What is a Passive Foreign Investment Company or PFIC, and why is a PFIC a potentially punitive tax consequence? Why is it important for any U.S. expatriate or U.S. taxpayer living or investing overseas to understand the concept of a PFIC and the implications these investments have on income tax in the United States?
Key Takeaways of Why is a PFIC a Potentially Punitive Tax Consequence:
- The IRS generally defines a Passive Foreign Investment Company (PFIC) as an offshore, non-U.S. (foreign) corporation that generates 75% or more of its income from passive sources (such as rental income, dividends, foreign currency gains, annuities, or royalties).
- The IRS considers many foreign mutual funds, Exchange Traded Fund or ETF, investment trusts, offshore Real Estate Investment Trusts (REITs), pension plans, and offshore hedge funds to qualify as a PFIC.
- PFIC investments are taxed at the highest marginal tax rate (presently 37%), and often require substantial expense to convert offshore reports and financial data into U.S. standards (GAAP) before completing IRS and state tax returns.
A “Top-Down” Approach to Determine if an Offshore Investment Qualifies as a PFIC
PFIC regulations apply a “top-down” approach to determine and attribute ownership of a PFIC-related stock by a U.S. taxpayer through all tiers of ownership structures. Several years ago, the regulations applied only to structures involving pass-through entities. PFIC classifications now encompass all qualifying ownership structures, including corporations and trusts.
Why is a PFIC a Potentially Punitive Tax Consequence for any U.S. taxpayer? The IRS PFIC regulations generally stipulate that a foreign corporation is considered a PFIC if 75% or more of its gross income is “passive” and at least 50% of its assets produce passive income (or are held with the expectation of delivering passive income). U.S. taxpayers who have ownership in a PFIC and receive either a distribution from the corporation or realize a gain as a result of PFIC ownership are faced with special taxes and interest charges.
PFIC shareholders must file Form 8621 (an informational form) that discloses their PFIC investments and activities.
The IRS has recently taken substantial measures to clarify the definition of a “shareholder” and how and when a U.S. taxpayer will be taxed as an indirect owner of stock in a foreign corporation through a U.S. corporation. However, IRS rules also stipulate that a “US person” will not be considered a PFIC shareholder based on ownership of PFIC stock through a tax-exempt entity.
IRS PFIC regulations include a “nonduplication rule” to clarify specific language in the previous tax regulations that could have been interpreted to assess the “same” ownership interest across multiple U.S. persons of the same stock of a fund under Section 1291 of the IRC. The IRS will determine the interest held in a foreign corporation that is not a PFIC by assuming that anyone who owns 50% or more of the stock of a U.S. corporation will be considered to own the same proportional percentage of any stock directly or indirectly held by that U.S. corporation.
Why is a PFIC a Potentially Punitive Tax Consequence for a U.S. Taxpayer?
Why is a PFIC a potentially punitive tax consequence for a U.S. taxpayer? Why is it important to review all offshore holdings, accounts, assets, and investments with an experienced international tax attorney and estate planning expert?
IRS PFIC regulations affect a substantial group of U.S. taxpayers, U.S. expatriates, and foreign U.S. residents with offshore interests. U.S. taxpayers with offshore investments must understand the ramifications of all foreign holdings, assets, and investments, as well as the associated tax regimes.
PFIC calculations maximize the tax applied to a foreign passive investment at the highest tax rate (marginal tax rate) in IRS tax tables (currently 37%). The IRS has, unfortunately, often applied this percentage indiscriminately (and incorrectly) to other assets in U.S. taxpayers’ portfolios.
Why is a PFIC a potentially punitive tax consequence for a U.S. taxpayer? It can generate substantially higher U.S. tax exposures, as well as additional expenses associated with converting supporting information to meet the tax reporting requirements of a U.S. taxpayer.
You need an experienced international tax attorney like Janathan L. Allen, supported by the integrated accounting, business, legal, and estate planning services and resources of Allen Barron. Unfortunately, U.S. Generally Accepted Accounting Principles (GAAP) differ significantly from International Financial Reporting Standards (IFRS) and other offshore accounting standards. It is often necessary to reconstruct substantiating information and reports from their original offshore format to the standards used to account for gains and losses, and complete resulting IRS and state tax returns.
It is not only important but essential for all U.S. taxpayers to remain informed about their tax exposures and the tax consequences of offshore assets and investments. If you have invested in a foreign mutual fund or a foreign trust, partnership, or corporation, your tax return will require expert preparation to reduce your exposures.
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.
