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 amendments limited the application in the case of U.S. Shareholders of controlled foreign corporation

Controlled Foreign Corporation

Controlled foreign corporation rules are features of an income tax system designed to limit artificial deferral of tax by using offshore low taxed entities. The rules are needed only with respect to income of entities that is not currently taxed to the owners of the entity. The basic mechanism and...

s.

PFIC Defined

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

Foreign personal holding company

Foreign personal holding company income is defined for U.S. controlled foreign corporation rules and, with modifications, for U.S. foreign tax credit rules. It consists of interest, dividends, rents, royalties, gains on property producing FPHCI, and certain other items...

 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

Foreign tax credit

Income tax systems that tax residents on worldwide income generally offer a foreign tax credit to mitigate the potential for double taxation. The credit may also be granted in those systems taxing residents on income that may have been taxed in another jurisdiction...

 with respect to the current and deemed prior year taxes, including the deemed paid credit for 10% corporate shareholders of the PFIC.

QEF Election

Shareholders of corporations are normally subject to U.S. tax only when the income is distributed. Shareholders of a U.S. mutual fund are subject to tax currently on their pro rata share of ordinary income and capital gains of the mutual fund. Each U.S. person owning shares of a PFIC may elect to include in his/her/its income currently his/her/its share of the ordinary income and net capital gains of the PFIC, similarly to shareholders of a mutual fund. Such election is effective for the year in which made and all subsequent years. To the extent such election applies, the tax and interest regime is avoided.

QEF status applies only to the shares of a particular shareholder acquired on a particular date. Such status does not apply to other shareholders or to persons acquiring the particular shares.

QEF status fully avoids the tax and interest regime only if it is effective from the beginning of the shareholder's holding period. If a shareholder elects QEF status for particular shares at a date later than the acquisition date, one of three additional elections may be made to “purge” PFIC status for prior years. The shareholder may make one of two gain recognition elections (deemed sale and mark to market) or, if the shareholder is a corporation, a deemed dividend election. In each case, the gain or deemed dividend recognized under the election is subject to the tax and interest regime.

Mark to Market

A shareholder of a PFIC may also elect each year to recognize gain or loss on the shares as if he/she/it had sold the PFIC shares at fair market value. Such election is available only for shares the market value of which is readily determinable (e.g., regularly traded shares). Shares subject to this election are not subject to the tax and interest regime.

Coordination with CFC Rules

U.S. Shareholders (generally 10% or more owners) of a controlled foreign corporation

Controlled Foreign Corporation

Controlled foreign corporation rules are features of an income tax system designed to limit artificial deferral of tax by using offshore low taxed entities. The rules are needed only with respect to income of entities that is not currently taxed to the owners of the entity. The basic mechanism and...

(CFC) are not subject to the tax and interest regime with respect to any share which was not a share of a PFIC at any time before 1997. Such shareholders are, instead, subject to the CFC rules.

Reporting & Making Elections

Each U.S. person owning shares of a PFIC is required to file IRS Form 8621 with his/her/its tax return. Such form is used to report actual distributions and gain, as well as income and gains under a QEF election. Such form is also used to make the QEF and purging elections described above. Failure to file such form in a year in which no income is properly reported does not carry specific penalties, but may render the return incomplete and potentially not subject to tolling of the statute of limitations.

Additional reading

• Kuntz & Peroni, U.S. International Taxation, ISBN 978-0-7913-1136-3
• Moore, Outslay & others, U. S. Tax Aspects of Doing Business Abroad, ISBN 978-0-87051-620-7