A Passive Foreign Investment Company (PFIC) is a foreign corporation that mainly earns passive income or holds passive assets. The IRS tends to define a PFIC using two basic PFIC testing methods, the Income Test and the Asset Test.
The income test involves a criteria where a foreign corporation would be classified as a PFIC if 75% or more of its gross income is passive income. Passive income includes dividends, interest, rents, royalties, and capital gains from investments. This passive income is deemed a distinguishing feature, as opposed to income generated from active business operations.
The asset test deems a foreign corporation to be also classified as a PFIC if 50% or more of its assets produce, or are held to produce, passive income. These assets are typically measured by their fair market value. Passive assets include investments like stocks, bonds, and other financial instruments.
In typical circumstances, using the basic criteria outlined, a foreign portfolio company would be classified as a corporation from a U.S income tax perspective, unless the company made an election to be treated otherwise.
Unfortunately, there is an issue with PFICs that can result in some negative consequences and punitive tax charges if certain elections are not made. That is why it is becoming regular practice for US-based investors to delegate the PFIC testing to the foreign portfolio company and use a professional accounting firm to perform the testing. However, using a non-US based accounting firm can be extremely expensive. The most economical approach would be to use US tax attorneys and accounting professionals to perform the PFIC testing.
Here are some key points to consider when looking at the PFIC regime and testing process.
You should give due consideration to the tax implications if you are a shareholder resident in the states. The bottom line is that investing in a PFIC can have significant tax consequences for US shareholders. In simple terms, it should be viewed that US tax rules are primarily designed to discourage investments in PFICs by imposing complex and often punitive tax treatment.
Here are the key implications.
Excess distribution regime – US shareholders of a PFIC are subject to the excess distribution regime. This applies to distributions and gains from the sale of PFIC shares. Excess distributions are allocated over the shareholder’s holding period and taxed at the highest ordinary income tax rate, plus an interest charge on the deferred tax.
Qualified Electing Fund (QEF) election – As a US shareholder, you can make a QEF election to include their share of the PFIC’s income in your current-year taxable income. This can simplify taxation and avoid the excess distribution regime, but it requires the PFIC to provide detailed annual financial information. This creates an added administrative burden and expense.
Mark-to-Market election – An alternative option is for shareholders to elect to mark their PFIC shares to market annually. This means recognizing any unrealized gains as ordinary income. Doing so helps avoid the excess distribution regime but potentially results in higher annual taxes.
What happens if you are not able to avoid a PFIC classification?
As you can see, it is desirable to try and avoid PFIC status as a foreign company. However, there will be situations where this classification is unavoidable. When this happens, you have the option to negate the excessive tax impact to a certain extent, by making a Qualifying Electing Fund (QEF) election.
Making a QEF election will only be permissible if the foreign portfolio company has the ability to provide US investors with the statutory information required to be able to file under QEF requirements.
Clearly, it makes sense for foreign companies to strive to avoid being classified as Passive Foreign Investment Companies (PFICs). This is principally due to the significant tax and reporting burdens imposed on US shareholders. There are some key reasons why avoiding PFIC status is beneficial for foreign companies. Let’s look at what these are.
More attractive to US Investors without PFIC status
Foreign companies that are classified as PFICs can become significantly less attractive to US investors due to the punitive tax treatment associated with PFIC investments. As a US-based shareholder you would have to deal with complex tax rules, including the excess distribution regime. This is where distributions and gains are taxed at the highest ordinary income tax rates and includes an interest charge on deferred taxes. This can easily prove to be a deterrent for potential US investors. The net result of this scenario would also be a hindrance to the company’s ability to raise capital from the US financial markets.
Avoiding PFIC status means simpler compliance and reporting requirements
PFIC status requires US shareholders to comply with extensive reporting requirements. These include filing Form 8621 annually. This form necessitates providing detailed information about the PFIC’s income, distributions, and assets. Foreign companies must provide this information to their US investors, creating additional administrative burdens and costs. By avoiding PFIC status, foreign companies can simplify compliance procedures and reduce the reporting requirements for their US shareholders, which is a win-win scenario.
Enjoy enhanced marketability by avoiding PFIC classification
It is more often the case that foreign companies that avoid PFIC classification can enhance their marketability to a broader range of investors. The complex tax implications associated with PFICs can discourage institutional investors, mutual funds, and individual investors from acquiring shares in the company.
By maintaining a structure that avoids PFIC status, foreign companies can appeal to a wider investor base. This has the potential to increase the share price and market liquidity.
Benefit from reduced shareholder tax burden
When a foreign company avoids PFIC status, it spares its US shareholders from the unfavorable tax treatment that PFICs generate. This includes the potential for double taxation and the complexities of making Qualified Electing Fund (QEF) or mark-to-market elections.
By avoiding PFIC status, foreign companies can provide a more favorable investment environment for their US shareholders.
There are numerous compelling reasons why foreign companies should actively seek to avoid PFIC status. It makes the company more attractive to US investors. It also simplifies compliance procedures, enhances marketability, and reduces the tax burdens on their shareholders.
It cannot be stated strongly enough that investing in a PFIC requires careful consideration. This is due to the complex and often unfavorable tax treatment that is an integral aspect of this status.
You should consult tax professionals to navigate the rules and determine the most advantageous tax elections for your specific situation. By gaining a better understanding of the intricacies of PFIC taxation you can help avoid unexpected tax liabilities and ensure compliance with US tax laws.
