PFIC - Passive Foreign Investment Company Tax Attorneys | Golding & Golding

PFIC – Passive Foreign Investment Company Tax Attorneys | Golding & Golding

A PFIC is a Passive Foreign Investment Company. In an attempt to dissuade U.S. taxpayers from investing in foreign mutual funds, investments funds, and foreign corporations in general, the U.S. has implemented very complicated and punitive PFIC Tax Rules. In other words, U.S. taxation of a PFIC for U.S. investors is very complicated.

If you are considering investing in a PFIC (which generally will consist of foreign mutual funds) then it is important that you speak with an experienced international tax attorney to assess your options and determine which tax regime will work best for you.

PFIC – Introduction

A PFIC is a Passive Foreign Investment Company. It is a foreign company in which at least 75% of the company’s income is derived from passive earnings or at least 50% of the average percentage of assets (determined under section 1297(e)) held by the foreign corporation during the taxable year are assets that produce passive income or that are held for the production of passive income. 

Unlike CFC rules (Controlled Foreign Corporations) in which a US investor must meet certain threshold requirements of ownership in order to be subject to CFC rules, any ownership in a PFIC will subject a US individual to PFIC rules (although reporting requirements and Tax Liability as reported on Form 8621 might be limited, depending on the amount of ownership and whether an “excess distribution” has taken place.)

For many years a PFIC was a great way to invest overseas and avoid discovery by the U.S. Government of your foreign earnings and income. Unfortunately, with the implementation of FATCA (Foreign Account Tax Compliance Act), FBAR Compliance and Reporting (Report of Foreign Bank And Financial Accounts) and various other forms that must be filed involving foreign businesses (8938, 3520, 3520-A, 5471, 5472, 8621) – the benefits of a PFIC are often outweighed by the reporting requirements and penalties associated with the failure to report and disclose.

One of the biggest detriments to PFICs is that U.S. Shareholders generally have to pay Income Tax on distributions and other appreciation of asset values, even if the income would be labeled “Capital Gains” for the same investment if it was made in the United States, unless certain elections are made (although these elections may result in other unintended income).

While the U.S. Shareholder investor may have the option to treat the PFIC as a QEF (Qualified Electing Fund) or elect MTM (Mark-to-Market) treatment and have the class of income such as Capital Gains to be taxed at Capital Gain rates, there are other pitfalls to consider as well.

Cons to Investing in a PFIC

There are several negatives to investing in a PFIC; for most people, these negatives outweigh the positives of these types of foreign investments:

Form 8621: Even from the IRS perspective, IRS Form 8621 is a monster of a form which requires upwards of 20-30 hours to prepare each year, and now must be filed even if no distributions were made. Most CPAs and tax attorneys (assuming either professional knows how to prepare the form), charge upwards of $10,000 to prepare the form. (The exceptions for individuals to not have to file this form are very limited).

Tax Rate: Unless an investor elects otherwise, the tax rate for all earnings in PFICs are at income tax rate, in addition to various interest charges for excess distributions (which are taxed at the highest tax rate irrespective of the net effective tax rate of the Taxpayer). Thus, the taxes far exceed the tax rate for the same investment under U.S. Capital Gains Tax rules.

Additional Taxes: U.S. investors in PFICs may be subject to tax and interest charges on any “excess distributions” from a PFIC, including any gain on the disposition of PFIC stock. An excess distribution is the amount of a distribution received from a Sec 1291 fund which is over 125% of the average of the last three year’s distributions. (This calculation is very complex and beyond the scope of this introductory article on PFICs)

Capital Losses: Generally, capital losses cannot be carried forward in a foreign PFIC whereas if the investment was made in a U.S. mutual fund, the losses can be carried forward.


General PFIC Tax Rules

A U.S. investor in a PFIC is able to defer payment of U.S. tax until earnings are distributed or PFIC stock is sold. But, no matter what the character of the distribution is, the U.S. taxpayer is taxed at the maximum ordinary income tax rates instead of capital gain rates.

Moreover, the investors pays a retroactive interest charge on excess distributions to offset the deferral period of when the income was not distributed. In other words, the IRS is charing an interest rate for the time-period in which the excess distributions were being held but not distributed for a retroactive three-year period.


Electing QEF Status

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, please read our summary below on FBAR Reporting and Compliance, OVDP and Streamlined Submissions.


IRS Voluntary Disclosure of Offshore Accounts

Offshore Voluntary Disclosure Tax law is very complex. There are many aspects that go into any particular tax calculation, including the legal status, marital status, business status and residence status of the taxpayer.

When Do I Need to Use Voluntary Disclosure?

Voluntary Disclosure is for individuals, estates, and businesses who are out of compliance with the IRS and the Department of Treasury. What does that mean? It means that if you are required to file a U.S. tax return and you don’t do so timely, then you are out of compliance.

If the IRS discovers that you are out of compliance, you may become subject to extensive fines and penalties – ranging from a warning letter all the way up to tax liens, tax levies, seizures, and criminal investigations. To combat this, you can take the proactive approach and submit to Voluntary Disclosure.

Golding & Golding – Offshore Disclosure

At Golding & Golding, we limit our entire practice to offshore disclosure (IRS Voluntary Disclosure of Foreign and U.S. Assets). The term offshore disclosure is a bit of a misnomer, because the term “offshore” generally connotes visions of hiding money in secret places such as the Cayman Islands, Bahamas, Malta, or any other well-known tax haven jurisdiction – but that is not the case.

In fact, any money that is outside of the United States is considered to be offshore; the term offshore is not a bad word. In other words, merely because a person has money offshore (a.k.a. overseas or in a foreign country) does not mean that money is the result of ill-gotten gains or that the money is being “hidden.” It just means it is not in the United States. Many of our clients have assets and bank accounts in their homeland countries and these are considered offshore assets and offshore bank accounts.

The Devil is in the Details…

If you do have money offshore, then it is very important to ensure that the money has been properly reported to the U.S. government. In addition, it is also very important to ensure that if you are earning any foreign income from that offshore money, that the earnings are being reported on your U.S. tax return.

It does not matter whether your money is in a country that does not tax a particular category of income (for example, many Asian countries do not tax passive income). It also does not matter if you are a dual citizen and/or if that money has already been taxed in the foreign country.

Rather, the default position is that if you are required to file a U.S. tax return and you meet the minimum threshold requirements for filing a U.S. tax return, then you have to include all of your foreign income. If you already paid foreign tax on the income, you may qualify for a Foreign Tax Credit. In addition, if the income is earned income – as opposed to passive income – and you meet either the Bona-Fide Resident Test or Physical-Presence Test, then you may qualify for an exclusion of that income; nevertheless, the money must be included on your tax return.

What if You Never Report the Money?

If you are in the unfortunate position of having foreign money or specified foreign assets that should have been reported to the U.S. government, but which you have not reported —  then you are in a bit of a predicament, which you will need to resolve before it is too late.

As we have indicated numerous times on our website, there are very unscrupulous CPAs, Attorneys, Accountants, and Tax Representatives who would like nothing more than to get you to part with all of your money by scaring you into believing you are automatically going to be arrested, jailed, or deported because you have unreported money. While that is most likely not the case (depending on the facts and circumstances of your specific situation), you may be subject to extremely high fines and penalties.

Moreover, if you knowingly or willfully hid your foreign accounts, foreign money, and offshore assets overseas, then you may become subject to even higher fines and penalties…as well as a criminal investigation by the special agents of the IRS and/or DOJ (Department of Justice).

Getting into Compliance

There are five main methods people/businesses use to get into compliance. Four of these methods are perfectly legitimate as long as you meet the requirements for the particular mechanism of disclosure. The fifth alternative, which is called a Quiet Disclosure a.k.a. Silent Disclosure a.k.a. Soft Disclosure, is ill-advised as it is illegal and very well may result in criminal prosecution.

We are going to provide a brief summary of each program below. We have also included links to the specific programs. If you are interested, we have also prepared very popular “FAQs from the Trenches” for FBAR, OVDP and Streamlined Disclosure reporting. Unlikes the technical jargon of the IRS FAQs, our FAQs are based on the hundreds of different types of issues we have handled over the many years that we have been practicing international tax law and offshore disclosure in particular.

After reading this webpage, we hope you develop a basic understanding of each offshore disclosure alternative and how it may benefit you to get into compliance. We do not recommend attempting to disclose the information yourself as you may become subject to an IRS investigation insofar as you will have to answer questions directly to the IRS, which you can avoid with an attorney representative.

If you retain an attorney, then you will get the benefit of the attorney-client privilege which provides confidentiality between you and your representative. With a CPA, there is a relatively small privilege which does provide some comfort, but the privilege is nowhere near as strong as the confidentiality privilege you enjoy with an attorney.

Since you will be dealing with the Internal Revenue Service and they are not known to play nice or fair – it is in your best interest to obtain an experienced Offshore Disclosure Attorney.