In a globalized world, cross-border investments have become increasingly common, but also more complex from a tax point of view. United States taxpayers who invest in foreign companies may be subject to the Passive Foreign Investment Company ( PFIC ) regime, which is designed to prevent the improper deferral of taxes on income generated by these investments abroad.

This tax regime, implemented to regulate investments in entities that generate mostly passive income, offers different reporting methods that significantly influence the taxation of this income.

Through this article, we will generally explore the tax implications of investments in PFICs, including the excess distribution regime, the qualified election fund (QEF), and the mark-to-market regime, providing a clear understanding of each option and its tax consequences.

As such, the PFIC regime is activated when a significant proportion of the foreign entity’s income or assets is of a “passive” nature.

Taxpayers who invest in PFICs have three main options to declare that they are in such a regime as noted below, under: (1) the excess distribution regime (or section 1291 fund of the United States Internal Revenue Code, by its acronym in English “IRC”); (2) the qualified election fund (QEF) regime; and (3) the market adjustment regime.

The PFIC regime, incorporated in 1986, has as its main objective to prevent the deferral of the payment of taxes with respect to obtaining passive income through foreign entities. This regime, along with the Controlled Foreign Corporation (CFC) and Subpart F income provisions, constitutes one of the primary anti-deferral mechanisms in the IRC.

What is a PFIC?

A foreign company is considered a PFIC if it meets at least one of the following two tests:

• Passive assets test : A foreign corporation is a PFIC if 50% or more of its assets, held during the tax year, generate passive income or are held to produce such income.
• Passive income test : A foreign corporation is a PFIC if 75% or more of its gross income during the tax year is passive income.

Passive income, with certain exceptions, includes any income that would be considered foreign personal holding company income under IRC Section 954(c) Passive income, includes, with certain exceptions, dividends, interest, rents, royalties and certain gains from real estate.

Excess distributions

“Excess Distributions” from a PFIC are subject to the IRC Section 1291 regime. This regime imposes taxes and interest on distributions that exceed the average annual distributions by more than 125% during the three preceding tax years (or the shareholder’s holding period, if shorter), as if they had been subject to tax in prior tax years. Additionally, under this regime, any gain from the sale of PFIC shares is treated as ordinary income, even if they were held as capital assets.

The above is calculated by prorating the excess distribution over the holding period of the PFIC shares. The excess allocated to the current year is included in ordinary income. The excess applied to previous years is taxed at the highest marginal rate applicable in those years, plus interest.

Any portion of the actual distribution that is not considered excess is treated as an IRC Section 301 distribution. Additionally, under this regime, any gain from the sale of PFIC shares is treated as ordinary income, even if they were held as assets. of capital.”

Qualified Election Fund (“QEF”)

Alternatively, taxpayers may choose to treat a PFIC as a QEF.

By making a valid and timely QEF election, taxpayers must pay annual taxes on the income and net profits received from the PFIC, reporting it on Form 8621, “ Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund .” This choice must be made by the first US taxpayer in the ownership chain.

When electing QEF treatment, the shareholder must include in his or her current income his or her proportionate share of the ordinary income and net profits of the PFIC. Additionally, gains from the sale of PFIC shares under QEF treatment are treated under ordinary capital gains rules, which may be more tax favorable.

It is important for taxpayers to be aware of “unprotected FCRs,” which could be subject to the excess distribution regime. Importantly, under certain circumstances, an entity’s classification as a PFIC may be removed.

Market value regime 

Some shareholders may have another method of reporting income from their participation in a PFIC under IRC Section 1296. Mark-to-Market provisions apply to stocks that are regularly “traded” on a “qualified exchange or other market”.

Under IRC section 1296(a), a United States person who owns (or is deemed to own under IRC section 1296(g)) marketable shares of a PFIC may elect to include in income gross the excess of the fair market value of the shares over the adjusted basis of the shares or, if the adjusted basis exceeds the fair market value of the shares, deduct the lesser of the excess or uninvested inclusions. In other words, the shareholder recognizes ordinary income or loss on the shares at the end of each year. Said ordinary income is measured by the difference between the basis of the shares and their fair market value.

Investments in PFICs represent a significant challenge and opportunity for U.S. taxpayers internationally. Deeply understanding the reporting options—excessive distribution, QEF, and mark-to-market—is essential to making informed decisions and optimizing your tax burden.

Each option offers a different approach to managing the tax consequences of passive foreign investments, and the appropriate choice depends on the investor’s individual circumstances and long-term objectives. With the right advice and a clear understanding of the rules, taxpayers can effectively manage their PFIC investments to align with their overall investment and tax compliance strategies.

At Freeman Law we represent all types of clients, from individuals, fast-growing Fortune 100 companies, to family-owned businesses with estate planning or international planning questions. At Freeman Law, we can advise you to answer your questions about foreign trusts in simple terms and any questions regarding tax matters. Call us to schedule a consultation about your international tax questions at (214) 984-3000 or (469) 998-8492.

 

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