What is a PFIC?
A foreign corporation will qualify as a PFIC if 75 percent or more of the foreign (i.e. non-US) corporations’ gross income were passive income. Passive income includes interest, dividends, rents and royalties. In addition, under the asset test, a foreign corporation is also considered a PFIC if 50 percent or more of the average value of its assets consist of assets that produce, or that are held for the production of, passive income.
Why were the PFIC rules introduced?
The PFIC regime was introduced in the Tax Reform Act of 1986 in order to dissuade US persons from sheltering investment income in offshore corporations and to remove any tax advantage previously present for US persons investing in non-US mutual funds as opposed to US mutual funds.
How are PFICs taxed?
A US investor who owns an investment which is considered a PFIC is subject to 1 of 3 taxation schemes.
- 1) Excess distribution regime.
- 2) Qualified electing fund (QEF) regime.
- 3) Mark-to-market (MTM) regime.
The taxation scheme to avoid is the ‘excess distribution regime’ as it is designed to prevent the tax-deferred accumulation of passive income in a foreign investment in a manner that defers current taxation of the US investor’s portion of such income. To accomplish this purpose, the ‘excess distribution regime’ imposes an interest charge on any passive income not being taxed on in the year that it was earned, i.e. income which was deferred. The interest charge is assessed when a US investor receives an ‘excess distribution’ from the foreign investment or sells shares in a PFIC at a gain (i.e., disposes of the foreign investment).
QEF election
A US investor can avoid the interest charge associated with the excess distribution regime by making a timely election to treat the investment in the PFIC as a “Qualified Electing Fund”. Under this regime, the US investor will annually include in income their pro-rata share of the passive income earned by the foreign investment. To make this election, the US investor must make the election on Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, (Election A of the form for a QEF) in the first year that the investment was made or the PFIC shares were acquired.
MTM election
Finally, a US investor may also make a MTM election under the mark-to-market regime to avoid the interest charge imposed otherwise. To clarify, a US investor of a PFIC may make an election to mark-to-mark their interest in the PFIC if such stock is marketable (e.g., the PFIC is a publicly traded company). Under this election, the US investor will pay US income taxes the fair market value of the PFIC stock at the close of the taxable year over the US investor’s adjusted basis in the stock. The US investor must make the election on Form 8621 (Election C of the form) in the first year that the investment was made or the PFIC stock was held.
Typical UK type investments to look out for
Any foreign corporation which meets either of the asset or income tests is a PFIC. Typical UK types of investments which will be considered PFICs are UK unit trusts, UK ETFs, UK mutual funds, stocks and share ISAs (which contain PFICs).