Passive Foreign Investment Company
Passive Foreign Investment Company (PFIC) for US expats
For US taxpayers, owning shares in a PFIC can trigger special US tax rules and may require annual reporting on Form 8621.
PFIC rules at a glance
- A foreign corporation can be a PFIC if 75% or more of its gross income is passive income.
- It can also be a PFIC if at least 50% of its average assets produce, or are held to produce, passive income.
- Meeting either test can result in PFIC status.
- Foreign mutual funds and foreign-domiciled ETFs are common investments that may fall under the PFIC rules.
- US taxpayers who own PFIC shares may need to file Form 8621, with the tax treatment depending on the circumstances.
These tests are established under IRC Section 1297 and are reflected in the current Form 8621 instructions.
PFICs often catch US expats by surprise. Someone may invest in a perfectly ordinary foreign mutual fund or ETF without realizing that, from a US tax perspective, the investment could fall under a much more complicated set of rules.
Aya Takriti, an IRS Enrolled Agent with 12 years of expat tax experience, specializes in US tax preparation, tax planning and tax advice for US citizens and Green Card holders living and working in the Middle East. *Schedule a consultation with Aya today.
*30-minutes US$247.
Table of Contents
What is a Passive Foreign Investment Company (PFIC)?
A Passive Foreign Investment Company is a foreign corporation that meets either the PFIC income test or asset test.
- The first is the income test. If 75% or more of the corporation’s gross income for the year is passive income, it will generally be treated as a PFIC.
- The second is the asset test. If at least 50% of the corporation’s average assets produce passive income, or are held for the production of passive income, it can also be classified as a PFIC.
A relevant and common example of a PFIC is when a company invests in a non-American mutual fund; however, the term encompasses a far wider range of investments than simply this.
Common potential PFICs include foreign-domiciled ETFs, foreign investment companies, and some hedge funds organized as foreign corporations. Foreign pensions and insurance products require separate analysis because their legal structure and applicable treaty or statutory rules may produce a different result.
Many people are unaware they have a PFIC, often because of investments made by those in control of a mutual fund in which they have invested.
How will I know if I have a Passive Foreign Investment Company (PFIC)?
To determine whether a foreign corporation is a PFIC, you generally need to apply two tests: the income test and the asset test. Meeting either one can result in PFIC status.
Income vs asset test for PFICs
|
PFIC test |
When the test is met |
What it looks at |
Common examples |
|
Income test |
75% or more of the foreign corporation’s gross income for the tax year is passive income |
The company’s income |
Interest, dividends, certain rents, royalties, and gains from investments |
|
Asset test |
At least 50% of the foreign corporation’s average assets produce passive income or are held for producing passive income |
The company’s assets |
Investments, cash, and other assets that generate or are held to generate passive income |
A foreign corporation only needs to meet one of these tests to potentially be classified as a PFIC.
A common situation is a US citizen living overseas who invests in a foreign mutual fund or foreign-domiciled ETF through a local brokerage platform. The investment may look completely normal in that country, but it can have a very different tax treatment in the US.
However, simply owning a foreign investment does not automatically mean you own a PFIC. For example, buying individual shares in a foreign company does not by itself make those shares a PFIC. The company would still need to meet the 75% passive income test or 50% passive asset test.
What investments commonly trigger PFIC rules?
Foreign mutual funds are one of the most common areas where US taxpayers encounter PFIC rules. Other investments that may require a closer look include:
- foreign-domiciled ETFs
- foreign investment funds
- certain pooled investment products
- shares in foreign investment companies
The important point is that the investment account itself is not necessarily the PFIC. It is generally the underlying foreign corporation or fund that must be tested.
For example, a brokerage account could contain cash, individual foreign company shares, and foreign funds. Those investments would not automatically receive the same PFIC treatment simply because they are held inside the same account.
Get PFIC Tax Guidance
How is a PFIC reported to the IRS?
If you own shares in a PFIC, you may need to report the investment to the IRS using Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.
A US person generally files Form 8621 when they:
- receive certain distributions from a PFIC
- recognize gain from selling or disposing of PFIC shares
- report income under a Qualified Electing Fund or mark-to-market election
- make certain PFIC elections
- have an annual reporting requirement under Section 1298(f)
A separate Form 8621 is generally required for each PFIC held directly or indirectly. That can become particularly important where someone owns several foreign funds. So, if you hold 10 separate foreign funds that are PFICs, you could potentially be dealing with 10 separate Forms 8621.
Form 8621 is normally attached to the taxpayer’s US tax return and filed by the return’s due date, including extensions. If the US person is not required to file an income tax return or other applicable return, Form 8621 may still need to be filed separately with the IRS.
What are the tax consequences of owning a PFIC?
Owning a PFIC can lead to more complicated US tax reporting and, depending on the tax treatment that applies, potentially higher tax costs.
There are three main ways PFICs are generally taxed:
|
PFIC treatment |
How it generally works |
|
Section 1291 |
The default rules can apply special tax and interest calculations to excess distributions and gains |
|
Qualified Electing Fund (QEF) |
The shareholder generally reports their share of the PFIC’s ordinary earnings and net capital gain each year |
|
Mark-to-market |
Eligible marketable PFIC shares are generally valued annually for US tax purposes |
Under the default Section 1291 rules, gains from selling PFIC shares is be treated as excess distributions. Part of the gain may be allocated across earlier years in the holding period, with tax calculated using the highest applicable rate for those years, plus an interest charge.
A QEF election works differently. Instead of waiting until the investment is sold, the shareholder generally reports their share of the PFIC’s ordinary earnings and net capital gain each year. However, this usually requires the PFIC to provide specific financial information.
A mark-to-market election may be available for certain marketable PFIC shares. Under this method, increases in the investment’s value can generally be recognized as ordinary income each year, even if the shares have not been sold.
PFIC ownership can also create additional reporting because a separate Form 8621 is generally required for each PFIC when a filing requirement applies. This is why PFICs can become particularly complicated for US expats who hold several foreign mutual funds or foreign-domiciled ETFs.
Are there exceptions to Form 8621 reporting?
There are some exceptions to PFIC reporting, but they should not be confused with a blanket exemption from PFIC tax. One commonly discussed exception applies to certain Section 1291 funds where the total value of a shareholder’s PFIC holdings is US$25,000 or less at the end of the year.
For married taxpayers filing jointly, the combined threshold is generally US$50,000.
However, this exception does not generally apply where the taxpayer received an excess distribution or recognized gain from selling or disposing of the PFIC during the year. In other words, being below US$25,000 does not necessarily mean the PFIC rules can simply be ignored.
There is also a separate US$5,000 exception in certain cases involving indirectly owned Section 1291 funds.
Other exceptions can apply in more specialized situations, including some interests held through qualifying pension arrangements under a US income tax treaty.
What happens when I sell a PFIC?
Selling a PFIC does not necessarily make the tax problem disappear. Under the default Section 1291 rules, the entire gain from selling or disposing of PFIC shares can generally be treated as an excess distribution.
That means it can be worth understanding the US tax consequences before selling the investment rather than assuming that divesting will automatically simplify everything.
The result will depend on factors such as:
- how long you have owned the PFIC
- whether a QEF or mark-to-market election has been made
- the amount of gain
- distributions received during the holding period
What should I consider before selling a PFIC?
Once someone discovers they own a PFIC, one of the first questions is often whether they should simply sell it. That may be an option, but the timing and tax consequences matter.
There is also a rule commonly summarized as “once a PFIC, always a PFIC.” Broadly, if a company was a PFIC during part of your holding period, later ceasing to meet the PFIC tests does not necessarily remove the historic PFIC treatment for you.
In some cases, special elections, including deemed sale or deemed dividend elections, may be used to address earlier PFIC status. These rules can become fairly technical, so this is generally something to review before making changes to the investment.
How can I avoid investing in a PFIC?
PFIC problems are often easier to deal with before an investment is purchased rather than after. If you are a US citizen or Green Card holder investing outside the US, it can help to check:
- where the fund or company is domiciled
- whether you are buying an individual company share or a pooled foreign fund
- whether the company appears to meet either PFIC test
- whether the investment provides the information required for a QEF election
- whether a US-domiciled alternative is available and appropriate for your circumstances
Individual shares in an active foreign operating company are not automatically PFICs. Foreign mutual funds and foreign-domiciled ETFs, however, deserve much closer attention.
A little tax planning before buying can save a considerable amount of reporting work later.
Frequently Asked Questions
Is a foreign ETF automatically a PFIC?
Not automatically, although many foreign-domiciled ETFs may meet the PFIC tests because of the nature of their income and assets. The underlying entity still needs to be analyzed under the PFIC rules.
Are PFIC rules based on where I live?
No. PFIC rules generally apply because of your status as a US taxpayer and your ownership of a qualifying foreign corporation, not simply because you live in a particular country. US citizens and other US persons living abroad can therefore encounter PFIC rules when investing locally.
Can I make a QEF election for any PFIC?
Potentially, but the PFIC must normally provide a compliant PFIC Annual Information Statement or sufficient information to calculate the shareholder’s ordinary earnings and net capital gain. Many foreign funds do not provide this information, making a valid QEF election impractical.
What happens if I discover a PFIC from a previous tax year?
A previously unreported PFIC may affect earlier US tax returns and Form 8621 filing requirements. The appropriate action depends on factors such as when the investment was purchased, whether distributions or gains occurred, and whether any PFIC election was available or made. It is usually worth reviewing the earlier years before simply reporting the investment prospectively.
Can a PFIC cause problems even if the investment has fallen in value?
Yes. A fall in value does not automatically eliminate PFIC reporting requirements, and the treatment of a loss depends on the PFIC regime that applies. For example, deductions under a mark-to-market election are subject to specific limitations.
Do PFIC rules apply to investments held through another foreign company?
They can. PFIC ownership may be direct or indirect, and special look-through and ownership rules can apply where foreign corporations or other entities sit between the US taxpayer and the underlying PFIC. This can make multi-tiered foreign investment structures more complicated than directly held investments.
