The Passive Foreign Investment Company or "PFIC" has been in the Internal Revenue Code ("IRC") since the Tax Reform Act of 1986.  Added to crack down on what was perceived as a skirting of the Subpart F rules covering controlled foreign corporations ("CFCs") by U.S.-based hedge funds, leading to deferral of passive income outside the U.S., PFIC has taken on a life of its own and lurks in the shadows whenever a U.S. person invests directly or indirectly in a foreign corporation.

 

 

PFIC is a foreign corporation whose gross income for the year is at least 75% passive income or at least 50% of whose assets generate passive income.  When testing these amounts, the income and assets of foreign corporations owned at least 25% by the foreign corporation being tested are also considered.  This makes it possible for a foreign holding company whose assets would otherwise be passive, in the form of shares of stock of its subsidiaries, to take into account the income and assets of those subsidiaries whose business operations are more likely to be active.  Potential PFICs include any entity treated as a corporation for U.S. tax purposes, regardless of its designation under foreign law.

 

 

Because of the way that the income and asset tests are applied, service companies are particularly vulnerable.  Typically they do not have significant "hard" assets but generate cash that is kept offshore and earns interest.  Also vulnerable are start-up companies whose start-up period is lengthy or a company that has been impacted by economic conditions generating an unanticipated and lengthy period of losses.  While there is an exception from PFIC status for the start-up year of a business, this is only available if the potential PFIC does not meet the PFIC criteria in the two years following the start-up year.

 

A PFIC may turn out to be a surprise when shares of a foreign corporation are acquired by inheritance or gift, especially from a foreign person who would not have been impacted by these rules.  And while one might expect a candidate for PFIC status to be organized in a tax haven, PFICs can arise anywhere if the income or asset test is met.  Therefore, another likely case of an accidental PFIC would be a corporation owning oil and gas properties in a high-tax country, but the properties are still in the exploration stage.

 

 

Determining the status of a foreign corporation for PFIC purposes can be straightforward when, for example, a foreign holding company is owned 49% by a U.S. corporation and 51% by foreign shareholders.  The books and records should be available to the 49% U.S. shareholder in order to make the calculations on a quarterly basis and determine if the foreign corporation is getting close to either the asset or income test for becoming a PFIC.

 

The 1997 Tax Reform Act added an exception to the PFIC rules if the foreign corporation is also a CFC (more than 50% of voting power or value in the hands of U.S. persons owning at least 10% of voting power, i.e., U.S. Shareholders).  For those U.S. Shareholders, the foreign corporation will not be considered a PFIC.  But for any U.S. person owning less than 10% of voting power of the CFC, the PFIC danger still looms.  It can be particularly challenging when a foreign corporation has, for example, only one or two U.S. persons as shareholders and each has only a small percentage of the total company.  Difficulties also arise when the investment in the foreign corporation is made through a partnership with hundreds of partners but only a few of them are U.S. partners. For investments in foreign corporations that are not paying dividends currently, and where the strategy is to hold the shares and benefit from long-term appreciation, PFIC should be kept in mind, especially while a reduced rate of tax still applies to long-term capital gains rather than the ordinary income treatment applying to a sale of a PFIC.

 

 

The IRC references the rules in Subpart F, specifically those covering Foreign Personal Holding Company Income, to define passive income.  This would include dividends, interest, rents, royalties and certain capital gains.  While exceptions are available, such as for rents from unrelated parties earned in an active business, and royalties from a related CFC paid from that CFC's active earnings, it is not clear how long these exceptions might apply.  For purposes of the asset test, an item such as cash, even if working capital for an active business is considered a passive asset, while an account receivable from a customer would not be.  For purposes of other assets, they are determined on a gross basis without considering deductions, even if directly related, such as a mortgage on a factory building.  The basis of the assets for tax purposes is used although there is the possibility, in certain cases, to use fair market value.  There are also special rules governing leased assets. 

 

 

All too often, the impact of the PFIC rules is not discovered until it is too late -- an investment in a PFIC is sold and an expected long-term capital gain turns into ordinary income plus an interest charge.  In this case, the gain on the sale is allocated to each of the years in which the PFIC was held and is taxed at the highest marginal rate for that year, plus an interest charge on the unpaid tax.  The holding period may carry over from a previous owner if, for example, the shares were acquired by inheritance.

 

Tax practitioners are fond of saying, "once a PFIC, always a PFIC."  This comes from the fact that if the U.S. taxpayer does nothing, the PFIC rules will apply when shares are sold or another form of excess distribution is made.  There are possibilities to confront PFIC status, however.  One is for the U.S. person to elect to treat the PFIC as a Qualified Electing Fund or "QEF" for purposes of that person's interest in the PFIC.  This requires the U.S. person to recognize each year a portion of income earned by the PFIC.  There is also the possibility to make a "purging" election and recognize income from prior years so that, upon eventual disposition of the shares, the gain is not treated as described above. 

 

 

The key to anticipating PFIC is vigilance.  That means understanding the entire foreign structure in which an investment has been made, requesting information from the managers of mutual funds and other investment vehicles in order to run the asset and income tests (including consideration of foreign subsidiaries of the potential PFIC) on a quarterly basis and, if advisable, taking preventive action.