I was hoping that tax reform would have done away with, or at least modified, the troublesome provisions surrounding the PFIC or so-called “Passive Foreign Investment Company”. This was not to be and it prompted me to review the PFIC rules and count the ways they cause trouble!
What is a PFIC?
A PFIC is a so-called “Passive Foreign Investment Company” which is defined to include any foreign (non-US) corporation if 75% or more of its gross income for the year consists of “passive income” (“income test”), or (2) at least 50% of the average fair market value of its assets during the year are assets that produce or are held for the production of passive income (“asset test”). Passive income generally includes dividends, interest, rents, royalties, most foreign currency and commodity gains, and capital gains from assets that produce such income. For those invested in foreign mutual funds, just about all of the income of a foreign fund will usually qualify as passive and so, nearly all foreign funds will qualify as PFICs.
Under the PFIC rules, the US shareholder of the PFIC suffers severe US income tax and tax reporting consequences. There is no minimum level of stock ownership required by a US person to be subject to the PFIC tax regime. It therefore often comes as a surprise to many investors that even foreign public companies can be considered PFICs in their hands for US tax purposes. Admittedly, such investors have become unwilling PFIC shareholders, but the tax bite will remain the same.
Underlying Purpose Behind the PFIC Rules
The PFIC tax regime was enacted with the Tax Reform Act of 1986. The regime was generally designed to prevent tax deferral with the use of non-US corporations. It was also designed to assist US-based mutual funds that were losing business to foreign-based mutual funds caused by a tax disparity between the two. A US mutual fund was forced to pass-through all investment income earned by the fund to its investors and the investors had to pay current US income tax on that income. Foreign mutual funds were often created in tax haven jurisdictions and did not pay tax; the fund’s US investors also did not pay tax so long as no distributions were made to them. This tax deferral aspect was very valuable as deferral could go on for years and years. After the passage of the PFIC tax regime, this deferral advantage completely disappeared since the PFIC rules made the practice of delaying the distribution of income prohibitively costly for US investors.
Harsh Tax Results – Compounded Interest, Loss of Capital Gain Treatment and More
Once a corporation qualifies as a PFIC, very harsh tax consequences can result. In the absence of making a special election, taxation will generally occur when the PFIC either makes what is called an “excess distribution” to its US shareholder or when the shareholder disposes of his PFIC shares. When taxation occurs, the amounts will be taxed at the highest ordinary income tax rate currently in effect, without regard to other income or expenses (currently the highest individual rate is 37 % with a possible 3.8% Medicare surcharge tacked on for high income earners). Long-term capital gains treatment does NOT apply. Further, the amounts are treated as if they were earned ‘pro rata’ over the investor’s holding period for his shares. What this means is that the amounts to be taxed are “thrown back” evenly over each of the earlier tax years commencing with the year when the shares were first held. Tax is then assessed for each year at the highest possible tax rate, and interest is compounded on the tax deemed due for each year. Due to the imposition of compounded interest charges, the rates can easily eat up the offshore investment.
Active Businesses Getting Caught in The Passive Net
A very harsh effect of the PFIC tax regime is the fact that the definition of a “PFIC” is from a fairytale world that ignores business reality. It is overly broad with the result that many active businesses are getting caught in the PFIC net. How does this happen? It happens because a company can be classified as a PFIC upon application of either the “income test” or the “asset test”, discussed above. The IRS has unequivocally stated in Notice 88-22 1988-1 C.B. 489, that cash, including working capital is to be treated as a “passive asset”. Many sales and services companies will meet the asset test under this definition since they often do not have significant assets other than cash and working capital, which has been defined by the IRS to be per se, “passive.” Take for example, a computer servicing business or a website development business – the assets of this type of business will likely be only a few desks, computers and the like, but the business may have a large bank or other financial account. Notice 88-22 created significant problems for newer foreign enterprises that are flush with private venture capital (or that have recently undergone an initial public offering). This capital is often meant for active business purposes and not for passive investing. The Notice’s summary edict that all working capital is to be treated as passive provided no rationale for this treatment, but the result on these kinds of companies is clear – PFIC treatment looms large, even though they are not the foreign mutual funds that Congress intended to target.
The “income test” can also inadvertently capture an active business. For example, an active foreign corporation may have a poor performance year with low income. Perhaps, it generated losses from the business enterprise in a bad year. Yet, that same corporation could generate significant passive income in the same “bad” year (for example, dividends, capital gains and interest from a portfolio investment). This unfortunate income mix can cause the otherwise active business to be classified as a PFIC. … and once so classified, the PFIC can live happily ever after.
While the test for determining PFIC status is based on the corporation’s income or assets in a particular tax year, once a corporation is classified as a PFIC, the PFIC “taint” will generally carry over to all future years that the US shareholder holds shares in the company. This is known as the “once a PFIC, always a PFIC” rule. Certain elections can be made to purge the PFIC taint, but of course, the price tag is steep. So, as in all fairytales, the PFIC will live forever and the IRS will be happily ever after collecting PFIC tax dollars.
Practitioners have been voicing the need to redefine PFICs in a manner that is more consistent with the intended purpose of the legislation – that is, to prevent tax deferral and to level the playing field for US- and foreign-based funds. The voices, unfortunately, have fallen on deaf ears and the PFIC regime continues to bite the unsuspecting investor time and time again.
To add insult to injury, a US investor in a PFIC must also file various information and tax forms (e.g., Form 8621, Form 8938, FBAR). Record-keeping and preparation time for the Form 8621, alone, is extremely complicated and a separate Form must be filed for each PFIC owned. The IRS estimates that the time required with regard to Form 8621 for each PFIC investment is at 22 hours per year! The tax preparation costs are very high and many tax return preparers are ill equipped to handle returns involving PFICs. Many will not take on such work. To avoid possible penalties, the investor should examine the proper tax treatment and filings with a tax professional who is qualified and knowledgeable in this area.
Posted: December 14, 2018
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12 thoughts on “PFICs – The Fairytale Definition That Lives Happily Ever After…”
Do the regs allow for a 25,000.00 exemption broke the reporting kicks in? Unless there is a sale?
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Sorry, I am not understanding your question 😦
I have hated PFICs for decades. But since last year’s TCJA, I have come to like them more.
With the denial of a deduction for management fees and state and local taxes, holding PFIC shares with a QEF election (assuming you can obtain the necessary information) now comes at a lower tax cost than holding the shares directly. Because QEF inclusion is limited by the PFIC’s earnings and profits, and both management fees and state and local taxes are deductible for earnings and profits purposes.
We truly have come full circle â it is sometimes better to own a PFIC than to own the underlying assets directly!
Of course, QEF shares are most attractive to US citizens and residents who live in a state with a substantial state income tax. Most of your blog readers live outside the US and face a different tax environment. For them, PFICs may well continue to be toxic.
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Richard, Thank you for your extremely helpful & astute comment. You are correct that the clients I see are not those State-side, so they cannot benefit from this TCJA change. However this is great to know and I had not thought about it. With regard to QEF elections generally, you correctly note the point parenthetically, that in order to make the QEF election, certain (a lot of) information must be provided. This has proven to be an insurmountable hurdle for literally all of the clients I’ve worked with. For example, the entity must agree to provide its shareholders with a PFIC annual information statement which must include significant detailed information, including: (1) the shareholders’ pro rata share of the PFIC’s ordinary earnings and net capital gain; (2) sufficient information for a shareholder to calculate his pro rata share of the PFIC’s ordinary earnings and net capital gain; or (3) a statement that the PFIC has permitted the shareholder to examine its books and records to calculate his pro rata share of the PFIC’s ordinary earnings and net capital gain for US income tax purposes. Calculating the income according to US federal income tax principles is a burden in and of itself, but that’s not the end of the matter! A QEF must also generally provide its US shareholders with access to its books and records. The corporations in which my typical client holds shares (often, foreign mutual funds) have absolutely no connection to the United States other than these “troublesome” minority US shareholders! They simply will not provide the information.