US citizens living overseas naturally invest in foreign investment vehicles as that’s where they live. With it may come some bad surprise, a punitive taxation regime that can sidetrack you if not planned. Anyone who has made investment outside the USA or is considering making an investment in foreign companies, it is important for him/her to understand associated tax obligations. This blog post covers a summary of US tax rules related to passive foreign investment companies or PFIC. The PFIC rules apply to US persons i.e. individuals, corporations, estates and trusts who are US residents or US citizens.
So, what is a PFIC and why should you care about it?
Congress dislikes the idea that taxpayers would be able to defer income, especially when it comes to foreign investment vehicles. As such, it created a very punitive excess distribution regime, taxing income at the maximum tax rate and adding interest to it.
A relief was that it allowed US persons to treat income earned through PFICs in the same way as the income through US mutual funds is treated, which would be a QEF election. Or alternatively on a mark-to-market basis, which would be a mark-to-market election.
A PFIC is a foreign corporation that meets either a 50% passive asset test or a 75% passive gross income test. PFIC status is relevant only for US persons who own an equity interest in that corporation. It is irrelevant to depositors, account holders or non-us persons’ brokerage accounts.
A foreign mutual fund or investment company can be a PFIC; some other foreign corporations may also be PFIC. The main objective behind implementing the PFIC tax scheme was to discourage US citizens from establishing foreign entities and doing passive investments through them, thereby making an attempt to shift their tax jurisdictions out of the USA.
U.S. taxation for holders of PFICs
US individuals and US corporations that own shares of such a company either directly or through a partnership estate or trust are subject to the PFIC rules.
A U.S person who owns shares of a PFIC can elect to treat the PFIC as a qualified electing fund or a quit (mark to market) under a quest election.
Qualified electing fund
Under this option, the shareholder includes in his/her or its income each year, the share of the fund’s ordinary income and the share of the fund’s capital gain for the year. This share is computed as if the fund had distributed the full amount of each to its shareholders. The shareholder then gets an increase in basis in the shares; so, things are counted only once. This mimics the treatment for US mutual funds.
An election of quest status is made by the shareholder on Form 8621. The fund must consent to the election and agree to provide information each year to the shareholder. One Shareholder’s election does not affect anyone else. The question is made just once and continues each year.
Mark to Market
Alternatively, a shareholder may elect once to mark the shares of the PFIC to market each year under this election. The shareholder recognizes gain each year to the extent the fair market value of those shares exceeds the basis. The shareholder then gets an increase in basis in the shares. If the value declines in a year, the shareholder recognizes loss and basis is reduced but the loss is limited to the gains previously recognized. Any gain or loss is treated as ordinary income, not capital gains; any distributions are recognized as dividends. The marked market is only available for publicly traded shares. The election is also made on Form 8621 and continues each year.
Excess distribution or Tax plus interest regime:
If the shareholder doesn’t elect either QEF or mark-to-market, then a tax plus interest regime applies. Under this regime, tax on any larger than average distributions and on any gain is imposed as if the distributions are gain happened over the full period of ownership. This tax is at the top tax rate (not graduated rates). Interest is charged as if the tax were a prior year assessment. This can be quite harsh as it applies to any gain on any disposition of the shares as well as the portion of any distribution in excess of 125 percent of the average of the prior three years distributions. This amount is apportioned among all the days the shareholder held the PFIC shares.
The computations under this regime can be complex and the results very unpleasant. Shareholders of the corporation may get foreign tax credits with respect to taxes withheld on distributions or with respect to the underlying tax of the corporation
US Income tax filing requirements for PFIC shareholders
Any US citizen or resident who directly or indirectly holds more than $25,000 worth of PFIC shares at year-end is required to file form 8621 on an annual basis. In addition, form 8621 is required any year a disposition is made and perhaps more importantly, filing form 8621 is required in order to make an election and avoid the dreaded excess distribution taxation regime.
This form is filed irrespective of the distribution made during the tax year, provided that your holdings exceed $25,000. Previously, filing requirements of form 8621 were mandatory, if
- Distributions are made by PFIC,
- The shareholder elected for an alternative PFIC scheme by shareholders, or
- If PFIC was sold.
However, since 2013, it was made obligatory to file form 8621 even if none of the above events happened. Even the persons who are not required to file annual income tax returns are still obligated to file from 8621 with IRS.
In this form, basic information must be provided about the PFIC in all cases where nothing, but the quest inclusion is happening. The form is pretty simple you just disclose basic information about the PFIC and your shares of ordinary income and capital gain.
The USA has been taking stringent actions to avoid passive foreign investments. The recently published regulations provide important guidelines for tax assessment and filing obligations for US citizens holding PFIC shares. Few exceptions have also been provided that might allow some relief to the individuals who unintentionally held PFIC investments. However, the investors should be cautious about all the investments and due diligence procedures should be undertaken to conclude whether the said investment comes under PFIC criteria or not.