The PFIC Investment Rule Nightmare

Many portions of the U.S. tax code possess confusing and sometimes harsh rulings. The PFIC rules for Passive Foreign Investment Companies (PFIC) are incomparable in their complexity and almost draconian features.

Countless times, Americans overseas have come to us to prepare what they thought would be straightforward tax returns. Only to later learn that they had made in a non-US mutual fund. And subjecting themselves to all the onerous significant filing requirements and tax obligations that apply to owning a PFIC.

It is beyond this article’s scope to cover all the numerous details of the PFIC reporting requirements. Nevertheless, we hope to provide guidance and insight into the world of PFICs so you can avoid them whenever possible.

What Is A PFIC? The PFIC Test

A PFIC is a passive foreign investment company.

It is a “passive” company if it meets either of the following tests that apply to passive income:

  • PFIC Income Test: 75% or more of the corporation’s gross income is passive income. Such as interest, dividends, capital gains, etc.
  • PFIC Asset Test: 50% or more of the corporation’s total assets are passive assets. Passive assets are investments that produce interest, dividends and/or capital gains.

PFICs often include foreign-based mutual funds, money market accounts, and pension funds. They can also include partnerships and other pooled investment vehicles, such as many foreign REITs.

Finally, a foreign holding company that possesses passive investments (like rental real estate or government bonds) would be subject to PFIC regulations if it is set up as a corporation.

PFICs are subject to complicated and strict tax guidelines. The complex rules covering these investments’ treatment are in Sections 1291 through 1297 of the income tax code. Both the PFIC and the shareholder must keep accurate records of all transactions. This includes share basis, dividends, and any undistributed income earned by the company.

PFICs are subject to reporting on Form 8621. Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, is an attachment to the taxpayer’s federal income tax return. This is the case for every year in which the taxpayer recognizes gains or distribution. Or makes a taxation method “election.”

Adding to the complexity and volume of paperwork is that a separate Form 8621 requirement applies for each PFIC. For example, each separate mutual fund.

Why PFIC Taxation?

The PFIC tax regime came about via the Tax Reform Act of 1986. The intent was to level the playing field for United States investment funds.

Before the legislation of 1986, U.S.-based mutual funds had to pass-through all investment income from the fund to its investors. The result of this was taxable income.

In contrast, foreign mutual funds were able to shelter the taxable income. So long as there was no distribution to its U.S. investors.

After the passage of the Tax Reform Act of 1986, the U.S. effectively nullified foreign mutual funds’ main advantage. The Act made the practice of delaying the distribution of income prohibitively expensive for most investors.

Foreign Mutual Fund Examples

As a result, almost all foreign mutual funds and other investment funds are PFICs, such as typically the following:

  • Exchange-Traded Funds (ETFs)
  • Pooled Funds
  • Real Estate Investment Trusts (REITs)
  • SICAV investments
  • Unit-Linked Insurance Policy such as with Friends Life (Akiva), Singapore AIA, India LIC or Prudential, AIG, HSBC, Alliance
  • Superannuation or Provident Funds (in specific situations)

To enforce this punitive regime, the IRS requires shareholders of PFICs to effectively report undistributed earnings via choosing to be subject to taxation through one of three possible methods:

  • Section 1291 fund
  • Qualified Election Fund
  • Mark to Market election

The strict PFIC tax guidelines exist to discourage ownership of PFICs by U.S. investors. While there may be tax delay until distribution (payment of dividends) or disposition (sale) of the funds, the tax liability will grow exponentially during the holding period.

An option that investors have is to seek the qualification of a PFIC investment as a qualified electing fund (QEF). This may reduce the PFIC tax rate on certain transactions. It also forces the investor to pay taxes even on income from the foreign company in which there has been no distribution to shareholders.

Most investors in PFICs must pay income tax on all distributions and appreciated share values. This is regardless of whether capital gains tax rates would normally apply.

Section 1291 Fund And Excess Distributions

The Section 1291 Fund election (Excess Distribution) is the default taxation method unless the taxpayer chooses either of the two alternatives.

Under the Sect 1291 regime, all “excess distributions” for prior years are subject to taxation at the highest marginal rate for each particular year an “excess” occurred and will incur an underpayment interest charge on those unpaid taxes. The excess distribution determination is on a per-share basis. There is an allocation to each day in the shareholder’s holding period of the stock for both tax and interest.

In contrast, the current year “excess distributions” are subject to reporting on the “Other Income” line of one’s tax return. For this election, “excess distributions” are either:

  • The part of the distribution received from a section 1291 fund in the current tax year that is greater than 125% of the average distributions received in respect to such stock by the shareholder during the three preceding tax years (or, if shorter, the portion of the shareholder’s holding period before the current tax year; or
  • Any capital gains that result from the sale of PFIC shares.
  • To add to the complexity, excess distributions result in an allocation of taxes and interest for every year since the most recent excess distribution was taken (if any).
  • Furthermore, all dividends are still subject to reporting on Schedule B of the income tax return, but any capital gains or losses do not get reported on Schedule D.

QEF (Qualifying Election Fund)

A simpler option for shareholders of PFICs is the QEF election.

At first glance, it would appear to be a much better option for most investors since it results in a PFIC classification similar to a US-based mutual fund. According to a percentage of ownership, the ordinary and capital gain income of the PFIC separately flow through to the shareholder.

Yet, there is a rule that the PFIC sends an annual information statement to all shareholders.

An election by the shareholder’s due date for filing taxes is a requirement for the year for which the election applies, and it will remain active until revocation.

When a PFIC is a QEF, the income or gains subject to inclusion in income and increase the PFIC stock basis, with the income treated as ordinary income and the capital gain treated as a long-term capital gain. Distribution of income currently or previously recognized will exclude income and reduce the PFIC stock basis. However, any excess distributions are a capital gain.

Mark-To-Market Election

The final option available to PFIC shareholders is to make a mark-to-market election. This method allows the shareholder to report the annual gain in market value (i.e., unrealized gain) of the PFIC shares as ordinary income on the “other income” line of their tax returns.

“Unrealized losses” are only reportable to the extent that gains have been previously reported. The adjusted basis for PFIC stock must include the gains and losses previously reported as ordinary income. Upon the sale of the PFIC shares, all gains are subject to reporting as ordinary income, whereas losses are subject to reporting on Schedule D.

To choose this method, the PFIC must be available for trading on a major international stock exchange and can only apply to the current and future tax years. This election is also independent of previous PFIC elections (i.e., QEF or Sect 1291 election).