The PFIC Investment Rule Nightmare

While many portions of the U.S. tax code possess confusing and sometimes harsh rulings, the PFIC investment rules for Passive Foreign Investment Companies (PFIC) is almost unmatched in its 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 the small foreign investment they had made in a non-US mutual fund is now subjecting them to all the significant filing requirements and tax obligations that apply to a PFIC. While it is beyond the scope of this article to cover all the numerous details related to PFIC reporting requirements, our hope is to provide guidance and insight into the world of PFICs so that they can be avoided whenever possible.

What Is A PFIC? The PFIC Test

A foreign corporation is classified as a PFIC (passive foreign investment 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 (interest, dividends, capital gains, etc.), or the
  • 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, pension funds, partnerships and other pooled investment vehicles (such as many foreign REITs) that have at least one U.S. shareholder. Finally, a foreign holding company that possesses passive investments (like rental real estate or government bonds) would be subject to PFIC regulations if the company is set up as a corporation.

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

PFICs are reported on Form 8621. The Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, must be filed with the taxpayer’s federal income tax return every year in which the taxpayer recognizes certain gains or distribution, or makes a taxation method “election”. Adding to the complexity and volume of paperwork is that a separate Form 8621 must be filed for each PFIC (i.e. each separate mutual fund).

Why PFIC Taxation?

The PFIC tax regime was created via the Tax Reform Act of 1986 with the intent to level the playing field for U.S. based investment funds (i.e. mutual funds). Prior to the legislation of 1986, U.S.-based mutual funds were forced to pass-through all investment income earned by the fund to its investors (resulting in taxable income).

In contrast, foreign mutual funds were able to shelter the aforementioned taxable income as long as it was not distributed to its U.S. investors. After the passage of the Tax Reform Act of 1986, the main advantage of foreign mutual funds was effectively nullified by a tax regime that made the practice of delaying the distribution of income prohibitively expensive for most investors. To employ this punitive regime, the IRS requires shareholders of PFICs to effectively report undistributed earnings via choosing to be taxed through one of three possible methods- Section 1291 fund, Qualified Election Fund, and Mark to Market election.

The strict PFIC tax guidelines are set up to discourage ownership of PFICs by U.S. investors. An option that investors have is to seek qualification of a PFIC investment as a qualified electing fund (QEF). This may reduce the PFIC tax rate on certain transactions but also forces the investor to pay taxes even on income earned by the foreign company that is not distributed to shareholders.

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

Section 1291 Fund

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 will be taxed at the highest marginal rate for each particular year an “excess” occurred and will incur underpayment interest expenses on those unpaid taxes. The excess distribution is determined on a per share basis and is allocated to each day in the shareholder’s holding period of the stock.

In contrast, the current year “excess distributions” are added to the “Other income” line of one’s personal tax return. For the purposes of 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 3 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 that are taken (in either of the two aforementioned forms) must be allocated ratably over every year since the most recent excess distribution was taken (if any). Furthermore, all dividends are still required to be reported 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 effectively results in the PFIC being treated like a US based mutual fund in that the ordinary and capital gains income of the PFIC separately flow through to the shareholder according to percentage of ownership. However, a PFIC annual information statement must be issued to all shareholders.

The election should be made by the shareholder’s due date for filing taxes for the year for which the election applies and it will remain active until revocation.

When a PFIC is treated as a QEF, the income or gains will be included in income and increase the PFIC stock basis, with the income treated as ordinary income and the capital gain treated as long-term capital gain. Distribution of income that is currently or was previously recognized will be excluded from income but will reduce the PFIC stock basis; however, any excess distributions will be treated as 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 reported as ordinary income whereas losses are reported on Schedule D.

To choose this method, the PFIC generally must be traded on a major international stock exchange and can only apply to the current and future tax years. Also, this election is independent of prior PFIC elections (i.e. QEF or Sect 1291 election).

As you can see, the PFIC rules are extremely complex and vary with individual circumstances. Before proceeding, it is best to consult with your tax professional.

Get Expert U.S. Tax Preparation And PFIC IRS Form 8621 Preparation Wherever You Live

Tax Samaritan is a team of Enrolled Agents with over 25 years of experience focusing on the taxation of US taxpayers living abroad. Our PFIC services include PFIC Form 8621 preparation for your PFIC reporting requirements. We maintain this tax blog where all articles are written by Enrolled Agents. Our main objective is to educate Americans abroad on their tax responsibilities, so that they can stay in compliance.