Investors beware! The Passive Foreign Investment Company rules were added by the Tax Reform Act of 1986 in order to close a tax shelter used by U.S. investors to defer their income taxes by investing in foreign mutual funds or other passive foreign corporations. The intent was to level the playing field between domestic investments and foreign investments in companies that are passive in nature. The new rules in regards to these types of investments prevent the deferral of taxes and subject these investments to less preferential tax rates in most cases.
What is a PFIC?
A foreign corporation will fall under the Passive Foreign Investment Company rules if it meets either the Income Test or the Asset Test.
- Income Test
- 75% or more of the corporation’s gross income for its taxable year is passive income (Passive income for these purposes generally includes dividends, interest, royalties, rents, annuities, and gains from the sale or exchange of certain property).
- Asset Test
- At least 50% of the average percentage of assets held by the foreign corporation during the taxable year are assets that produce passive income or that are held for the production of passive income.
Due to these definitions, almost every foreign mutual fund will meet these requirements and will fall under the Passive Foreign Investment Company regime. It’s important to know when opening foreign securities accounts what type of investments will be made and whether they may be considered PFICs.
What does investment in a PFIC mean?
Generally, a U.S. Taxpayer is able to defer paying income taxes on the income earned by a foreign corporation each year until those earnings are brought back to the United States in the form of a dividend. One of the exceptions to this rule is the PFIC regime. Under PFIC rules, the income is taxed in the year earned and if the income is not taxed in the year earned, investors end up paying interest on that deferral. Not only is there no deferral allowed under the PFIC regime, but the income generated from holding and from the sale of PFICs is treated as ordinary income. This means that PFICs are not eligible for the preferential tax rates provided by capital gain income or qualified dividend income as is the case in many otherwise similar domestic investments. Further, in most cases, the income is taxed at the highest marginal tax rate even if the PFIC principal is not in the highest marginal tax bracket.
Due to the strict guidelines and complex regulations associated with PFICs, it is important to know whether a foreign corporation will fall under these rules. A foreign corporation that is defined as a PFIC by the Internal Revenue Code can oftentimes mean high compliance costs and a lower after-tax return.
How can BeachFleischman help?
- Determine whether elections can be made to lower the tax burden
- Determine whether an investment may be considered a PFIC
- Preparation of applicable PFIC forms as prescribed by the Internal Revenue Service
- Aid in determining whether the compliance and tax cost may outweigh the possible benefits of the investment
Contact our International Tax Team
BeachFleischman CPAs provides international tax services in Phoenix and Tucson, Arizona (AZ) and throughout the United States. If you are interested in learning more about how BeachFleischman’s tax professionals can assist you, please fill out the submission form below and you will receive a prompt response.