Background:
U.S investors in foreign mutual funds could avoid U.S taxes. The fund itself could avoid U.S taxes because it was a foreign corporation that only derived foreign source income. U.S investors avoided U.S taxes because fund did not pay any dividends.
When U.S investors eventually did realize the fund’s earnings through the sale of fund’s stock, they could convert the fund’s earnings into capital gain.
Congress therefore enacted the PFIC provisions to deal with this abuse by U.S investors in foreign mutual funds.
PFIC rules apply to any foreign corporation that meets either the PFIC income test or asset test, regardless of whether U.S shareholders individually or in the aggregate have a significant ownership stake in the foreign corporation.
Foreign corporations that qualify as both a CFC (Controlled foreign corporation) and a PFIC (Passive foreign investment corporation) is not treated as PFIC by a U.S shareholder. Therefore, a shareholder that is subject to the current inclusion rules of Subpart F is not also subject to the PFIC rules with respect to the same stock.
PFIC Definition:
A foreign corporation is a PFIC if it meets either an income test or an asset test.
Income Test:
Under the income test, a foreign corporation is a PFIC if 75% or more of the corporation’s gross income for the taxable year is passive income.
Example:
Tony buys 2% of ForFund a foreign corporation. ForFund, however, deposits all the money it receives from investors in an interest bearing bank account at Hong Kong Bank. ForFund is a PFIC because 100 % of its income is passive income.
Asset Test:
Under the asset test, a foreign corporation is a PFIC if the average market value of the corporation’s passive assets during the taxable year is 50% or more of the corporation’s total assets.
Example:
Tony purchases 2% of the shares of ForFund, a foreign corporation. ForFund takes all the money it receives form investors and buys Gold Bullion. Although bullion does not produce any income, ForFund is a PFIC because the gold bullion, which comprise 100% of ForFund’s assets, is a passive asset.
Taxation of PFIC
A PFIC’s undistributed earnings are subject to U.S taxation under one of the three methods, each of which is designed to eliminate benefits of deferral.
Qualifies electing fund method:
Under the qualified electing method (QEF), shareholders who can obtain the necessary information can elect to be taxed currently on their pro rata share of the PFIC’s earnings and profits. The income inclusion is treated as ordinary income and capital gains to the extent of taxpayer’s pro rata share of the QEF’s net capital gain. A taxpayer’s pro rata share is the amount that the taxpayer would have received if, on each day of the QEF’s taxable year, the QEF had actually distributed to each of its shareholders a pro rata share of that day’s ratable share of the QEF’s ordinary earnings and net capital gains for the year. To prevent double taxation of the QEF’s earnings, any actual distribution made by a QEF out of its PTI are tax free to the U.S investor.
Example:
Tom purchases 1% of the shares of ForFund, a foreign corporation. ForFund deposits all the money it receives from investors in an interest bearing bank account at Hong Kong Bank. During 20X1, ForFund earns $500,000 of interest. When filing his return in 20X1, Tom makes a QEF election and reports $5,000 (1% of $500,000) of income on his return.
Excess distribution method:
Under the excess distribution method, the taxpayer is allowed to defer taxation of PFIC’s undistributed income until the PFIC makes an excess distribution, which is defined as any actual distribution made by the PFIC, but only to the extent the total actual distribution received by the taxpayer in the preceding three taxable years.
The amount of an excess distribution is treated as if it had been realized pro rata over the holding period for the PFIC’s stock and the tax due on an excess distribution is the sum of the deferred yearly tax amounts, plus interest. Therefore, the excess distribution method eliminates the benefits of deferral by assessing an interest charge on the deferred yearly tax amounts. Any actual distributions that fall below the 125% threshold are treated as dividends, which are taxable in the year of receipt and are not subject to the special interest charge.
Example:
On January 1, 20Y1, Tom a U.S citizen, purchases 1% of the stock of FM, a foreign mutual fund that constitutes a PFIC. Tom does not make a QEF or mark-to-market election. FM is highly profitable, but it does not make a distribution until December 31, 20Y3, when it pays Tom a dividend of $300,000. Under the excess distribution method, the dividend is treated as if it were received ratably ($100,000 per year) over 20Y1, 20Y2 and 20Y3, taxed at the highest rate in effect each year, and subject to an interest charge.
If FM distributed $100,000 during 20Y2, 125% of the previous years, distributions would be $62,500 (125% of $100,000 divided by 2) and the excess amount of $237,500 ($300,000 less $62,500) would result in an allocation of $79,166 to each of the three years.
An excess distribution will also include any gain realized on the sale of PFIC stock.
Market-to-Market method:
If the stock of a PFIC is marketable, the taxpayer may elect to use the market-to-market approach. Under this election, any excess of the fair market value of the PFIC stock at the close of the tax year over the shareholder’s adjusted basis in the stock is included in the shareholder’s income.
Any income or loss recognized under the market-to-market election is treated as ordinary in nature. In addition, a shareholder’s adjusted basis of PFIC stock is increased by the income recognized under the market-to-market election and decreased by the deduction allowed under the election.
Example:
On January 01, 20Y1, Tom a U.S citizen pays $1 million for 1% of the stock of FM, a foreign mutual fund that constitutes PFIC. The stock of FM is marketable and Tom makes a market-to-market election. On December 31, 20Y1, the stock is worth $1.2 million, and Tom will recognize an income of $200,000
Reporting Requirements for PFIC:
Code section 198(f) requires each U.S person who is a shareholder of a PFIC to file an annual report by filing form 8621.
References:
Practical Guide to US Taxation of International transactions 9th Edition
Robert J. Misey Jr.
Michael S. Schadewald
Publishers: Wolter Kluwer, CCH Incorporated.