What is a 'Passive Foreign Investment Company - PFIC'
A passive foreign investment company (PFIC) is a foreign-based corporation that exhibits either one of two conditions. The first condition, based on income, is that at least 75% of the corporation's gross income is "passive," income that is derived from investments rather than from the company's regular business operations. The second condition that determines a company as a PFIC, based on assets, is that at least 50% of the company's assets are investments that produce income in the form of earned interest, dividends or capital gains.
BREAKING DOWN 'Passive Foreign Investment Company - PFIC'PFICs, as defined by the Internal Revenue Service (IRS) tax code, include foreign-based mutual funds, partnerships and other pooled investment vehicles having at least one U.S. shareholder. The majority of investors in PFICs must pay the higher personal income tax rate on all distributions and capital gains resulting from increases in share values, regardless of whether the lower capital gains tax rate would ordinarily apply to such income if it was derived from investments in a U.S.-based corporation.
The History of PFICs
PFICs became recognized through tax reforms in 1986, which were designed to close a tax loophole that some U.S. taxpayers were using to shelter offshore investments from U.S. taxation. The instituted tax reforms not only sought to close the loophole and bring such investments under U.S. taxation, but also to tax such investments at high rates, so as to discourage U.S. taxpayers from making them.
PFICs and the IRS
Investments designated as PFICs are subject to strict and extremely complicated tax guidelines by the Internal Revenue Service, delineated in Sections 1291 through 1297 of the U.S. income tax code. The PFIC itself, as well as shareholders, are required to maintain accurate records of all transactions related to the PFIC, such as share cost basis, any dividends received, and undistributed income that the PFIC may earn.
An example of the strict tax treatment applied to shares in a PFIC is provided by the guidelines concerning cost basis. With virtually any other marketable security or other asset, a person who inherits shares is allowed by the IRS to step up the cost basis for the shares to the fair market value at the time of the inheritance. However, the step up in cost basis is not typically allowed in the case of shares in a PFIC. Additionally, determining the acceptable cost basis for shares in a PFIC is often a challenging and confusing process.
There are some options for an investor in a PFIC that can reduce the tax rate on his shares, such as seeking to have a PFIC investment recognized as a qualified electing fund (QEF). However, doing so may cause other tax problems for shareholders.
Form 8621, the tax form that PFIC investors are required to fill out, is a lengthy, complicated form that the IRS itself estimates may take more than 40 hours to fill out. For this reason alone, PFIC investors are generally advised to have a tax professional complete the form for them.