U.S. taxpayers with offshore investments should be wary of PFICs (Passive Foreign Investment Company). Many foreign nationals live and work in the United States. For those who invest in offshore companies that generate income in a passive nature (i.e. rents, royalties, interest, income from commodities or derivative trading) are permanent residents or have received their green card or other qualifying visa, it is important to understand your requirements as a US taxpayer and the impact your foreign investments may have upon the taxes you will owe to the IRS.
Important Takeaways About Why U.S. Taxpayers with Offshore Investments Should be Wary of PFICs:
- A Passive Foreign Investment Company or PFIC is a foreign corporation that generates 75% or more of its gross income in a “passive” manner, or, if the 50% or more of the average value of the foreign company’ assets (fair market or on an adjusted basis) produce passive income.
- Passive income includes, but is not limited to, interest, rents, royalties, dividends, investment income, as well as income from trading derivatives or commodities.
- The types of foreign assets held by a company that qualifies as a PFIC often include real estate held for appreciation or rental income, a portfolio of investments that include mutual funds, stocks, bonds, or even cash or digital assets held for the purpose of investment.
- Foreign mutual funds, offshore Real Estate Investment Trusts (REITs), Deposits held by a foreign corporation in a foreign bank, offshore hedge funds or private equity, and offshore investment trusts often qualify as a PFIC under IRS rules.
What is a PFIC?
Under IRS rules, a Passive Foreign Investment Company or PFIC is either:
– a foreign corporation that generates 75% or more of its gross income in a “passive” manner
– a foreign company where 50% or more of the average value of the foreign company’ assets (fair market or on an adjusted basis) produce passive income
Many foreign nationals have offshore savings and investments prior to their arrival in the United States. Often they have invested in offshore mutual funds and other investments that fall under the IRS classification as a “Passive Foreign Investment Company” or PFIC. Foreign mutual funds, offshore Real Estate Investment Trusts (REITs), Deposits held by a foreign corporation in a foreign bank, offshore hedge funds or private equity, and offshore investment trusts often qualify as a PFIC under IRS rules.
Passive income is usually generated through interest, rents, royalties, dividends, investment income, as well as income from trading derivatives or commodities. The types of foreign assets held by a company that qualifies as a PFIC often include real estate held for appreciation or rental income, a portfolio of investments that include mutual funds, stocks, bonds, or even cash or digital assets held for the purpose of investment.
Why Should a U.S. Taxpayer Be Concerned about PFIC Issues?
Why should every U.S. taxpayer be concerned about the nature of their offshore investments? Basically, U.S. tax code is designed to prevent U.S. taxpayers from sheltering investment income or assets outside of the United States. The simple reason: heavy taxes and onerous reporting requirements.
If any of your investments qualify as a PFIC under IRS tax regulations, you will be required to pay the highest personal income tax rate (currently 37%) on all associated income. This is much higher than the typical capital gains tax for like investments that do not qualify as a PFIC. Foreign nationals living and working in the United States, U.S. expatriates, and U.S. offshore investors should beware of PFICs and the heavy taxation and reporting requirements that could result.
How Does the Difference Between U.S. GAAP Accounting and IFRS Affect PFIC Reporting and Taxation?
Another factor in the PFIC equation is the difference between U.S. GAAP accounting principles and the International Financial Reporting Standards (IFRS), used by the European Union and more than 135 other international jurisdictions.
Therefore, the process to determine how and when income is realized (and taxed) is completely different here in the Unites States than in most tax jurisdictions around the world. Reports generated using the IFRS standard fail to provide many of the details necessary to complete IRS tax forms and calculate income and associated taxes. The result: an extensive accounting process to establish and document investment-related data in order to establish “basis,” as well as the actual amount of income (gain) or loss under U.S. tax laws, and complete all associated IRS calculations and tax forms.
Many foreign nationals and U.S. taxpayers are quite disturbed to learn that one or more of their investments qualifies as a PFIC, and are shocked by the exceptionally high tax rates as well as the associated expense of preparing IRS tax returns. If any of your holdings qualify as a PFIC you will need the advice of a seasoned international tax attorney with extensive experience with FinCEN Form 114 (Often referred to as an FBAR) as well as accounting and IRS reporting requirements.
PFIC is a Punitive IRS Tax Regime
The failure to accurately report offshore activities that qualify as PFIC investments is quite punitive. When a U.S. taxpayer sells a PFIC investment generating a gain (or if the PFIC makes an “excess distribution”), the IRS will spread that income across all years during which the taxpayer held that specific investment. Remember, each year’s portion of income would then be taxed at the highest marginal rate as well as “non-deductible interest” based on the time the taxpayer held the asset in which income was generated.
The effective resulting tax rate on a PFIC investment can therefore exceed 50% to 60%, serving as a punitive penalty for failure to accurately account for and report PFIC income. This is why U.S. taxpayers with offshore investments should be wary of PFICs (Passive Foreign Investment Company).
Janathan Allen provides insightful international tax planning and legal advice for US residents, US taxpayers and those who are involved in business and investment overseas.
We invite you to learn more about the integrated tax, legal, accounting and business consulting services of Allen Barron and contact us or call today to schedule a free consultation at 866-631-3470.
Learn more about your tax exposure, PFICs and FBAR reporting requirements.
