PFIC 101: Reporting PFIC Tax Obligations for Foreign Stockholders

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When U.S. taxpayers own stock in foreign mutual funds and other investment companies, they may know the income from those assets need to be reported to the IRS. They may even know they can be taxed on that foreign income. But for many U.S. shareholders, it can be hard to know how to do that, or what PFIC tax obligations to expect.

This is the second post in a blog series to U.S. taxpayers with stock interest in foreign companies understand their reporting and tax obligations. The last post covered the definitions of Passive Foreign Investment Companies (PFIC) and related issues. Today’s post will cover your reporting and PFIC tax obligations. Future issues will explain how to tell if you have PFIC stock interests, and what you can do to avoid PFIC excess distribution interest penalties.

IRS Reporting Obligations for Foreign Securities and Stockholders

U.S. taxpayers (including resident aliens and U.S. citizens living overseas) are required to disclose foreign assets to the IRS. These disclosures start with including income from foreign sources on Schedule B of the taxpayer’s annual tax returns. Assets held in foreign banks and financial institutions must also be reported in Form 8938, the Statement of Specified Foreign Financial Assets. They also trigger FBAR requirements to file annual FinCEN 114 forms under the Bank Secrecy Act.

When those foreign assets take the form of securities, stocks, or stock options, there are additional filing requirements:

  • Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or a Qualified Electing Fund
  • Form 5471, Information Return with Respect to a Foreign Corporation.

Very few U.S. taxpayers will have to file both forms. If a company qualifies as a Passive Foreign Investment Company (PFIC) or a Qualified Electing Fund (QEF), then Form 8621 applies, and there are PFIC tax obligations. For all other foreign corporate interests, Form 5471 applies, but only for informational purposes.

There are some cases where both forms are required. If a U.S. taxpayer has foreign corporate interests, he or she should work with a tax preparer and attorney who understands the PFIC filing requirements and makes certain the proper forms are filed.

Qualified Electing Fund Options for PFICs

PFICs fall into one of 4 categories, depending on the elections made by a PFIC or a US shareholder in that foreign company:

  • Pedigreed Qualified Electing Fund, which applies when the company had made the necessary election from either the day the company became a PFIC or the day the shareholder obtained shares in the company.
  • Unpedigreed Qualified Electing Fund, which applies when the company is now, but has not always been a QEF while the shareholder owned shares in the company.
  • Non-Qualified PFIC Funds, which applies when the company does not make the necessary election
  • Marked-to-Market Funds, which applies when the company designates funds for sale on a publicly stock exchange or similar recognized market.

How these elections are made will be covered in a later post. The categories bring with them different tax obligations.

Tax Obligations for Qualified Electing Funds

QEFs have the best tax consequences of the PFICs. They avoid any penalties or taxes that otherwise attach to passive income financial companies. Income from dividends or disposal of QEF shares are reported as ordinary income. A QEF’s shareholders are also required to report their pro-rata shares of any net long-term capital gains by the company.

Pedigreed QEF funds ignore the rule that “once PFIC, always PFIC”. The shareholder is entitled to this favorable tax treatment for all years he or she owns shares. Unpedigreed QEF funds only get that treatment for the years the election was made.

PFIC Tax Obligations for Non-Qualified Funds

If a PFIC or shareholder has not made a QEF election, and does not qualify as a Controlled Foreign Company (CFC), the tax consequences are more complicated, and more costly. Ordinary earnings are treated the same as QEF shares. But excess distributions – income over 125% of the average distribution over the last 3 years – incur additional penalty interest. The calculation of this PFIC tax obligation spreads the distribution over the holding period, taxes it at the highest tax rate for the year, and incurs interest from that point forward. These excess distributions are calculated regardless of earnings or profits made by the company.

There are a variety of events that will result in deemed or constructive distributions. These corporate transactions can cause significant tax consequences without immediate gain. Instead, they will increase a shareholder’s basis in the PFIC stock until an actual distribution is issued. When that happens, the shareholder will not be taxed twice.

Determining when a PFIC excess distribution occurs and the tax consequences of that event takes careful accounting and a clear understanding of the Tax Reporting Act. U.S. taxpayers with foreign stock interests should maintain a close relationship with their accountants, and with a tax attorney familiar with the PFIC reporting requirements and process.

Tax Obligations for Marked-to-Market Funds

Some PFICs and other foreign companies make their money by buying and selling the stock of other companies. For the shareholders of these companies, the PFIC tax consequences could be expensive, even cost prohibitive. So the IRS allows for a PFIC or shareholder to mark certain shares for market at the end of the year – for loss or gain.

A securities dealer is required to mark all its inventory held at year end. A PFIC can also mark its own shares for market, as long as they are marketable. These shares are taken as taxable gain (or loss) in the first year of the election, even if it takes longer to make the sale. All gains are taxed, but losses are only allowable to the extent the shareholder had an equivalent amount of gains in the previous tax year. Tracking the elections, gains, and losses connected to a marked-to-market election can be difficult and time-consuming. Shareholders with interests in these kinds of companies need to keep especially meticulous books and employ well-qualified tax professionals.

Keeping track of taxable events and constructive distributions can be difficult, particularly in the case of foreign companies. Calculating a U.S. taxpayer’s filing requirements and PFIC tax obligations for a PFIC company can be complicated – even overwhelming. If you own international stocks, you will need the help of an accountant and tax attorney experienced in foreign filing requirements to ensure you meet your IRS obligations.

Attorney Joseph R. Viola is a tax attorney in Philadelphia, Pennsylvania with over 30 years experience. If you have questions about your potential PFIC tax obligations, contact Joe Viola to schedule a consultation.