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.

RELATED TERMS
  1. Tax Fairness

    Tax fairness is a tax system that aims to create a system of ...
  2. Income Tax

    A tax that governments impose on financial income generated by ...
  3. Tax Return

    A tax return is a form(s) filed with a taxing authority which ...
  4. Bilateral Tax Agreement

    An arrangement between two jurisdictions that codifies tax laws ...
  5. Vertical Equity

    Vertical equity is a method of collecting income tax in which ...
  6. Effective Tax Rate

    The effective tax rate is the average rate at which an individual ...
Related Articles
  1. Investing

    Investing While Living Abroad as an Expatriate

    The Foreign Account Tax Compliance Act has made it harder for expatriates to invest while overseas.
  2. Taxes

    Which Countries Have the Highest Taxes on High Incomes?

    These countries charge the highest taxes on high incomes.
  3. Managing Wealth

    What Determines Your Cost Basis?

    Understanding the cost basis is critical for tracking the gains or losses of an investment, and what the tax consequences on it are.
  4. Investing

    Understanding Taxes on Mutual Funds Dividends

    Learn about the basics of mutual fund dividend taxation, including how and why mutual funds pay dividends and when different tax rates apply to dividend income.
  5. Insights

    How Fortune 500 Companies Avoid Paying Income Tax

    President Donald Trump is not alone in not paying taxes.
  6. Investing

    How Mutual Funds Are Taxed in the U.S.

    A look at how mutual funds are taxed and how investors can be more tax efficient.
  7. Taxes

    Taxes in California for Small Business: The Basics

    Understand the tax implications of running a small business in California, and learn which state taxes apply based on business type.
  8. Taxes

    How the GOP Tax Bill Affects You

    Here's how the new tax bill changes the taxes you file in 2018.
  9. Taxes

    5 Tax-Efficient Portfolio Tips for High Income Earners

    High income earners can use these tips to make their portfolio more tax-efficient.
  10. Investing

    U.S. Expats and Regular Savings Plans

    Regular savings plans are one of the few investment options for many U.S. expats.
Hot Definitions
  1. Inflation

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  2. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  3. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  4. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  5. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  6. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
Trading Center