ELITE ADVISOR BEST PRACTICES
Passive Foreign Investment Company (“PFIC”) Reporting Rules - Part One
Recognizing ownership in a PFIC and expansion of the filing requirements
By Michele Carter and Neel Modha
- PFICs are foreign corporations that predominantly earn passive investment income or own passive investment assets.
- U.S. shareholders who receive distributions from PFICs or gains from sales of PFIC shares are subject to tax at ordinary rates (preferential tax rates are not available) plus an interest charge based on the holding period of the PFIC.
- U.S. owners of a PFIC are required to file Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund) annually to report their PFIC ownership unless an exception applies—even when no income is earned from the PFIC.
Beginning in tax year 2013, the IRS substantially expanded the PFIC reporting requirements. The expansion of the PFIC filing requirements is important for taxpayers, tax practitioners and other financial advisors to understand due to the exposure that can result related to the omission of or improper PFIC reporting. Although there is currently no monetary penalty imposed for a failure to file Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund), the statute of limitations for a shareholder’s entire tax return will not begin until Form 8621 is filed properly.
What is a PFIC?
Before the PFIC rules came into law in 1986, U.S. taxpayers who owned foreign mutual funds could defer paying U.S. tax on investment earnings of the foreign funds until the earnings were distributed to the U.S. investor or when the investment was sold. Once sold, the gain amount would be taxed at reduced capital gain rates. In comparison, income earned by a U.S. mutual fund would be taxed in the U.S. annually at the fund level if the income was not distributed or at the U.S. investor level if the income was distributed. Thus, foreign mutual funds offered a tax deferral advantage over U.S. mutual funds.
The PFIC rules enacted in 1986 were an attempt by the IRS to level the playing field between ownership in U.S. versus foreign mutual funds and other passive investment vehicles. A PFIC (Passive Foreign Investment Company) is a U.S.-owned foreign corporation that meets one of the tests below:
- 75 or more percent of its gross income for the year is passive income (e.g., dividends, interest, rents, royalties) or
- 50 or more percent of the value of its assets are assets that produce passive income or are held for the production of passive income.
Types of PFICs and elections available to PFIC shareholders
There are three types of PFICs, and each one is subject to a different tax regimen:
1. A Section 1291 Fund (“PFIC”)—Absent an election, a PFIC will be treated as a Section 1291 Fund. This default PFIC rule allows the owner to avoid paying U.S. tax on earnings of the PFIC until the earnings are distributed to its U.S. owner or when PFIC stock is sold. PFIC distributions (including amounts classified as a return of capital) and gain from the sale of PFIC shares are taxed at ordinary tax rates (20 percent qualified dividend rates and long-term capital gain rates are not available for PFICs). PFIC income is treated as if earned evenly throughout the U.S. owner’s holding period of the PFIC. Income treated as earned in a prior year is subject to tax at the highest ordinary rate in that year. An interest charge is imposed on the income tax amounts attributed to prior years and is computed from each prior year tax return due date in the holding period through the current year tax return due date.
2. Qualified Electing Fund (“QEF”)—A U.S. investor may elect to treat a PFIC as a QEF. This election results in the individual being subject to tax in the year that the QEF earns the income even if there is no distribution received. Thus, there is no tax deferral under the QEF regimen. This election is not always possible because it requires the QEF to issue an annual earnings statement to its shareholders. Losses incurred by a QEF on an annual basis are not recognized. Gain from the sale of shares in a QEF may be taxed at preferential capital gain tax rates. No interest charge is imposed on any QEF income. It is important to make the QEF election in the first year of PFIC ownership.
3. Mark-to-Market (“MTM”)—A U.S. person may make a mark-to-market election for a PFIC whose shares are marketable. This election results in the U.S. person recognizing income annually to the extent that the fair market value in the MTM stock ownership increases. Losses are not recognized. Gain on the sale of an entity with an MTM election is subject to tax at ordinary rates (preferential capital gain rates are not available). The MTM regimen may be favorable over the PFIC/Section 1291 Fund regimen because the income received or gained from the sale is not spread through the holding period of the PFIC and no interest charge is applied.
PFIC Reporting Basics and Expansion
Generally, all U.S. persons must file Form 8621 annually for each PFIC, QEF or MTM owned directly or indirectly, unless an exception applies.
Under the PFIC reporting rules prior to 2013, only U.S. persons who received distributions from a PFIC or sold PFIC stock were required to file Form 8621. For tax years 2014 and beyond, the PFIC reporting requirements were substantially expanded. One of the main changes of the new legislation was the filing requirement for all U.S. direct or indirect shareholders of a PFIC regardless of whether or not it received a distribution or sold PFIC stock during the year. For those taxpayers not receiving a distribution, or who sold shares of a PFIC, they are required only to fill out Part I (Summary of Annual Information) of Form 8621. This limited information reporting includes number of shares held, date acquired, value and PFIC type. For all other taxpayers required to fill out other portions of Form 8621, they must disclose more information depending on the type of entity owned (PFIC, QEF or MTM) and income earned.
The following U.S. persons are required to file Form 8621 unless an exception applies:
- U.S. direct shareholder of a PFIC regardless of whether he or she received a distribution or had a sale of PFIC stock during the year.
- U.S. direct or indirect shareholder of a PFIC that is treated as a QEF or MTM during the year.
- U.S. direct or indirect shareholder making an election to treat the foreign entity as a QEF or MTM for the first time or making any other PFIC elections in Part II of Form 8621.
- U.S. indirect shareholder of a PFIC whose ownership is through a foreign entity (i.e., U.S. person owns a foreign entity and the foreign entity owns the PFIC). The first U.S. person in the chain of ownership of a PFIC is generally required to report.
- U.S. indirect PFIC shareholder through one or more U.S. entities if the indirect shareholder:
- receives a distribution from the PFIC or had a sale of PFIC stock,
- has income from a QEF or
- has income from an MTM.
The IRS has substantially expanded the reporting rules for PFICs since 2013. In Part 2 of this article, we’ll look closer at PFIC reporting exceptions.