Passive Foreign Investment Company (PFIC)

Key takeaways
* A PFIC is a non‑U.S. corporation subject to special U.S. tax rules when most of its income or assets are passive.
* A foreign corporation meets the PFIC tests if either:
* 75% or more of its gross income is passive (income test), or
* 50% or more of its assets are held to produce passive income (asset test).
* U.S. shareholders of PFICs must generally report activity on IRS Form 8621; gains and distributions are often taxed as ordinary income under anti‑deferral rules.
* Common examples include many foreign mutual funds and investment holding companies; U.S. investors can reduce PFIC exposure by using comparable U.S. funds or ETFs that hold foreign assets.

What is a PFIC?
A Passive Foreign Investment Company (PFIC) is a foreign corporation that primarily holds passive investments or generates passive income. The Internal Revenue Service applies two objective tests:
* Income test: 75%+ of gross income is passive (interest, dividends, capital gains, rents, royalties, etc.).
* Asset test: 50%+ of average assets produce passive income.

Why PFIC rules exist
PFIC provisions were enacted in the Tax Reform Act of 1986 to prevent U.S. taxpayers from indefinitely deferring U.S. tax by sheltering investment income offshore. The rules impose anti‑deferral tax and reporting regimes intended to neutralize the tax benefit of holding certain foreign investment entities.

Tax treatment and reporting
* U.S. shareholders must generally file IRS Form 8621 for each PFIC investment to report distributions, dispositions, and certain elections. The form is detailed and may be time‑consuming to prepare.
* Distributions and excess gains from PFICs are typically subject to complex anti‑deferral rules that can result in ordinary income treatment and interest charges.
* Some PFIC shareholders can make a Qualified Electing Fund (QEF) election to be taxed currently on their share of the PFIC’s income, which can simplify future tax treatment but may have other consequences.
* Shares acquired before 1997 are generally grandfathered from the PFIC excess distribution regime.

Recordkeeping and basis rules
Shareholders should keep thorough records of purchase price (cost basis), distributions, and any PFIC earnings allocated to them. Unlike many other inherited marketable securities, step‑up in basis on inherited PFIC shares is generally restricted, making basis tracking important.

Relevant changes and exceptions
* The Tax Cuts and Jobs Act modified PFIC rules and added an insurance exception effective for tax years beginning after Dec. 31, 2017: income attributable to an active insurance business is not treated as passive unless insurance liabilities exceed 25% of total assets as reported on the company’s financial statements.
* Treasury and IRS regulatory updates in recent years have refined definitions and reduced certain burdens associated with overlapping international reporting regimes.

Examples of passive income
Passive income typically includes:
* Interest and dividends
* Capital gains
* Rents and royalties (from activities in which the taxpayer is not materially involved)
* Income from limited partnerships or other passive business interests

Practical considerations and avoidance strategies
* Many U.S. investors avoid PFIC complications by investing in U.S. mutual funds or ETFs that hold foreign securities rather than owning foreign investment funds directly.
* Because Form 8621 and PFIC elections are complex, investors holding suspected PFICs should consult a tax professional to ensure correct reporting and evaluate whether a QEF or other election is appropriate.

Bottom line
PFIC rules close a long‑standing offshore tax‑deferral loophole by subjecting certain foreign investment vehicles to onerous U.S. tax and reporting rules. Any U.S. person holding shares in a foreign corporation should determine whether the income‑ or asset‑based PFIC tests apply, maintain detailed records, and comply with Form 8621 filing requirements to avoid unexpected tax and interest charges.