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PASSIVE FOREIGN INVESTMENT COMPANY SPECIAL RULES FOR TAXES - Form 8621
For purposes of income tax in the U.S., U.S. persons owning shares of a passive foreign investment company (PFIC) may choose between (i) current taxation on the income of the PFIC or (ii) deferral of such income subject to a deemed tax and interest regime. The provision was enacted as part of the Tax Reform Act of 1986 as a way of placing owners of offshore investment funds on a similar footing to owners of U.S. investment funds (regulated investment companies). The original provisions applied for all foreign corporations meeting either an income or an asset test. However, 1997 amendmentslimited the application in the case of U.S. Shareholders of controlled foreign corporations.
Any foreign (i.e., non-U.S.) corporation meeting either the income test or the asset test is a PFIC with respect to each shareholder when the test is met. PFIC status applies separately for each U.S. person owning shares, and also separately with respect to shares acquired at different times. PFIC status does not, itself, have any impact on the foreign corporation or foreign shareholders.
The income test is met if 75% or more of the foreign corporation's gross income is passive income, defined as foreign personal holding company income with modifications.
The asset test is met if 50% or more of the foreign corporation's average assets (as defined in the IR Code) produce, or could produce passive income, or are assets (such as cash and bare land) that produce no income. The test is applied based on the foreign corporation's adjusted basis, for U.S. tax purposes, of the assets, or at the election of the particular shareholder, fair market values of the assets.
Look-thru of 25% subsidiaries: Interests in 25% or more owned foreign corporations are treated similarly to partnership interests (i.e., looked through) for the income test and the asset test.
Effect of PFIC Status
If a U.S. person receives income from a PFIC or recognizes gain from disposition of shares of a PFIC, such person is subject to a tax and interest regime. A shareholder may elect out of this regime (see QEF below). The regime applies only to any distribution or gain in excess of 125% of the average distributions for the prior three years. This regime is as follows: First, such income or gain (in excess of the 125%) is allocated pro rata to each day of the person's holding period for the particular shares. Next, the amounts allocated to prior years after 1986 are excluded from current year taxable income. Then tax is computed on amounts allocated to each prior year at the maximum rate of tax applicable to the type of taxpayer for such year (prior year tax). Then interest is computed on such prior year tax as if it were an underpayment of tax (interest charge). Finally, current year tax is increased by the aggregate of prior year tax amounts and interest charge amounts.
The interest charges are computed using daily compounding. Thus, the interest charges and prior year tax amounts may exceed the income recognized, if the holding period of the shares is long enough.
Shareholders of a PFIC (including a QEF) are eligible for foreign tax credit with respect to the current and deemed prior year taxes, including the deemed paid credit for 10% corporate shareholders of the PFIC.
Shareholders of a PFIC should consider filing IRS Form 8621 to make certain elections which may reduce their tax burden. Read more about the PFIC rules by downloading the IRS Instructions.