PFIC 101: What is a Passive Foreign Investment Company?
When U.S. taxpayers own or have interest in foreign assets overseas, it can raise reporting and tax consequences they don’t expect. FBARs and foreign asset reporting requirements can leave taxpayers worrying about what other legal obligations they might have without knowing it. When those interests are in a Passive Foreign Investment Company (PFIC) or overseas mutual fund, the issue gets even murkier.
This blog series helps U.S. taxpayers who own stock interest in foreign companies understand their reporting and tax obligations. Today’s post will cover the definitions of Passive Foreign Investment Companies (PFIC) and related issues. Future issues will explain your reporting and tax obligations, how to tell if you have PFIC stock interests, and what you can do to avoid PFIC excess distribution interest penalties.
Tax Reform Act Targets Passive Foreign Investment Companies
The federal government has been working on ways to track and tax the foreign assets of U.S. taxpayers for decades. The Tax Reform Act of 1986 created additional reporting and tax implications for the shareholders of Passive Foreign Investment Companies (PFICs). Originally, this law was supposed to remove advantages for shareholders investing in foreign mutual funds over U.S.-based funds. However, over time, the extremely complex laws related to PFICs have encompassed a variety of overseas business interests.
What is a PFIC?
In general terms, the Internal Revenue Code defines a PFIC as a foreign corporation which has either:
- At least 75% of its gross income is passive income
- At least 50% of its total assets are passive assets – assets that don’t produce business income
It sounds like simple accounting, but determining passive income for a foreign company operating overseas can be challenging. It can take careful digging into a company’s accounting to identify passive income and passive assets, and determine whether a company qualifies as a Passive Foreign Investment Company.
What is Passive Income?
To determine if your company qualifies as a PFIC, you will need to distinguish active and passive income generated by the business. Passive income includes:
- Foreign currency gains
- Disposition (sale or transfer) of any of these assets
- Notional principal contracts
- Some rents
Rent is considered passive unless it comes from a related person (such as an officer or shareholder) or is a part of the active conduct of the business including rent from:
- Leasing property produced by the company
- Real property managed or operated by the company
- Personal property leased when it would otherwise be idle
- Adjunct to the foreign company’s marketing business
Unlike many other parts of the IRC, there is no “facts and circumstances” test. If a rent payment doesn’t technically fall into one of these four categories, it will be considered passive. This can make it especially difficult to determine whether real property management companies qualify as passive foreign investment companies, and requires careful analysis of corporate structures and ownership interests.
Passive Assets Test
A company is also considered a PFIC if 50% of its assets produce or are held to produce passive income. The difficulty here comes in setting the values of company assets. Generally, it is based on the Fair Market Value of all assets calculated at the end of each quarter and averaged over the year. However, a PFIC may elect to use the book value of their assets and CFCs use adjusted bases for their U.S. shareholders (more on this later). Once the assets’ values are set, they must be classified as active or passive assets:
- Depreciable property used in the business is non-passive
- Trade receivables are generally non-passive
- Working capital (cash and cash alternatives) is passive
- Stock and securities in the corporations own account are generally passive
- Stock and securities held for sale by dealers are non-passive
- Raw land may be passive or non-passive depending on if it is intended for use (current or future) in the business
To make things even more complicated, when a parent company owns at least 25% of a subsidiary, all the subsidiary’s assets and income must be included in the computations in proportion to the parent company’s ownership interests. This can create a chain of business valuations passing up the line of ownership. Because this necessarily involves overseas businesses, it can take significant time and expense to make a PFIC determination.
Once a PFIC, Always a PFIC
The application of the Tax Reform Act applies to any stock assets ever owned by a PFIC. As will be explained in a later post, PFICs come with significant, ongoing tax consequences. The IRS also has a rule: “once a PFIC, always a PFIC”. This means that even after a company has transitioned below the passive income threshold or PFIC stocks have been distributed, they will still carry the “PFIC taint”.
This makes understanding the reporting and tax obligations for U.S. taxpayers even more challenging. Not only do you have to determine if your foreign business interests qualify as a PFIC today, you also need to know if they have ever hit the passive income or passive assets threshold, and if the PFIC taint has been purged (more on that later in this blog series).
Exceptions to PFIC Qualifications
There are also several exceptions that further complicate a taxpayer’s reporting requirements. A company is not considered a PFIC if it is a:
- Controlled foreign corporation
- Start-up in its first year with gross income and does not become a PFIC over the next two years
- Historic passive investment company that distributed 90% of its income to shareholders before 1963
The Controlled Foreign Corporation exception (CFC) is especially challenging because it excludes stock interests owned by U.S. shareholders who own at least 10% of the voting stock of the company. Internal changes in ownership or voting privileges can turn a foreign entity from a CFC into a PFIC for a particular shareholder, causing significant tax consequences.
Getting to the bottom of whether a U.S. taxpayer owns a passive foreign income company is exceedingly complicated. There are ways to avoid the tax consequences for a PFIC (discussed in a future post), but before you can make those elections, you need to know they apply to you and your business. If you have foreign investment assets, contact a tax attorney with foreign tax experience to make sure you understand and meet the tax law’s requirements.
Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you have questions about the PFICs and whether you qualify, contact Joe Viola to schedule a consultation.