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PFICs – A Fairytale Definition; Lives Happily Ever After

What is a PFIC?

A PFIC is a so-called “Passive Foreign Investment Company” which is defined to include any foreign (non-US) corporation if 75% or more of its gross income for the year consists of “passive income” (“income test”), or (2) at least 50% of the average fair market value of its assets during the year are assets that produce or are held for the production of passive income (“asset test”). Passive income generally includes dividends, interest, rents, royalties, most foreign currency and commodity gains, and capital gains from assets that produce such income. As pointed out in my earlier tax blog post just about all of the income of a foreign fund will usually qualify as passive and so, nearly all foreign funds will qualify as PFICs.

Under the PFIC rules, the United States shareholder of the PFIC suffers severe US income tax and tax reporting consequences. There is no minimum level of stock ownership required by a US person to be subject to the PFIC tax regime. It therefore often comes as a surprise to many investors that even foreign public companies can be considered PFICs in their hands for US tax purposes. Admittedly, such investors have become unwilling PFIC shareholders, but the tax bite will remain the same.

Underlying Purpose Behind the PFIC Rules

The PFIC tax regime was enacted with the Tax Reform Act of 1986. The regime was generally designed to prevent tax deferral with the use of non-US corporations. It was also designed to assist US-based mutual funds that were losing business to foreign-based mutual funds caused by a tax disparity between the two. A US mutual fund was forced to pass-through all investment income earned by the fund to its investors and the investors had to pay current US income tax on that income. Foreign mutual funds were often created in tax haven jurisdictions and did not pay tax; the fund’s US investors also did not pay tax so long as no distributions were made to them. This tax deferral aspect was very valuable as deferral could go on for years and years. After the passage of the PFIC tax regime, this deferral advantage completely disappeared and the new laws made the practice of delaying the distribution of income prohibitively costly for US investors.

Harsh Tax Results – Compounded Interest, Loss of Capital Gain Treatment and More

Once a corporation qualifies as a PFIC, very harsh tax consequences can result. In the absence of making a special election, taxation will generally occur when the PFIC either makes what is called an “excess distribution” to its US shareholder or when the shareholder disposes of his PFIC shares. When taxation occurs, the amounts will be taxed at the highest ordinary income tax rate currently in effect, without regard to other income or expenses (currently the highest individual rate is 39.6% with a possible 3.8% Medicare surcharge tacked on for high income earners). Long-term capital gains treatment does NOT apply. Further, the amounts are treated as if they were earned ‘pro rata’ over the investor’s holding period for his shares. What this means is that the amounts to be taxed are “thrown back” evenly over each of the earlier tax years commencing with the year when the shares were first held. Tax is then assessed for each year at the highest possible tax rate, and interest is compounded on the tax deemed due for each year. Due to the imposition of compounded interest charges, the rates can easily eat up the offshore investment.

Active Businesses Getting Caught in The Passive Net

A very harsh effect of the PFIC tax regime is the fact that the definition of a “PFIC” is from a fairytale world that ignores business reality. It is overly broad with the result that many active businesses are getting caught in the PFIC net. How does this happen? It happens because a company can be classified as a PFIC upon application of either the “income test” or the “asset test”, discussed above. The IRS has unequivocally stated in Notice 88-22 that cash, including working capital is to be treated as a “passive asset”. Many sales and services companies will meet the asset test under this definition since they often do not have significant assets other than cash and working capital, which has been defined by the IRS to be per se, “passive.” Take for example, a computer servicing business or a website development business – the assets of this type of business will likely be only a few desks, computers and the like, but the business may have a large bank or other financial account.

The “income test” can also inadvertently capture an active business. For example, an active foreign corporation may have a poor performance year with low income. Perhaps, it generated losses from the business enterprise in a bad year. Yet, that same corporation could generate significant passive income in the same “bad” year (for example, dividends, capital gains and interest from a portfolio investment). This unfortunate income mix can cause the otherwise active business to be classified as a PFIC. … and once so classified, the PFIC can live happily ever after.

While the test for determining PFIC status is based on the corporation’s income or assets in a particular tax year, once a corporation is classified as a PFIC, the PFIC “taint” will generally carry over to all future years that the US shareholder holds shares in the company. This is known as the “once a PFIC, always a PFIC” rule. Certain elections can be made to purge the PFIC taint, but of course, the price tag is steep. So, as in all fairytales, the PFIC will live forever and the IRS will be happily ever after collecting PFIC tax dollars.

Practitioners have been voicing the need to redefine PFICs in a manner that is more consistent with the intended purpose of the legislation – that is, to prevent tax deferral and to level the playing field for US- and foreign-based funds. The voices, unfortunately, have fallen on deaf ears and the PFIC regime continues to bite the unsuspecting investor time and time again.

Tax Filings

To add insult to injury, a US investor in a PFIC must also file various information and tax forms (e.g., Form 8621, Form 8938, FBAR). Record-keeping and preparation time for the Form 8621, alone, is extremely complicated and a separate Form must be filed for each PFIC owned. The IRS estimates that the time required with regard to Form 8621 for each PFIC investment is at 22 hours per year! The tax preparation costs are very high and many tax return preparers are ill equipped to handle returns involving PFICs. Many will not take on such work. To avoid possible penalties, the investor should examine the proper tax treatment and filings with a tax professional who is qualified and knowledgeable in this area.

In accordance with Circular 230 Disclosure

Virginia La Torre Jeker J.D., has been a member of the New York Bar since 1984 and is also admitted to practice before the United States Tax Court. She has 30 years of experience specializing in US and international tax planning as well as international commercial transactions. She has been based in Dubai since 2001; prior to that time she worked in Hong Kong for 15 years as a US tax consultant for international law firms, major banks (including HSBC) international accounting firms (Deloitte) and trust companies. Early in her career she worked in New York with the top-tier international law firm, Willkie Farr & Gallagher.

Virginia is regularly asked to speak at numerous conferences and seminars for various institutes and commercial organizations; publishes a vast array of scholarly works in her area of expertise, been interviewed by CNN and is regularly quoted (or has her articles featured) in local and international publications. She was recently appointed to the Professional Tax Advisory Council, American Citizens Abroad, Geneva, Switzerland. She was a guest lecturer at the University of Hong Kong, LL.M Program (Law Department) and served as an adjunct Business Law professor at the American University of Dubai and at the American University of Sharjah where she also taught the legal / ethical aspects of internet law and internet based transactions.


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2 thoughts on “PFICs – A Fairytale Definition; Lives Happily Ever After

  1. A fine example of how a law that was meant to capture homeland tax payers who were trying to cheat the IRS has absolutely no relevance to non-resident U.S. persons since U.S. banks, that may operate in our country of residence, are not competing unfairly for the business of the non-resident expat. All banks including U.S. based banks are operating under the same laws as the none U.S. banks.

    It is the non-resident U.S. person who is being mistreated when he/she is forced to conduct his/her financial affairs “as if” s/he is resident in the U.S. and using U.S. currency and Treasury.

    If U.S. expats are forbidden under U.S. law from having their local financial sector, without artificially defined limits on the amount held, as their domestic banking system then that is discrimination. This is a powerful disincentive for any U.S. person to leave the reserve.

  2. Wendy Wixson says:

    Nice article, Virginia. I’ve seen too many active businesses fall under the unexpected implications of PFIC status.

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