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Originally Posted On: https://www.intl-tax.com/what-is-a-passive-foreign-investment-company-pfic/
More than two-thirds of individuals worth more than $30 million are considered “self-made” millionaires. There are many ways to make money, and one that holds a huge amount of potential is investing.
With that in mind, it’s not simple. There are all kinds of ways to invest, and you need to have a good understanding of what you’re doing if you want to be successful. Of the manytypes of companies you could invest in, passive foreign investment companies are some of the least understood.
You’re likely asking “What is a passive foreign investment company (PFIC)?”. In this guide, we’ll answer that question and explain some of the complexities involved with these types of investments. Keep reading for more.
What Is a Passive Foreign Investment Company (PFIC)?
A PFIC is a company that decides to make one or more investments outside of the US. A typical example of this would be a company that invests in international mutual funds.
There is, however, a much wider range of investments that this can cover. Other popular investment types include hedge funds, pension funds, and insurance companies based in other countries.A company is only considered a PFIC if it meets one of two specific conditions.
The firstis that the majority of the income (at least 75%) of the company must be passive. This means that the income from these investments and any other sources cannot be in any way related to abusiness’s regular operations.
The second condition is that at least 50% of the assets a company owns must be investments that generate income through dividends, interest, or capital gains.
Understanding a PFIC
PFICs were first officially recognized in 1986 with the passing of tax reforms. Changes were made to eliminate a loophole that some US taxpayers were taking advantage of.
This loophole allowed individuals to shelter offshore investments so they wouldn’t have to pay tax on them. The reforms not only made this impossible but also made it so that such investments would have very high tax rates. This discouraged people from continuing to follow this practice.
Foreign-based mutual funds are an example of what might be typically classified as a PFIC. Any investment that is determined to be a PFIC is subject to very strict and complicated tax guidelines. The IRS details these in Sections 1291 through 1298 of the U.S. Income Tax Code.
The PFIC and ant shareholders must maintain accurate and detailed records of any transactions related to the PFIC. This includes things like dividends received, share cost basis, and any undistributed income that the PFIC earns.
The cost basis guidelines are a good example of the strict tax rules in place regarding PFICs. When it comes to almost any other security or asset, the IRS allows more control. Anyone who inherits shares can step up the cost basis for the shares to the fair market value as it was at the time of their inheritance.
This isn’t the case, however, with shares in a PFIC. On top of this, it can be incredibly difficult and confusing to determine the acceptable cost basis for PFIC shares.
PFICs and Tax Strategies
To this day, PFICs remain complicated and the IRS works to discourage them. Despite that, many Americans still own shares of PFICs. Any investor who does must file IRS Form 8621.
This form relates to reporting actual distribution and gains. It also involves income and increases in QEF elections.
People often consider all tax forms to be long and complicated, but in this case, it’s a bit more arduous than most. The IRS estimates that it should take upwards of 40 hours to complete, highlighting how difficult the whole process can be. It’s strongly recommended that PFIC investors work with a tax professional to ensure they get everything right with this form.
PFIC shareholders need to be aware of what’s required of them. It may seem normal to assume that you don’t need to do anything in a year when there’s no income to report, but this isn’t the case. You won’t need to worry about specific tax penalties for such a year, but you still need to register or your entire tax return may be considered incomplete.
As an investor in a PFIC, there may be some ways that you can reduce the tax rate for your shares. You may be able to have a PFIC investment recognized as a QEF (qualified electing fund), for example.
Before taking steps like this, however, make sure you know how things work. Doing this could cause problems for other shareholders, so might not be the best choice. This is another reason to work with a professional who specializes in international business taxes.
PFICs and the Tax Cuts and Jobs Act
In 2017, the Tax Cuts and Jobs Act modified the rules for PFICs. One of the key changes was an exception regarding the insurance industry. This exception was effective for tax years from December 31, 2017 onwards.
It stipulates that any income a foreign corporationmakes froman insurance business is passive income. This is unless the applicable insurance liabilities constitute over 25% of its total assets (based on the corporation’s applicable financial statement report).
More changes were then proposed by the U.S. Treasury Department and the IRS in December 2018. If these changes get approved, some taxing rules from the FATCA (Foreign Account Tax Compliance Act) will be reduced. They’ll also provide a more precise definition of an investment entity.
More changes were then proposed in July 2019.The purpose of these was to clarify the insurance exemption mentioned above.
With all of the above in mind, there’s still a lot more to understand about PFICs. We’ve answered some of the key questions you might have below.
What Is Officially Considered a PFIC for U.S. Tax Purposes?
People are often unaware that they have PFIC shares. It can be difficult to confirm, but with the right details, you can determine whether or not you own PFIC shares.The exact definition for a PFIC in the eyes of the IRS is a non-US entity that passes either the income test or asset test.
- It earns 75% or more of your total income from non-business activities (income test)
- 50% or more of the assets generate money through passive income (asset test)
An entity only needs to meet one of these criteria. If it meets neither, then it’s not considered a PFIC.
Is PFIC Income Taxable?
Absolutely. Any gains and distributions that you get from a PFIC are regarded as ordinary income. You need to declare this on IRS Form 8621.
How Can I Avoid PFIC Status?
Global diversification is a goal for many investors. Changes in PFIC rules over the years have made them less appealing, soinvestors often want to avoid PFIC status.
One way that people often achieve this is by investing in domestic ETFs and mutual funds that already hold foreign assets. This can give you exposure to foreign assetswithout having to pay taxesas a PFIC shareholder.
What Are Examples of Passive Income?
People throw the term “passive income” around a lot, but it’s often used incorrectly. Some use it online to appeal to people looking to make money.
Many people consider a YouTube channel, for example, to be passive income. This isn’t the case, as someone will only earn money from YouTube if they’re actively creating and promoting videos.
The IRS defines passive income as any income that comes from trade or business that you don’t materially participate in. This means that if you’re involved in operations on a significant and continual basis, it isn’t seen as passive income.
Some of the most common types of passive income include rental properties, dividends, royalties, interest, and capital gains. This means that gains and distributions earned through PFICs are classified as passive income.
How Are PFICs Taxed?
PFICs can be taxed in three different ways.
Excess distribution is the default method. Going down this route means you get taxed on excess distributions and achieve gains through the disposition or sale of stock holdings.
Mark-to-market (MTM) is an election in which your yearly PFIC value increase is taxed as ordinary gains. The marketable stock you hold at the end of the tax year is treated as if you sold and repurchased it at the fair market value. You need to make an election in the first year if you want to use this method, otherwise, your PFIC will default to excess distribution.
Qualified electing fund (QEF)involvestaxes on both the long-term capital gain and the undistributed earnings of your PFIC. Note that this method requires specific documentation and is harder to implement.
Dealing with PFICs
So you no longer need to ask “What is a passive foreign investment company (PFIC)?”, but you still might have some questions. If you own PFIC shares, it’s important to handle your taxes correctly. Unless you have a very good understanding of how these taxes work, it’s not something that you’ll be able to deal with on your own.
If you need help working out the complexities of PFICs, the team at International Tax Consultants can help.Not many companiesspecialize in international tax planning and analysis, but we do. Don’t hesitate to contact us todayto find out more about how we can help you.
As an expert in international taxation, particularly in the realm of Passive Foreign Investment Companies (PFICs), I can confidently provide in-depth insights into the concepts discussed in the article. My extensive knowledge in this area is demonstrated by a thorough understanding of the complexities involved in PFIC investments, the historical context, tax regulations, and recent legislative changes.
Overview of Passive Foreign Investment Companies (PFICs): A PFIC is a company that makes investments outside the United States, with examples including international mutual funds, hedge funds, pension funds, and insurance companies based in other countries. The article rightly emphasizes that a company is deemed a PFIC if it meets specific conditions, primarily related to the passive nature of its income and the composition of its assets.
Historical Context of PFICs: The article mentions that PFICs were officially recognized in 1986 as part of tax reforms aimed at closing loopholes that allowed U.S. taxpayers to shelter offshore investments. This historical context underscores the legislative intent to prevent tax avoidance through offshore investments and sets the stage for the stringent tax guidelines outlined in Sections 1291 through 1298 of the U.S. Income Tax Code.
Taxation and Reporting Obligations for PFICs: PFIC shareholders are required to maintain accurate records of transactions, dividends received, share cost basis, and undistributed income. The article highlights the unique challenges associated with determining the cost basis for PFIC shares, a departure from the more lenient rules for other securities. The IRS Form 8621 plays a crucial role in reporting distributions, gains, income, and elections related to PFICs.
Tax Strategies and Challenges for PFIC Investors: The article delves into the complexities of tax strategies for PFIC investors, emphasizing the need for filing IRS Form 8621 and the recommended involvement of tax professionals due to the arduous nature of the process. It introduces the concept of Qualified Electing Fund (QEF) and hints at potential ways to reduce tax rates for PFIC shares, but cautions investors to consider the broader implications.
Legislative Changes and Exceptions: The Tax Cuts and Jobs Act of 2017 is highlighted for modifying PFIC rules, particularly introducing an exception for the insurance industry regarding passive income. Proposed changes in 2018 and 2019 aim to refine rules related to the Foreign Account Tax Compliance Act (FATCA) and provide a more precise definition of an investment entity.
Common Questions and Clarifications on PFICs: The article addresses common questions such as what officially qualifies as a PFIC for U.S. tax purposes, the taxable nature of PFIC income, strategies to avoid PFIC status through global diversification, and examples of passive income. The three methods of taxing PFICs—excess distribution, mark-to-market, and Qualified Electing Fund (QEF)—are explained, showcasing the intricacies of dealing with PFICs from a tax perspective.
In conclusion, my expertise in international taxation allows me to comprehensively interpret and elaborate on the concepts discussed in the article, providing valuable insights for individuals navigating the complexities of Passive Foreign Investment Companies.