In the 30 years since the regulations regarding Passive Foreign Investment Companies (PFICs) were first established by U.S. lawmakers, PFICs have become almost unmatched in their complexity. These regulations and the enforcement efforts by the Internal Revenue Service have created a procedural obstacle course related to foreign investment. When looking at the full picture of what might appear on the surface as a simple money-making opportunity, the process of investing in a foreign mutual fund is one that quite often becomes highly scrutinized. Investors in foreign mutual funds can be exposed to a labyrinth of complex reporting, disclosure and, in many cases, higher tax rates on the income they generate. Yet, as the world’s economy becomes more globalized and foreign investment continues to expand, it is vital for those considering these opportunities to hold a greater understanding of the tax implications.
Background on PFIC Regulations
PFIC regulations were included as part of the 1986 Tax Reform Act, which was the second of the Reagan tax cuts to be passed by Congress in that year. The purpose behind the creation of the PFIC regulations was to establish an even playing field for U.S. investment funds. Before the Tax Reform Act became law, U.S. mutual funds were required to pass all investment income to investors annually while foreign funds were allowed to shelter taxable income since it was not taxable until distributed. The passage of the Tax Reform Act essentially eliminated this advantage foreign funds had over U.S. funds by imposing new rules that essentially penalized foreign funds that delay distribution of income and established rules around how these distributions are taxed at the investor level.
The Foreign Company Test
Under the law, a foreign investment company has to meet one of two tests to be considered a PFIC. The criteria can be established through either the income test or the asset test.
- The income test is met if 75 percent or more of the foreign corporation’s gross income is passive income (Interest, dividends, capital gains, etc.).
- The asset test is met if 50 percent or more of the foreign corporation’s average assets (as defined by the Internal Revenue code) is held to produce, or could produce, passive income.
For U.S. tax purposes, the test is applied based on the foreign corporation’s adjusted basis of the assets or, at the election of the particular shareholder, fair-market values of the assets.
Impact on Shareholders in Foreign Investment Companies
Income earned by shareholders in a PFIC could be in the form of interest or dividends or even gain on the disposition of shares. This income will be taxed based on one of three methodologies depending on which, if any, elections the shareholders are qualified to make. The IRS details how income from PFICs is recognized and taxed under IRC Sections 1291 through 1298.The following bulleted list is an abridged summary of IRS descriptions related to the Default Method, the Marked to Market Method and the Qualified Electing Fund Method.
- The Default Method, under Section 1291, would apply if neither of the other two methods is elected. It is commonly called the “excess distribution” rule and many observers believe that it is designed to discourage investors from foreign investment. Section 1291 states that the gain from disposition of PFIC stock will be considered to be an “excess distribution” and as such, it will be taxed as ordinary income to the shareholders. It’s a very precarious situation because ordinary income is taxed at the highest marginal rates. Furthermore, long-term capital gain treatment is not an option, and any net losses from the sale of PFIC shares are not allowed to be deducted. To make matters even worse, the taxpayer has to assume that any gains are earned ratably over the period the investment was held, requiring such gains to be projected back to previous tax years with interest compounded annually on the resulting tax due.
- The Marked to Market Method, under Section 1296, allows shareholders to report the annual gain in market value (i.e. unrealized gain) of PFIC shares as ordinary income on the “other income” line of their tax return. Unrealized losses are only reportable to the extent that gains have been previously recognized. The adjusted basis for PFIC stock will include the gains and losses previously reported as ordinary income. Upon the sale of the PFIC shares, all gains are reported as ordinary income whereas losses are reported as capital losses on Schedule D. In order to elect this method, the PFIC generally must be traded on a major international stock exchange, and the election can only be made prospectively.
- The Qualified Electing Fund Method, under Section 1295, would appear to be the most favorable option for most U.S. investors since it effectively results in the PFIC being treated like a U.S. based mutual fund, with the ordinary income and capital gains of the PFIC separately flowing through to the shareholders according to percentage of ownership. Instead of providing a 1099, a PFIC should provide its U.S. shareholders with what is called a PFIC Annual Information Statement, which contains information to be used to file their tax returns. While this election does allow for long-term capital gains to be taxed at the lower long-term capital gain rates, losses are still disallowed. Other potential hurdles to this method are that the PFIC needs to be reported on a U.S. tax basis, and most foreign funds do not comply with U.S. GAAP or U.S. tax-basis accounting. The PFIC is also required to allow the shareholders access to inspect and copy its permanent book of account, records and other such documents. This is something many foreign funds may not be inclined to do since it could be cumbersome and could divulge certain investment strategy information they would otherwise want to keep private.
Working with PFICs under the Foreign Account Tax Compliance Act of 2010
With the establishment of the Foreign Account Tax Compliance Act in 2010, those investing in PFICs encountered additional reporting considerations. For example, IRC Section 1298 was amended, by the Hiring Incentives to Restore Employment Act, to require all U.S shareholders of PFICs (direct or indirect) to disclose ownership of foreign securities or stocks as well as other relevant taxpayer information. The IRS is keenly interested in ensuring that complete and accurate information is being reported about U.S. taxpayers holding foreign investments, and it is taking a number of measures to ensure compliance.
Holdings in PFICs are disclosed by direct and indirect U.S. shareholders on Form 8621, which must be filed for each PFIC held. These forms are due at the same time the U.S. shareholders’ tax returns are due, including extensions. The latest version of the form and instructions have been updated and revised as of December 2015.
We Can Help
Investment in PFICs can provide unforeseen tax challenges for U.S. investors looking to diversify their portfolio. The Elliott Davis Decosimo Investment Companies Team is experienced in the area of PFICs and we can help you evaluate the appropriate tax treatment and elections for your unique situation. We can help provide additional guidance related to the reporting requirements of a PFIC investment. We can also assist foreign entities that are required to provide such information to their U.S. investors. If you have any questions regarding PFICs, please check with your Elliott Davis Decosimo advisor or contact Shareholder Karl Jordan.