What Is a Passive Foreign Investment Com🥃pany (PFIC)?

A passive foreign investment company (PFIC) is a corporation that's located abroad and exhibits one of two conditions based on either income or assets. At least 75% of its gross income must be passive, deriving from investments or other sources that aren't related to regular business operations. This is the income test. Alternatively, at least 50% of its assets must be investments that produce income in the form of earned interest, dividends, or capital gains. This is the asset test.

How 📖a Passive Foreign Investment Company (PFIC) Works

PFICs first became recognized through tax reforms that were passed in 1986. The changes were designed to close a tax loophole that some U.S. taxpayers were using to shelter offshore investments 🔴from taxation. Theℱ instituted reforms not only sought to close this tax avoidance loophole and subject such investments to U.S. taxation but also to tax the investments at high rates to discourage taxpayers from following this practice.

Typical examples of PFICs include foreign-based mutual funds and startups that exist within the scope of the PFIC definition. Foreign mutual funds are typically considered to be PFICs if they're foreign corporations that generate more than 75% of their income from passive sources such as capital gains and dividends.

Investments designated as PFICs are subject to strict and extremely complicated tax guidelines by the Internal Revenue Service set out in Sections 1291 through 1298 of the U.S. income tax code. The PFIC itself as well as its shareholders are required to maintain✅ accurate records of all transactionsܫ related to the PFIC such as share cost basis, any dividends received, and undistributed income that the PFIC may earn.

The guidelines concerning cost basis provide an example of the strict tax treatment applied to shares in a PFIC. The IRS allows anyone who inherits shares of virtually any other marketable security or other asset to step up the cost basis for the shares to the fair market value at the time of the inheritance. This step-up in cost basis isn't typically allowed in the case of shares in a PFIC, however.

PFICs and Tax Strategies

U.S. investors who own shares of a PFIC must file with the IRS. This form is used to report actual distributions and gains along with income and increases in QEF elections. Tax form 8621 is a lengthy and complicated form that the IRS estimates can take about 49 hours to fill out in total. PFIC investors are general▨ly advised to have a tax professional handle the completion of the form.

Investors who don't have any applicable income to report don't have to worry about specific tax penalties but failure to register may render a whole tax return incomplete.

Investors in PFICs have some options to reduce the tax rate on the shares. One is to try to have a PFIC investment recognized as a qualified electing fund (QEF). Doing so may cause other tax problems for shareholders, however.

PFICs and the Tax Cuts and Jobs Act

PFIC rules were modifi♌ed in 2017 by the Tax Cuts and Job𒆙s Act (TCJA).

These changes included an exception relating to the insurance industry. The PFIC insurance exception provides that a foreign corporation’s income that's attributable to an insurance business won't be considered passive income in tax years beginning after Dec. 31, 2017. An exception exists, however, if the applicable insurance liabilities constitute more than 25% of its total assets as reported on the corporation’s financial statement.

The IRS and the U.S. Treasury Department proposed changes to the guidelines for taxing PFICs in December 2018. The amended regulation sought to reduce some of the existing rules from the 澳洲幸运5官方开奖结果体彩网:Foreign Account Tax Compl♒iance Act (FATCA) and to more precisely define an investment entity. The updated regulations became effective on Jan. 14, 2021.

The Bottom Line

American investors could avoid taxation by investing in foreign business entities that generated passive income before the mid-198ಌ0s. This tax loophole has since been closed, however, and U.S. investors who hold such foreign assets must declare this income in passive foreign investment companies (PFICs). The income is then taxed as ordinary income.

A foreign firm must have 75% of itsꦅ gross income categorized as passive or more than half its assets held for passive income generation to meet PFIC status.