deduct the lesser of the excess or the unreversed inclusions. In other words, the shareholder recognizes ordinary income or loss on the stock at the end of each year. That ordinary income is measured by the difference between the basis of the stock and its fair market value.
For other, related Insights, see Advising International Business Ventures: Controlled Foreign Corporations and Subpart F and Advising International Business Ventures: Tax Reform and a Quasi-Territorial Tax System.