With so many changes in the US taxation laws brought about by the Tax Cuts and Jobs Act, the IRS is not only scrutinizing assets and investments in the country but now, it is also paying an added attention to offshore accounts and foreign investments, more so than ever. When talking about foreign accounts and investments, you must have heard of terms like FATCA, FBAR, FDII, GILTI and so on. But have you ever heard of PFIC?
That’s precisely what today’s post is all about – Passive Foreign Investment Companies (PFICs).
What is a PFIC?
According to the Internal Revenue Code (IRC), a PFIC is any foreign corporation that meets either of the two conditions:
- At least 50% of the corporation’s assets are those that generate passive income in the form of earned interest (capital gains, dividends, interests generated from the sale of stock or royalties).
- At least 75% of the corporation’s gross income (GI) is passive income that comes from investments and not from its regular business operations.
Now, coming to the most important question: How are PFICs taxed?
Compared to any other foreign investment or offshore accounts, the taxation guideline for PFICs is extremely complicated and strict. They are subject to the rules laid down by the IRS under the Sections 1291 through 1297 of the IRC. Since tax matters are so rigid, a PFIC along with all its stakeholders must maintain accurate records of each and every transaction be it related to dividends or interests, or any earned undistributed income, and so on.
When it comes to a PFIC, taxpayers can choose from any of the three taxation methods:
1. Section 1291 Fund
Better known as the “Code” method, this is the default taxation method under which the shareholders of a PFIC are taxed if they receive a distribution. If this distribution amount contains any ‘excess distribution’, it will be subject to special reporting requirements. So, what, then, is considered to be an ‘excess distribution’?
If in a particular tax year a taxpayer receives a distribution that exceeds 125% of the average distributions received during the three consecutive tax years preceding it (if lesser than three years, then the amount of years in the holding period prior to the tax year in question), is regarded as ‘excess distribution’. Furthermore, 100% of any gain generated from an undertaking of the PFIC will be viewed as an excess distribution (but it will be taxed as ordinary income).
2. Mark-to-Market Election (MTM)
To avail the MTM method (as stated in Section 1296 of the IRC), a PFIC must be a marketable stock which means that it could be any marketable stock – a mutual fund, a foreign securities exchange, or an ETF, among others.
Under this method, a shareholder has to delineate each PFIC stock to its year-end market value and report any increase in the value as an ordinary income. This means that the shareholder is, then, choosing to be taxed only on unrealized gains. On the other hand, if there’s any unrealized loss, the shareholder can report it as an ordinary loss, provided that there are records of his/her previously recognized profits, also known as “unreversed inclusions”. Thus, if you opt for the MTM method, you cannot mark a stock that stands whose market value stands below its original cost.
3. Qualifying Electing Fund (QEF)
The final option, that is, the QEF election allows a taxpayer to report his/her net capital gains and share of earnings from the PFIC on an annual basis. While the net capital gains are taxed as long-term capital gains, the earnings are taxed as ordinary income. On the basis of the income reported, the adjusted tax basis will increase and when the stock is sold, the shareholder will incur either a capital gain or a capital loss.
A QEF is a little more complicated than the other two methods as in, to be eligible for a QEF, a PFIC must provide access to the IRS to all of its books and records and it must also provide statements for every U.S. shareholder, clearly stating their share of earnings, gains, and losses. For a non-US based corporation, this can be a pretty troublesome request.
All of this talk about PFIC got you even more confused, right? Well, it’s quite natural for PFIC reporting and taxation is more complex than any other taxation law you’ve ever come across. So, if your company is an ‘eligible’ PFIC, we’d suggest that you get expert help for taxation matters.
And what better than MyTaxFiler to help you out with tax and business matters? Write to us at firstname.lastname@example.org or call us at 1-(888)-482-0279.