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PFIC Compliance: Introduction | International Tax Lawyer & Attorney

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In the intricate realm of US international tax law, few areas are as challenging and potentially costly as PFIC compliance. Understanding the nuances of Passive Foreign Investment Companies (PFICs) is crucial for US taxpayers with foreign investments. This article provides an introduction to PFIC compliance, outlining key concepts and reporting requirements.

What is PFIC Compliance?

PFIC compliance refers to adhering to the US tax rules and reporting requirements for Passive Foreign Investment Companies. A PFIC is a foreign corporation that meets one of the following tests:

  1. Income Test: 75% or more of its gross income is passive income
  2. Asset Test: 50% or more of its assets generate passive income or are held for the production of passive income

Passive income typically includes dividends, interest, royalties, rental income (unless renting is the active business of the corporation) and capital gains.

The Importance of PFIC Compliance

PFIC compliance is a critical issue for US taxpayers, because the tax consequences of owning PFICs can be severe. The US tax code imposes punitive tax rates and interest charges on certain PFIC distributions and gains, making this area of US tax compliance a high-stakes area of tax law.

Key Aspects of PFIC Compliance

1. Identification: The first step is to identify whether you own any PFICs. This is not an easy process, but, generally speaking, all foreign mutual funds and ETFs are almost automatically PFICs.
2. Annual Reporting: A taxpayer must disclose the ownership and income from PFICs annually on Form 8621 for each PFIC owned. Actually, each block of each PFIC will require a separate Form 8621.
3. Tax Calculations: Depending on the chosen PFIC regime, complex calculations may be necessary to determine the tax owed on PFIC income.
4. Record Keeping: Meticulous record-keeping of all PFIC transactions and values is an absolute must for proper PFIC reporting.

PFIC Compliance Regimes

There are three main tax PFIC reporting regimes (there are other regimes, but we will not deal with them in this article, because these regimes come into effect only in special cases):

1. IRC Section 1291 Fund (Default Method): This is the default PFIC calculation regime which may result in a high tax burden with distributions and gains taxed at the highest ordinary income rate plus an interest charge (called “PFIC interest”).

2. Qualified Electing Fund (QEF): This PFIC regime requires an election and cooperation from the foreign corporation but can result in more favorable tax treatment. Unfortunately, the cooperation from the foreign corporation is going to be the most difficult part.
3. Mark-to-Market (MTM): This is another PFIC regime that requires an election. It is available for marketable PFIC stock only and involves annual recognition of gains or losses, even in situations where a PFIC is not sold.

Common Challenges in PFIC Compliance

US tax reporting concerning PFICs presents several challenges:
1. Identification: Many taxpayers are unaware of the fact that they own PFICs, leading to inadvertent noncompliance. A failure to properly identify PFICs often forms the basis for a subsequence offshore voluntary disclosure.
2. Complexity: PFIC rules are highly complex and often require professional assistance from an international tax law firm, such as Sherayzen Law Office.
3. Information Gathering: Obtaining the necessary information for proper PFIC reporting can be difficult, especially in cases where PFICs have been held for many years.
4. Retroactive Compliance: Addressing past noncompliance can be particularly complex and costly. This point is especially important in a context of an IRS offshore voluntary disclosure, such as Streamlined Domestic Offshore Procedures or Streamlined Foreign Offshore Procedures.

PFIC Compliance Penalties

A failure to properly report PFICs can result in significant penalties:
1. Failure to file Form 8621 can result in the extension of the statute of limitations.
2. Substantial understatement penalties may apply if PFIC income is not properly reported.
3. In severe cases, criminal penalties could be imposed for willful noncompliance.

PFIC Compliance for Specific Situations

Taxpayers should be aware that different scenarios may require unique approaches to PFIC compliance. Here are a few common examples:
1. Inherited PFICs: Special rules apply when PFICs are acquired through inheritance.
2. PFICs Held in Foreign Pensions: The interaction between PFIC rules and foreign pension regulations can be complex.
3. PFICs Owned Through Partnerships: Additional reporting may be required for PFICs owned indirectly through partnerships.

Contact Sherayzen Law Office for Professional Help with PFICs

Navigating the complexities of PFIC compliance can be daunting for any taxpayer. This is why you need to contact Sherayzen Law Office for help. We are a leading firm in PFIC compliance in the United States. Our deep understanding of international tax law and extensive experience in PFIC matters allows us to help ensure your PFIC compliance is accurate and up-to-date.

Whether you’re dealing with PFIC identification, annual reporting, or addressing past noncompliance, Sherayzen Law Office provides tailored solutions to meet your specific needs. Our team of specialists can guide you through the intricacies of PFIC tax regimes, help you choose the most advantageous compliance method and assist with complex calculations and reporting requirements.

We have helped hundreds of US taxpayers around the world to resolve past PFIC noncompliance in the context of an IRS offshore voluntary disclosure option, such Streamlined Domestic Offshore Procedures, Streamlined Foreign Offshore Procedures, Delinquent International Information Return Submission Procedures, et cetera. We can help you!

Contact Us Today to Schedule Your Confidential Consultation!

International Tax Lawyers | Passive Foreign Investment Company

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Congress enacted the Passive Foreign Investment Company provisions (PFIC) as part of the Tax Reform Act of 1986 in order to deter U.S. investors from deferring or avoiding payment of U.S. taxes by investing in offshore entities. The PFIC rules are structured to provide a disincentive for U.S. investors to defer investment income taxes by owning passive investments in foreign companies that do not regularly distribute their earnings. If it is determined that a U.S. investor is a PFIC shareholder, there can be severe tax implications for the taxpayer.

U.S. taxpayers who are shareholders of PFIC are likely to pay a significant additional tax on realized gains from sales of PFIC shares, and on PFIC dividends that meet the definition of “excess distributions” (an “excess distribution” applies to gains or distributions that exceeds 125% of the average distributions for the previous three years, or less if applicable). In both cases, the tax is applied at the taxpayer’s ordinary income tax rate, regardless of whether capital gains rates would typically apply. Further, an interest charge may be imposed, to offset the years of tax deferral in holding the offshore investment. As an additional disincentive, PFIC shares may not receive a stepped-up cost basis at the shareholder’s death.

Definition of a PFIC and Two-Part Test

In general, a foreign corporation that is determined to be neither a “controlled foreign corporation” (CFC) as defined in IRC section 957, nor a “foreign personal holding company” (FPHC) as defined in IRC section 552, will be determined to be a PFIC if it includes at least one U.S. shareholder and meets either one of the two tests found in IRC section 1297. If at least 75% or more of its gross income is passive income (based upon investments as opposed to operating income), or if at least 50% of the average percentage of its assets are investments that produce, or are held for the production of passive income, the foreign corporation will meet the definition of a PFIC. Passive income generally includes interest, dividends, rents, capital gains, and similar items. There is no requirement of ownership of a certain minimum percentage of shares, as there is with CFCs or FPHCs. Thus, if the test is met, PFIC status will apply, even if a shareholder owns a minimal percentage of shares with no ability to influence the business decisions of the company.

The PFIC rules apply to each U.S. person (the precise definition of who constitutes U.S. person is beyond the scope of this article, but it may become an issue in many situations) regarding who a shareholder of a PFIC is. PFIC rules, however, do not apply to foreign shareholders or the foreign corporation itself. PFICs may include different types of entities such as various investment vehicles and foreign-based mutual funds.

Two options are commonly suggested by the U.S. tax lawyers to the shareholders in order to avoid PFIC taxation burden: Qualified Election Fund and Mark-to-Market. Both of these options, however, have their own peculiar characteristics and impose different types of tax obligations on the shareholders.

Qualified Electing Fund

In general, U.S. shareholders who own shares either directly or indirectly in a PFIC may be able to avoid the burdensome standard PFIC taxation provisions by electing to treat the PFIC as a Qualified Electing Fund (QEF) on Form 8621. Shareholders making this annual election are taxed on their pro rata share of the PFIC’s ordinary earnings as ordinary income, and their pro rata share of the net capital gains as long-term capital gain. A shareholder’s basis in the stock of a QEF is increased by the earnings included in gross income and decreased by a distribution from the QEF to the extent of previously taxed amounts. Finally, U.S. shareholders interested in making this election must also be able to obtain the required information from the PFIC.

While treating a PFIC as a QEF may be beneficial in that it allows taxpayers to opt out of the standard PFIC tax and interest rules, it also forces shareholders to pay taxes currently on undistributed income earned by a foreign corporation. Thus, QEF may be of limited use to taxpayers who lack adequate liquidity to pay taxes. Another important point about a QEF is that, due to the complexity of the rules and possible additional tax amounts, if the decision is made to elect QEF treatment of PFIC, it may be advisable to elect a QEF in the first year of holding an offshore investment.

Mark-to-Market

Another option for U.S. shareholders of a PFIC (who do not elect to treat a PFIC as a QEF), is to elect the mark-to-market method. This election is only available if the shares are considered “marketable stock”. Marketable stock is regularly traded stock with an ascertainable value on recognized exchanges as defined in the IRC regulations. If the shareholder elects to mark the stock to market, he will annually report, as ordinary income, the amount equal to any excess of the fair market value (FMV) of the PFIC stock as of the close of the taxable year over the adjusted basis of the shares (i.e. as if the shares had actually been sold at FMV). If the adjusted basis of the PFIC shares exceeds its FMV as of the close of the taxable year, the shareholder may generally deduct an ordinary loss (subject to certain statutory limitations).

Shareholders who directly own shares in a PFIC electing the mark-to-market method may increase their adjusted basis in PFIC shares through income recognized, and decrease the adjusted basis through deductions taken.

Conclusion

The tax issues surrounding PFICs are very complex and should be handled by a tax professional. Sherayzen Law Office can help you analyze your tax situation, determine whether PFIC rules apply, identify the alternatives in light of your whole tax situation, and implement the tax strategy most suited to your business and investment needs.

Contact Sherayzen Law Office to discuss your tax situation with an experienced tax lawyer!