PFIC Tax & Reporting Explained
A PFIC is a Passive Foreign Investment Company, as defined by the Internal Revenue Code in accordance with IRC 1291.PFIC Form Filing Requirements
26 U.S. Code § 1291 – Interest on tax deferral
A Section 1291 Fund is a PFIC (Passive Foreign Investment Company) and it receives different tax treatment than other foreign passive investments.
As defined by the code:
If a United States person receives an excess distribution in respect of stock in a passive foreign investment company, then—
(A) the amount of the excess distribution shall be allocated ratably to each day in the taxpayer’s holding period for the stock,
(B) with respect to such excess distribution, the taxpayer’s gross income for the current year shall include (as ordinary income) only the amounts allocated under subparagraph (A) to—
(i) the current year, or
(ii) any period in the taxpayer’s holding period before the 1st day of the 1st taxable year of the company which begins after December 31, 1986, and for which it was a passive foreign investment company, and
(C) the tax imposed by this chapter for the current year shall be increased by the deferred tax amount (determined under subsection (c)).
(2) Dispositions If the taxpayer disposes of stock in a passive foreign investment company, then the rules of paragraph (1) shall apply to any gain recognized on such disposition in the same manner as if such gain were an excess distribution.
General Rules of PFIC
Here are some of the more common PFIC rules, formulated in a Question and Answer format for you:
How is itTaxed?
It depends on whether:
- It is an Excess Distribution
- It is a Non-Excess Distribution
- An MTM or QEF election was made
How is Excess Distribution Calculated?
The calculation for an Excess Distribution is very detailed, and has multiple steps.
Is a Foreign Mutual Fund a PFIC?
Yes, since since it will almost always meet the 50% asset test or 75% income test under 1291 et seq.
Do you Pay Tax on Foreign Mutual Funds?
Yes. But, since most Foreign Mutual Funds are considered PFIC, the tax analysis is much complex (and complicated).
What about ETFs?
Yes, generally they will also be considered PFIC, since they generally function in the same vein as Mutual Funds.
Can you be a PFIC and CFC?
Yes. But, you may be limited in having to report both, and you may be able to avoid duplicate reporting (generally, the CFC status reporting trumps PFIC reporting)
What Kind of Elections are Available?
In order to reduce taxes on PFIC, you may be able to make an election. The two elections are QEF (Qualified Electing Fund) and MTM (Mark-to-Market)
PFIC Mutual Funds
Under the current tax rules, a foreign mutual fund is generally characterized as a PFIC.
The reason we emphasize the Foreign Mutual Fund as a PFIC because it is not a commonly known or understood item to be characterized/classified as a PFIC.
When somebody creates a holding company and proactively places various passive income investments into the holding company, they made a proactive step in forming a company – and therefore reporting comes as no big surprise.
Conversely, it is a bit overwhelming (to say the least) to impost complex tax calculations on a U.S. person simply because they hold foreign mutual funds as part of their portfolio — but unfortunately, that is the current state of the law.
Typically, when a person has a PFIC, they are required to file IRS form 8621. There are some exceptions and exclusions to filing the form, but generally the form is required. This is true, even if there is no income generated from the PFIC.
There are certain ways to avoid the significant fines and penalties and individual faces when they hold onto an undisclosed PFIC, and then receive what is called an excess distribution. Unfortunately, one of the elections QEF is very difficult if not for the mere fact that it requires cooperation between your foreign investment fund and the IRS — typically, foreign investment funds do not willingly engage the IRS anymore than they have to.
Alternatively, the MTM election can be very beneficial, but late elections are rarely allowed unless a person submits to a full-blown OVDP (as of July 2017 streamlined submissions do not allow for the MTM election).
A Qualified Electing Fund or (QEF) Status is one method for US investors of PFICs to try and limit punitive nature of the US tax regime on PFIC investments. By making a QEF election (which is very strict requirements and time limitations) it allows the foreign PFIC to be treated as a U.S. investment for IRS tax purposes. As a result, capital gains are taxed at the capital gain rate, while income is taxed at the income tax rate – as opposed to a PFIC where all “earnings” are taxed at the highest tax bracket.
The biggest hurdle in achieving a QEF election is that the foreign fund is now going to have to meet IRS tax reporting requirements. For the most part, the reason why US investors invest in a PFIC is to avoid this type of reporting requirement. Moreover, most foreign fund managers are not going to want to take the time and effort to ensure compliance with IRS requirements – especially now that FATCA has begun enforcement.
*Overall, the QEF status is generally better than a MTM (market-to-market election – which requires recognition on the annual increase or decrease in market value as ordinary income or loss, with losses being limited) or excess distribution regime. The QEF election is made on form 8621.
**The failure to having reported the PFIC on your FBAR may lead to significant tax consequences, fines and penalties. If you own a PFIC and have not properly reported or disclosed your foreign earnings, you should consider entering one of the approved IRS Offshore Voluntary Disclosure programs.
With the Mark-to-Market election, the investor is making the decision to pay tax on the gains each year, despite the fact that no money is being distributed from the fund. For example, let’s say David owns $100,000 worth of a foreign mutual fund. The fund does great, and David’s fund is now worth $120,000 on the last day of the year.
Even though the investment is not distributing any of the gain to David, he will still pay tax on the $20,000 gain. Moreover, David will pay tax at the ordinary income tax rate, and not any beneficial qualified dividend tax rate. In addition, it should be noted that when the fund loses money, David is highly restricted as to what losses he can take against the gains the already paid tax on.
An Excess Distribution is the catalyst that sparks this complex tax analysis. Essentially, an excess distribution is a distribution in the current year, which exceeds 125% of the average of the three prior years. In this particular scenario, there were no prior distributions and this is not the first year of the investment, therefore it is an excess distribution.
The IRS wants payback for the time your Foreign Mutual Fund was sitting overseas and growing – but not being taxed. Had the investment been in a U.S. mutual fund, it would’ve been distributed annually (even if immediately reinvested) and you would have been taxed (albeit at a lower tax rate). This is the IRS’ opportunity to get that money back from you.
The IRS is going to tax you for each year you held the investment and the IRS is going to tax you at the highest ordinary income tax rate available each year for the portion of the investment earnings allocated for that year (even if you are not in the highest tax bracket). In addition, the IRS is going to tack on interest for the unpaid allocations that you didn’t pay timely, in accordance with the amount of tax allocated for each tax year of total tax amount, even though the tax amount is only being determined for the first time right now with this initial distribution…simple, right?
First Distribution vs. Distribution in 1st Year of Investment
If you receive a distribution in the first year of your investment, it is typically never an “Excess” distribution, since there is nothing for it to be in “excess” of. This is different than receiving a “First Distribution” many years after the initial investment.
No Election, and No Distribution?
While if you do not make an election, you will not tax until you begin receiving distributions, it is important to understand that your first distribution will most likely be an excess distributions the prior-year distributions will be zero.
Thus, when you are finally receiving distributions the tax liability case, including having all of the money that is distributed tax at the highest ordinary income tax-free available during each year you held the investment, calculated per day – with interest.
The current year you are taxed at your own ordinary income rate. In other words, even if you receive long-term capital gain qualified dividends it will still be taxed at the ordinary action.
One of the most brutal aspects of failing to file Form 8621 is that such a failure to file suspends the statute of limitations. In other words, if a person fails to file form 8621, then the IRS can audit the entire return “forever” and would not otherwise be barred by the general statute of limitations.
Under ordinary circumstances, an individual can only be audited on the return for three years (presuming the return was filed timely – if no return was filed, the statue limitations does not even begin). The idea behind a Statute of Limitations is that it provides a form of closure for an individual to know that the tax return was filed and accepted by the IRS; it would be unfair to allow the IRS audit you “forever,” as documents and memories fade over time.
There are other circumstances in which the IRS can audit you for six years instead of three years (significant unreported income from U.S. or domestic sources) or no statute of limitations if the IRS can prove fraud. Fraud is a lot different than unknowingly not filing a Form 8621 because you never even heard of the form.
If you have not reported any of your PFICs — probably also means you never filed an FBAR in those years, you may consider entering the IRS offshore voluntary disclosure program to try to get back into compliance before it is too late.
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