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Passive Foreign Investment Company (PFIC)

Passive Foreign Investment Company (PFIC)

What Is a Passive Foreign Investment Company (PFIC)?

A passive foreign investment company (PFIC) is a corporation, found abroad, which exhibits both of two conditions, in view of one or the other income or assets:

  1. Something like 75% of the corporation's gross income is "passive" — that is, derived investments or different sources not connected with standard business operations.
  2. Something like half of the company's assets are investments, which produce income as earned interest, dividends, or capital gains.

Understanding a Passive Foreign Investment Company — PFIC

PFICs first became recognized through tax reforms passed in 1986. The changes were intended to close a tax loophole, which some U.S. taxpayers were utilizing to shelter offshore investments from taxation. The organized tax reforms not just looked to close this tax avoidance loophole and bring such investments under U.S. taxation yet in addition to tax such investments at high rates, to deter taxpayers from following this practice.

Regular instances of PFICs incorporate foreign-based mutual funds and startups that exist inside the scope of the PFIC definition. Foreign mutual funds regularly are viewed as PFICs in the event that they are foreign corporations that generate over 75% of their income from passive sources, like capital gains and dividends.

Investments designated as PFICs are subject to severe and very convoluted tax rules by the Internal Revenue Service, depicted in Sections 1291 through 1298 of the U.S. income tax code. The PFIC itself, as well as shareholders, is required to keep up with accurate records of all transactions connected with the PFIC, for example, share cost basis, any dividends received, and undistributed income that the PFIC might earn.

The rules concerning cost basis give an illustration of the severe tax treatment applied to shares in a PFIC. With practically some other marketable security or another asset, a person who inherits shares is permitted by the IRS to step up the cost basis for the shares to the fair market value at the hour of the inheritance. Be that as it may, the step up in cost basis isn't normally permitted in that frame of mind of shares in a PFIC. Moreover, deciding the acceptable cost basis for shares in a PFIC is much of the time a difficult and confounding cycle.

PFICs and Tax Strategies

U.S. investors who own shares of a PFIC must file IRS Form 8621. This form is utilized to report actual distributions and gains, alongside income and expansions in QEF races. The tax form 8621 is an extensive, muddled form that the IRS itself evaluations might require over 40 hours to finish up. Hence, PFIC investors are generally encouraged to have a tax professional handle completion of the form.

In a year where there is no income to report, they don't have to worry about specific tax punishments. In any case, inability to register might deliver a whole tax return fragmented.

There are a few options for an investor in a PFIC that can reduce the tax rate on the shares. One such option is to try to have a PFIC investment recognized as a qualified choosing fund (QEF). Be that as it may, doing so may cause other tax issues for shareholders.

U.S. investors who own shares of a PFIC acquired before 1997 are not subject to the tax and interest system for their shares.

True Example of a Passive Foreign Investment Company (PFIC)

PFIC rules were modified by the 2017 Tax Cuts and Jobs Act (TCJA). The changes included an exception connecting with the insurance industry. For tax years beginning after December 31, 2017, the PFIC insurance exception turns out that a foreign corporation's revenue owing to an insurance business won't be viewed as passive income — except if the applicable insurance liabilities comprise over 25% of its total assets as reported on the corporation's applicable financial statement.

In December 2018, the IRS and the U.S. Treasury Department proposed changes to the rules of taxing PFICs. Whenever approved, the new regulation will reduce a portion of the existing rules from the Foreign Account Tax Compliance Act (FATCA) and will all the more unequivocally characterize an investment entity. More proposed changes were delivered in July 2019, seeking to explain the above insurance exception.

Highlights

  • U.S. investors who own shares of a PFIC must file IRS Form 8621.
  • A foreign corporation is a considered passive foreign investment company (PFIC) in the event that 75% or a greater amount of its gross income is from non-business operational activities (the income test), or possibly half of its average percentage of assets is held for the production of passive income (the asset test).
  • PFICs are subject to severe and incredibly confounded tax rules by the Internal Revenue Service.