The term “passive foreign investment company” (PFIC) suggests a sophisticated, highly specialized non-U.S. investment medium that the majority of U.S. persons probably would not select as an investment. In reality, the scope and applicability of PFIC federal income tax provisions have developed to such an extent that U.S. persons may unwittingly become PFIC shareholders (e.g., by being unaware an entity is a PFIC or ownership attributed through another entity) and thus subject to unexpected federal income tax and reporting requirements. Furthermore, the IRS has demonstrated increased vigilance of international investments by U.S. persons in an effort to reduce the international tax gap (Vadim Blikshteyn, “Passive Foreign Investment Companies,” Tax Adviser, 2011, http://bit.ly/2Erqo1x).
The purpose of this article is to provide CPAs with a body of knowledge about PFICs sufficient to recognize the factors that make a foreign corporation a PFIC and to enable taxpayers to make decisions that will mitigate the U.S. federal income tax consequences of direct or indirect PFIC ownership.
Historical Perspective of PFIC Provisions
A tenet of U.S. federal income tax policy is that U.S. citizens, domestic corporations, and domestic trusts are taxed on their current worldwide income. Income from foreign subsidiaries of U.S.-based corporations, however, is generally not subject to U.S. taxation until it is repatriated to the United States.
The rules governing PFICs were enacted in 1986 to prevent U.S. taxpayers from deferring U.S. tax on passive investments or converting ordinary income to capital gains by effecting such investments through offshore entities, most often via mutual funds. The scope of PFIC rules has, however, broadened to such an extent that U.S. persons who are not necessarily seeking a foreign “tax haven” in which to invest are ensnared by PFIC provisions and may unwittingly become subject to an additional tax on “excess distributions” from a PFIC and additional tax return reporting requirements, become an “indirect” shareholder of a PFIC and subject to PFIC rules, or fail to make elections that affect the tax treatment of their PFIC investment.
The expansion of PFIC scope and applicability began with the Treasury Department’s 1992 promulgation of three proposed regulations. Among other things, they pertained to the determination of when a U.S. person will be treated as a PFIC shareholder and the taxation of such a shareholder upon the direct, indirect, or deemed receipt of distributions from the PFIC or disposition of the stock of the PFIC.
In 2013, the Treasury and the IRS issued temporary and final regulations (TD 9650) that provided guidance on what constitutes direct and indirect ownership of PFICs and implemented an annual reporting requirement for PFIC shareholders. They replaced and expanded various provisions of the 1992 proposed regulations.
Three years later, the Treasury and the IRS issued final regulations (TD 9806, Definitions and Reporting Requirements for Shareholders of Passive Foreign Investment Companies) that provided further definitive guidance on determining ownership of a PFIC and on certain mandatory annual reporting requirements for shareholders of PFICs to file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. The final regulations withdrew the temporary regulations issued December 31, 2013, affected U.S. persons that own interests in PFICs and certain U.S. shareholders of foreign corporations, and became effective December 28, 2016. The provisions of TD 9806 are discussed below.
The scope of PFIC rules has broadened to such an extent that U.S. persons who are not seeking a foreign “tax haven” are ensnared by PFIC provisions.
The Passive Foreign Investment Company
The PFIC designation derives entirely from entity characteristics, without regard to the number of owners or their characteristics. A generic, nontechnical description (although not a federal income tax definition) of a PFIC is a pooled investment that is registered outside of the United States, containing such assets as mutual funds, hedge funds, and insurance products. It is possible, however, for a foreign-operating (i.e., noninvestment) corporation to be classified as a PFIC; this might occur when a foreign corporation, lacking business opportunities that would produce operating income, invests excess cash in passive assets to provide an income stream until its business opportunities improve. The presence of certain amounts of passive assets and income makes the corporation vulnerable to PFIC classification under U.S. federal income tax law.
Internal Revenue Code (IRC) sections 1291–1298 contain the federal income tax provisions pertaining to PFICs. IRC section 1297(a) defines a PFIC as any foreign corporation if either—
- 75% or more of its gross income for the taxable year is passive income (the 75% test), or
- the average percentage of assets held during the taxable year that produce passive income is at least 50% (the 50% test).
For purposes of the 75% test, passive income is any income that would be foreign personal holding company income as defined in IRC section 954(c); however, IRC section 1297(b)(2) excepts from the definition of passive income any income that is from the active conduct of a banking or insurance business, as well as certain interest, dividends, rents, or royalties.
For purposes of the 50% test, fair market value is used to determine the average percentage of assets devoted to the production of passive income. IRC section 1297(e)(2), however, allows the computation to be based on adjusted basis if a nonpublicly traded corporation makes an election to apply this metric.
In Notice 88-22 (1988-1 CB 489), the IRS provided examples of passive assets, such as cash and other assets readily convertible into cash, accounts receivable from transactions generating passive income, and corporate stock. Notice 88-22 provides further guidance about the 50% test:
- The asset test is based on gross assets, unreduced by either secured or unsecured liabilities.
- Assets producing both passive and non-passive income during a taxable year must be treated as being partly passive and partly nonpassive in proportion to the respective amounts of each type of income produced by the asset.
- Securities that produce tax-exempt income are classified as passive assets unless certain conditions are met (e.g., securities are identified as inventory of a dealer in that type of security).
Each of these factors creates tax planning opportunities for the PFIC.
If a foreign corporation owns, directly or indirectly, at least 25% (by value) of the stock of another corporation, a look-through rule is applied in the computation of the 50% asset test and the 75% income test. Specifically, the foreign corporation is treated as if it—
- held its ratable share of the 25%-owned corporation’s assets, and
- received directly its ratable share of the 25%-owned corporation’s income.
The look-through rule is a double-edged sword. The foreign corporation benefits when the 25%-owned corporation has a relatively small amount of passive income and a small investment in assets that produce passive income, making it less likely that the corporation will be a PFIC; however, the converse is also true. Corporations should use the look-through rule judiciously to avoid PFIC status by not organizing a lower-tier subsidiary as a PFIC.
If certain requirements are met (e.g., no predecessor of the corporation was a PFIC), a corporation will not be treated as a PFIC during its start-up year (i.e., the first taxable year that the corporation has gross income). A similar grace period exists for a corporation that changes businesses [IRC section 1298(b)(3)].
U.S. Taxation of PFIC Shareholders
The statutory provisions contain three separate tax regimes that are applicable to U.S. persons that directly or indirectly own PFIC stock:
- Current taxation of income from qualified electing fund (IRC section 1293). This regime applies when a shareholder elects to treat his or her PFIC investment as an investment in a qualified electing fund (QEF). It requires that PFIC shareholders be taxed on undistributed PFIC income as it is earned.
- Interest on tax deferral (IRC section 1291). The interest-on-deferral regime allows the tax on PFIC income to be deferred, but requires the shareholder to pay tax plus interest on the deferral when the shareholder receives an excess distribution or a disposition of PFIC stock occurs. PFIC shareholders who have not elected to treat their investment as an investment in a QEF are treated as shareholders in a 1291 Fund.
- Mark to market for marketable stock (IRC section 1296). The mark-to-market (MTM) regime applies to PFIC shareholders who elect to recognize gains and losses from marketable stock [defined in IRC section 1296(e)] in the tax return of the year in which they occur.
Corporations should use the look-through rule judiciously to avoid PFIC status by not organizing a lower-tier subsidiary as a PFIC.
These regimes are covered in more detail below. First, however, a discussion of the term “indirect shareholder” is necessary, because the concept is expansive and can ensnare an unsuspecting U.S. person. Importantly, the determination of indirect ownership is made on a facts-and-circum stances basis; the substance, and not the form, of ownership is controlling. The various forms of ownership and their implication for the concept of indirect ownership within the PFIC provisions follow, including references to the final regulations.
- Ownership through a non-PFIC foreign corporation [Treasury Regulations section 1.1291-1(b)(8)(ii)(A)].A person who directly or indirectly owns 50% or more in value of the stock of a non-PFIC foreign corporation is deemed to own a proportionate amount (by value) of any stock owned directly or indirectly by the foreign corporation. This provision has the potential to ensnare unwitting U.S. persons who own a majority interest in a foreign corporation that itself is not a PFIC but does own stock in a PFIC.
- Ownership through a PFIC [Treasury Regulations section 1.1291-1(b)(8)(ii)(B)]. A person who directly or indirectly owns stock of a PFIC is deemed to own a proportionate amount (by value) of any stock owned directly or indirectly by the PFIC.
- Ownership through a domestic corporation [Treasury Regulations section 1.1291-1(b)(8)(ii)(C)(1)]. This provision applies to a U.S. person who owns 50% or more of the stock of a domestic corporation. For purposes of determining if a U.S. person meets the ownership threshold of paragraph (b)(8)(ii)(A) above, a U.S. person who owns 50% or more in value of the stock of a domestic corporation is deemed to own a proportionate amount (by value) of any stock owned directly or indirectly by the domestic corporation. Example 1 of Treasury Regulations section 1.1291(b) (8)(iv) demonstrates the practical scope and applicability of this provision.
- Ownership through partnership [Treasury Regulations section 1.1291-1(b)(8)(iii)(A)]. The partners in a partnership that owns directly or indirectly the stock of a foreign or domestic corporation are deemed to own such stock proportionately in accordance with their ownership interests in the partnership.
- Ownership through S corporation [Treasury Regulations section 1-1291-1(b)(8)(iii)(B)]. If an S corporation directly or indirectly owns stock, each S corporation shareholder is deemed to own such stock proportionately in accordance with the shareholder’s ownership interest in the S corporation.
- Ownership through estates and trusts. Treasury Regulations sections 1.1291-1(b)(8)(iii)(C) and (D) contain provisions pertaining to ownership through estates and trusts.
- Ownership through certain tax-exempt organizations [Treasury Regulations section 1.1291-1(e)(2)]. If a U.S. person owns stock of a PFIC through a tax-exempt organization, the U.S. person is not treated as a shareholder with regard to the PFIC stock. This exception applies to ownership through most tax-exempt organizations. Treasury Regulations section 1.1298-1(c)(1) contains more specific information about which tax-exempt entities are included in this exception. This provision constitutes definitive relief from the 1992 proposed regulations’ provision that would have attributed PFIC stock ownership through tax-exempt entities.
Qualified Electing Fund (QEF) Regime
The QEF regime was enacted to parallel the U.S. tax rules applied to domestic mutual funds so that investors in domestic and foreign funds are accorded similar tax treatment. IRC section 1293(a) provides that any U.S. person who owns (or is treated as owning) stock of a QEF [as defined by IRC section 1295(a)] at any time during the taxable year must include in gross income—
- ordinary income equal to his ratable share of the ordinary income of the fund for the taxable year; and
- long-term capital gain equal to his ratable share of the net capital gain of the fund for such year.
IRC section 1293(f) provides that QEF shareholders that are domestic corporations owning at least 10% of the QEF’s stock may avail themselves of the indirect foreign tax credit. Actual distributions from a QEF are nontaxable to the extent that they are distributions of previously taxed QEF earnings, and IRC section 1293(d)(2) provides that these nontaxable QEF distributions reduce the shareholder’s stock basis.
For purposes of the PFIC shareholder tax consequences of IRC section 1293(a) described above, IRC section 1295(a) defines what constitutes a QEF under U.S. federal income tax law. A PFIC will be treated as a QEF with respect to the taxpayer if—
- an election by the taxpayer under subsection (b) applies to the PFIC for the taxable year, and
- the PFIC complies with the Treasury Secretary’s requirements for determining the company’s ordinary earnings and net capital gain and otherwise carrying out the purposes of the statute as it pertains to PFICs.
It is important to note that a PFIC is classified as a QEF with regard to only those shareholders that have elected QEF treatment.
It is important to note that a PFIC is classified as a QEF with regard to only those shareholders that have elected QEF treatment. PFIC shareholders who do not elect to be designated as QEF shareholders are treated as shareholders of a 1291 fund. Treasury Regulations section 1295-1(f) provides that the shareholder makes the election by completing Form 8621 and attaching it to the shareholder’s federal income tax return for the first taxable year to which the election will apply. The election and Form 8621 reporting is an annual requirement.
Furthermore, the annual Form 8621 reporting must contain information provided to the shareholder by the PFIC in the PFIC Annual Information Statement [the content of which is identified in Treasury Regulations section 1.1295-1(g)]. The PFIC Annual Information Statement provides a shareholder with, among other things, her ratable ordinary income and net capital gain, or sufficient information to enable the shareholder to calculate such amounts, for the current taxable year.
Elections to Purge IRC Section 1291 Taint
Before the 1992 Treasury Department regulations, Boris Bittker and Lawrence Lokken concluded that the multitude of disadvantages associated with the IRC section 1291 interest-on-tax-deferral regime “suggest that the rules are designed to force the QEF election to be made wherever feasible” (Fundamentals of International Taxation, Warren, Gorham & Lamont, 1991). If a shareholder makes a QEF election in the first year of PFIC ownership, there is no section 1291 (interest-on-tax-deferral regime, discussed below) taint associated with the stock; however, a taxpayer or preparer may not be aware of the investment’s PFIC status when the stock is acquired, for the reasons mentioned previously. A QEF election after the first year of ownership protects the election and subsequent years from the section 1291 interest-on-tax deferral regime.
But what about the 1291 taint that attached to the pre-QEF election years? Requests for retroactive QEF elections are possible; however, the IRS is reluctant to grant retroactive relief except in special circumstances, such as those in which the shareholder satisfies the provisions of Treasury Regulations section 1.1295-3. Fortunately, IRC section 1291(d)(2) works in tandem with a QEF election to cleanse the 1291 taint associated with pre-election taxable years. It provides two elections by which the shareholder of a section 1291 fund can purge the PFIC stock of its section 1291 taint. The tax cost to cleanse section 1291 taint is taxation in the year of election.
Deemed-sale election (IRC section 1291(d)(2)(A)).
Once a shareholder elects the QEF regime and can establish the fair market value of the fund stock on the first day of the taxable year of the QEF election, the shareholder can elect to recognize the inchoate gain in the stock as if he had sold it at its fair market value on the first day of the QEF election year. This election permits a shareholder of a 1291 fund to convert the investment into a QEF. The tax price of the conversion is current recognition of gain. The election is particularly beneficial when little appreciation exists with respect to the PFIC stock.
Treasury Regulations section 1.1291-10(d) describes the deemed-sale election process. The electing shareholder makes the election by filing Form 8621 with the return of the taxable year, reporting the recognized gain as an excess distribution pursuant to IRC section 1291(a), and paying the tax and interest due on the excess distribution.
Treasury Regulations section 1.1291-10(f) provides that an electing shareholder who owns stock directly increases the adjusted basis of the PFIC stock by the amount of gain recognized on the deemed sale, and section 1.1291-10(g) provides a fresh-start holding period for the PFIC stock, beginning on the date of the deemed sale. An indirect shareholder who makes the deemed-sale election increases the basis of the property owned directly by the shareholder through which ownership of the PFIC is attributed. This is further evidence that knowledge of indirect PFIC ownership is essential to mitigate the impact of any PFIC tax consequences.
Deemed-dividend election (IRC section 1291(d)(2)(B)).
If a QEF is also a controlled foreign corporation (CFC) as defined in IRC section 957(a), a shareholder can purge the fund’s section 1291 taint by electing to include in gross income her proportionate share of the post-1986 PFIC earnings as of the first day that the QEF election is effective. This election is particularly beneficial when the shareholder’s proportionate share of post-1986 PFIC earnings is small.
When the interest on deferral regime is in effect, a shareholder who receives an excess distribution or disposes of PFIC stock at a gain is subject to tax on the deferral and an interest charge.
The election process and the consequences of the deemed-dividend election are similar to those of the deemed-sale election, and they are described in Treasury Regulations section 1.1291-9. For example, the deemed dividend is treated as an excess distribution on the day of the deemed dividend, the adjusted basis of the fund stock is increased by the amount of the dividend, and the shareholder’s holding period in the stock is treated as beginning on the day of the deemed dividend.
Interest on Tax Deferral Regime
The interest on tax deferral regime allows a U.S. person to defer taxation on PFIC income until the U.S. person receives an excess distribution from the PFIC or disposes of PFIC stock at a gain. When the interest on deferral regime is in effect, a shareholder who receives an excess distribution or disposes of PFIC stock at a gain is subject to tax on the deferral and an interest charge. The income from an excess distribution and the gain from a disposition of PFIC stock are ordinary income, in accordance with IRC sections 1291(a)(1)(B) and 1291(a)(2), respectively.
IRC section 1291(b)(2)(A) defines an excess distribution as the excess (if any) of—
- the amount of the distribution received by the taxpayer during the taxable year, less
- 125% of the average amount received by the taxpayer during the three preceding taxable years (or, if shorter, the part of the taxpayer’s holding period before the taxable year).
Allocation of excess distributions.
The amount of the excess distribution (or gain) is ratably allocated to each day that the shareholder held the stock [IRC sections 1291(a)(1)(A) and (a)(2)]. Amounts allocated to the current year (i.e., the taxable year of the excess distribution or disposition) are subject to regular U.S. taxation. The tax on amounts allocated to PFIC years exclusive of the current year is computed at the highest rate of tax that is applicable to the shareholder for the applicable tax years [IRC section 1291(c)(2)]. Furthermore, IRC section 1291(c)(3) imposes an interest charge on the tax, computed using the rates and method applicable under IRC section 6621 for underpayment of tax.
Implementation of the deferral method also requires taking into account certain adjustments described in IRC section 1291(b)(3). For example:
- Computations are on a share-by-share basis, except that shares with the same holding period can be aggregated.
- Stock splits and stock dividends must be taken into account.
- If the shareholder’s holding period includes periods during which stock was held by another shareholder, distributions to the other shareholder must be treated as if they were received by the subject shareholder.
- If distributions are received in a foreign currency, computations are made in that currency, and the amount of any excess distribution is translated into dollars.
Coordination with mark-to-market regime.
Treasury Regulations section 1.1291-1(c)(3) provides that if PFIC stock is marked to market under IRC section 1296 (discussed below) for any taxable year, then IRC section 1291 and the Treasury Regulations thereunder are not applicable to any distribution with respect to section 1296 stock or any disposition of such stock for that taxable year.
Election of Mark to Market for Marketable Stock
IRC section 1296 permits a U.S. shareholder of a PFIC to mark to market the PFIC stock if it is “marketable stock,” as defined by Treasury Regulations section 1.1296-2. The stock must be regularly traded on a qualified exchange or other market, defined by Treasury Regulations section 1.1296-2(c) as—
- a national securities exchange that is registered with the SEC;
- the national market system established under section 11A of the Securities Exchange Act of 1934; or
- a foreign securities exchange that is regulated or supervised by a governmental authority of the country in which the market is located and has the characteristics described in Treasury Regulations section 1.1296-2(c)(1)(2), such as trading volume and disclosure requirements.
In accordance with IRC section 1296(a), the PFIC shareholder tax consequences of the mark-to-market election are either—
- gain recognized to the extent that the fair market value of the stock as of the close of the taxable year exceeds its adjusted basis; or
- loss recognized to the extent that the adjusted basis of the stock exceeds the fair market value of the stock as of the close of the taxable year.
IRC section 1296(c)(1) further provides that the gain included in gross income is ordinary income and the loss, which is also ordinary, is deductible in computing adjusted gross income. The six examples in Treasury Regulations section 1.1296-1(c)(7) illustrate the recognition of gain or loss associated with the mark-to-market election.
In addition, a PFIC shareholder’s stock basis is adjusted to reflect recognized gain or loss. Treasury Regulations section 1.1296-1(d)(1) provides that if the shareholder holds the stock directly, stock basis is increased by the amount included in gross income or decreased by the amount allowed as a deduction. If the stock is held through a foreign entity, held through a regulated investment company, or acquired from a decedent, the basis adjustment is described in Treasury Regulations sections 1.1296-1(d)(2), (d)(3), or (d)(4), respectively.
It has become increasingly possible for U.S. persons to unwittingly become shareholders of PFICs, the results of which are unexpected federal income taxation and an annual requirement to file Form 8621.
PFIC Shareholder Filing Responsibilities
The IRS Instructions for Form 8621 succinctly summarize the filing responsibilities of PFIC shareholders and provide extensive practical guidance about the QEF and the mark-to-market elections. They state that a U.S. person who is a direct or indirect shareholder of a PFIC must file Form 8621 for each taxable year if that person—
- receives certain direct or indirect distributions from a PFIC;
- recognizes gain on a direct or indirect disposition of PFIC stock;
- is reporting information with regard to a QEF or MTM election;
- is making a QEF election; or
- is required to file an annual report pursuant to IRC section 1298(f). Treasury Regulations section 1.1298-1 identifies the IRC section 1298(f) annual reporting requirements for U.S. persons who are shareholders of a passive foreign investment company.
It is significant to note that these criteria are applicable to both direct and indirect shareholders. This once again demonstrates the importance of identifying U.S. persons who are classified by the statute and regulations as indirect PFIC shareholders.
Avoid Being Caught Unawares
It has become increasingly possible for U.S. persons to unwittingly become shareholders of PFICs, the results of which are unexpected federal income taxation and an annual requirement to file Form 8621. Without guidance from their tax advisors, those U.S. persons may not be aware of elections that mitigate the unexpected federal income tax consequences of PFIC ownership. Knowing the ins and outs of what qualifies as a PFIC is crucial for helping taxpayers recognize when an investment has the potential to be classified as a PFIC, understand what the federal income tax consequences of that investment are, and make timely elections to mitigate the negative tax effects of PFIC ownership.