Many people today look to diversify their investment portfolios. They may accomplish this goal by investing in a Passive Foreign Investment Company (PFIC). There are benefits to doing so, but there are also disadvantages.
What is a PFIC?
A passive foreign investment company is an investment fund or collective investment located abroad. It may include foreign-based mutual funds, startups, or other investments. The IRS taxes these investments at a different rate, which confuses many individuals. The tax consequences can be disastrous if someone doesn’t report the investments correctly. For this reason, PFIC testing is essential.
Why Is This an Issue?
Congress passed the Foreign Account Tax Compliance Act in 2010. Before the passage of this legislation, investors could place their money in offshore accounts to avoid taxation. Congress wanted to ensure the IRS collected all funds due to the government and established this act to close the existing loophole. It included a provision requiring these investments to be taxed at a higher rate to discourage investors from trying to skirt United States tax laws.
Foreign financial institutions now report accounts to the IRS, so investors must show these investments on their taxes. When people file their taxes, they pay the ordinary income tax rate, not the capital gains rate. In addition, capital losses cannot offset capital gains with PRICs.
If they invest in PFICs, taxpayers must follow complex and time-consuming reporting requirements. Reporting thresholds differ based on the investor’s filing status and location. U.S. citizens living in other countries must also meet specific requirements for reporting their PFICs on U.S. income tax forms.
Determining Whether an Investment is a PFIC
Many people are confused about whether their foreign investments qualify as PFICs. They look at the account to make this determination, but they must also look at the investment itself. Investors who own individual stocks and bonds often don’t have to report a PFIC on their income tax. However, collective investments must be reported as PFICs.
When making this determination, the investor must consider whether the entity is organized for investment and whether it is American or foreign. Furthermore, they need to question the limitation of liability. When there is no limitation of liability, the IRS doesn’t consider it a company. There are two tests a person might use to determine whether a foreign company qualifies as a PFIC under U.S. tax law.
The Passive Income Test
The passive income test is often used to make this determination. When 75 percent or more of a foreign company’s gross income qualifies as passive income for a taxable year, it is a PFIC. When using this test, an investor must look at all gross income for that tax year. As the rules don’t define gross income, the IRS has provided a definition investors may use. It states gross income includes all income from any source.
Under this definition, income may be derived from the business, interest it collects, rent, and royalties. Dividends from investments made by foreign companies also qualify as income. Manufacturing and merchandising companies must also report any income from incidental or outside sources or operations. Under current U.S. law, a foreign corporation with zero gross income for a taxable year isn’t considered a PFIC. However, when passive income from investments exceeds a business’s net operating loss, the company would be a PFIC.
Many people find they need help from a tax specialist when using the income test to determine whether a foreign company is a PFIC. They might also choose to use the asset test to make this determination. It’s always best to talk to a tax specialist to ensure all investments are correctly listed on an income tax return.
The Asset Test
The asset test is another way to tell if an investment is a PFIC. When 50 percent of a company’s assets are set aside to produce passive income, the company qualifies as a PFIC. For example, a startup will amass cash to establish operations. As this money has yet to be spent, the IRS considers it a PFIC because the cash is reserved to produce passive income. When looking at the assets, the IRS considers the gross amount before any liabilities, even when assets secure those liabilities.
When determining whether a company qualifies for PFIC status, the IRS looks at its passive assets’ average fair market value and compares that to the total assets the company holds. This review takes place quarterly, and the IRS looks at all four quarters to determine whether the company’s passive assets meet the 50 percent threshold. If they do, the company is classified as a PFIC.
What is Passive Income?
Passive income is any unearned income. The individual or company invests little to no labor to earn this income. Dividends and interest on bank accounts are good examples of passive income, as the person earns these funds even if they do nothing. Rental income and royalties qualify as passive income. Capital gains, gains from hedging, and business activities in which the person doesn’t materially participate are also passive income sources. When making this determination, investors should speak to their financial advisors to ensure no passive income sources are overlooked.
Holding PFICs
Many people wonder where they will find PFICs. Brokerage accounts often hold these investments, but they are also found in numerous other locations. For instance, a person with a non-US pension or preferred account might find they have one or more PFICs. Nominee accounts and directly held securities might also qualify.
Insurance hybrid investment products in other countries may or may not qualify as PFICs. The individual must determine whether the product has an investment component. If it does, the account is a PFIC. If it doesn’t, it doesn’t qualify as a PFIC. The insurance provider should provide this information when asked.
Investors often express confusion about PFICs. They aren’t sure whether the investments they hold in other countries qualify. A professional accountant, tax specialist, or financial advisor can help clarify what falls under this category to ensure the investor doesn’t misreport their holdings and end up with a significant tax bill because of this error.
