American citizens and resident aliens are all too familiar with the IRS practice of worldwide taxation. For most expats, this simply means having to file an additional tax return each year. But where the rules can get complex and, in many cases counter-intuitive, is where these rules extend their reach into overseas assets owned by US tax persons, whether they live overseas or in the US. It is vital to be aware of these pitfalls, as failure to comply can have expensive consequences.

Most investors will be well versed in the basics of owning shares. A company generates revenue and pays tax. You, as the investor, only see income when the company pays you a dividend, or when you sell your shares in that company. This core principle posed a challenge to the IRS’ ambition of taxing US persons on all of their worldwide income. After all, what was to stop a person from placing assets into a non-US company to generate otherwise taxable income in such a way that would be invisible and therefore non-taxable in the US? Even more problematic, this apparent tax advantage would provide an incentive for US persons to do exactly that, moving assets overseas and out of the US economy.

To resolve this dilemma and place offshore investors on a similar footing to those in the US, Congress enacted the Tax Reform Act of 1986. This legislation introduced the concept of the Passive Foreign Investment Company, or “PFIC”.

What is a PFIC?

The term PFIC describes a type of investment that is subject to a special tax and compliance regime. In order to meet the definition of a PFIC, the investment must meet three criteria: (1) it is an entity formed outside the US, (2) it is an entity taxable as a corporation under US law, and (3) it meets either the income test or the asset test, which are as follows:

• Income test: 75 percent or more of its gross income for the tax year consists of passive income;
• Asset test: 50 percent or more of the average fair market value of its assets consists of assets that produce or can produce passive income.

For the purposes of these two tests, passive income generally includes interest, rents, dividends, royalties and capital gains. Accordingly, common examples of passive assets will be cash (interest), real property (rental income and capital gains), company shares (dividends) and intangible assets (royalties). An important distinction here is that these assets do not need to be actually producing passive income to be considered a passive asset. Cash placed into an interest-free account would still generally be considered to be a passive asset under the IRS interpretation of the rules. 

One must also consider the “look-through” rule, which states that when performing a PFIC analysis on a company, you must also include that company’s proportionate share of any income or assets of 25 percent or more owned subsidiaries. This can be a useful rule as it allows holding companies, which may otherwise only be directly holding passive assets, to include their share of tangible assets from operating company subsidiaries.

It is worth noting that there is some overlap between the PFIC rules and the rules of another compliance regime, the Controlled Foreign Corporation or “CFC”. In cases where an investment meets both definitions, the CFC rules take priority and investors should follow the rules of that regime instead.

As with all things US tax related, a great deal of the interpretation of the rules will depend on the facts and circumstances of each case. A blunt application may capture businesses that do not really fall within the intent of the legislation; for example, businesses that are inherently cash heavy such as start-up companies and consulting businesses. For this reason, there are many nuances and exceptions that may apply. It is important to seek robust US tax advice.

What is the effect of PFIC ownership?

US persons who own shares in a PFIC are subject to a special tax and reporting regime. They will need to file Form 8621 with their tax return for every year in which the PFIC is owned. This form discloses certain information with respect to the filer’s shareholding in the PFIC and allows the filer to elect one of the three following tax classifications:

• 1291 Fund – the default treatment

If the filer does not elect i an alternative classification, they are subject to the default PFIC rules. These rules are designed to be punitive. Under these rules, a US shareholder in a PFIC is subject to additional tax and an interest charge when they either sell their interest in the stock of the company or when they receive an “excess distribution”. 

An excess distribution is any current year distribution regarding a share of stock that exceeds 125 percent of the average amount of distributions regarding the share of stock received during the three preceding years (or, if shorter, the total number of years of the taxpayer’s holding period before the current tax year.)  Gain from the disposition of the stock is also treated as an “excess distribution”.  Distributions that are not “excess distributions” are subject to tax under the normal income tax rules.

The US tax due on an excess distribution is the sum of: 

1. US tax computed using the highest statutory rate of tax for the investors (without regard to other income or expenses the investor may have in those years) on the income attributed to their holding period (other than the current year and other than years before the foreign corporation was a PFIC); plus 
2. Interest computed from the due date of the return (disregarding extensions) for the year of disposition (or year of receipt) imposed on the deferred tax; plus 
3. US tax on the income attributable to the current year and to the years in which the foreign corporation was not a PFIC that preceded the year of disposition (for which no interest is due).

• Qualified Electing Fund

A US person who owns stock of a qualified electing fund “QEF” at any time during the QEF’s tax year will include in gross income their pro rata share of the QEF’s ordinary earnings and net capital gain for the QEF’s tax year.  This election may only be made, however, if the PFIC agrees to make available the information necessary to determine inclusions under the QEF rules and to assure compliance. Consequently, the ability to make the election is subject effectively to a “veto” by the PFIC. 

A shareholder’s pro rata share is the amount that would have been distributed if, on each day of the QEF’s tax year, the QEF had distributed to each shareholder a pro-rata share of that day’s ratable share of ordinary earnings and net capital gain for the year. It is important to note that the carried interest rules under IRC Section 1061 for certain carried interest arrangements apply to gains generated from a PFIC with a QEF election in place thereby requiring a three-year holding period to qualify for long-term capitals gain treatment.

Amounts previously taxed under this election may be distributed by the PFIC tax-free. However, those amounts reduce the basis of the shareholder’s stock. Any inclusion of income under these rules to a US shareholder of a controlled foreign corporation that is also a PFIC is treated as an inclusion of income under the CFC rules for purposes of the subpart F rules pertaining to previously taxed income.

Crucially, in order for this election to be valid, it must be made during the first year in which the US person owned shares in the PFIC.

• Mark-to-Market for Marketable Stock

Finally, a shareholder of a PFIC may elect to be taxed under a “mark-to-market” approach, provided the PFIC stock is marketable. 

Under the election, the shareholder includes in income each year gain on the shares as if they had sold the PFIC shares at fair market value as of the last day of the taxable year. These gains are taxable as ordinary income. Similarly, the shareholder is allowed a deduction for any market loss. However, deductions are allowable under this rule only to the extent of any net mark-to-market gains on the stock included by the shareholder for prior tax years.

The mark-to-market election is available only for PFIC stock that is “marketable.” For this purpose, PFIC stock is considered marketable if it is regularly traded on a national securities exchange that is registered with the Securities and Exchange Commission or on the national market system established under the Securities and Exchange Act of 1934. 

An election to mark to market applies to the tax year for which made and all subsequent tax years, unless the PFIC stock ceases to be marketable or the IRS consents to the revocation of the election.

Indirectly Owned PFICs

US taxpayers also need to be aware of the rules relating to indirect ownership of PFICs, as these could potentially create a compliance obligation that is not immediately obvious.

A US person who owns shares in a PFIC is also considered to indirectly own shares in any PFICs owned by that first PFIC. Thus, if you determine company stock to be PFIC, you must also consider whether that company’s subsidiaries are PFICs, potentially resulting in additional Form 8621 filings.

The usual constructive and indirect stock attribution rules also apply here. If you own more than 50 percent of a company, you could still be deemed to indirectly own any PFIC shares held by that company, regardless of whether that first company is a PFIC. Similarly, PFIC stock owned directly or indirectly by or for a foreign partnership, trust, or estate may be treated as owned proportionately by the partners or beneficiaries.

The PFIC rules are complex and contain a number of nuances for different types of businesses and structures. The ideal solution will depend on the investor’s specific circumstances. What should be clear, with these high rates of taxation and strict timing requirements, is that the price of failing to plan ahead can be severe.

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