Most tax issues can be difficult to navigate and understand; however, there is one set of regulations in particular that is especially complex. In the realm of international tax issues are the passive foreign investment company (PFIC) regulations, which came about as part of the 1986 Tax Reform Act. Prior to the PFIC rules, the use of a foreign corporation allowed for (1) the deferral of current U.S. taxation of income and (2) the conversion of ordinary income to capital gains, which are subject to preferential tax rates. Foreign corporations and foreign mutual funds were allowed to shelter taxable income, while U.S. mutual funds were required to distribute all investment income to investors. After the 1986 Tax Reform Act, foreign funds no longer had an advantage. Under the new regulations, there are several ways in which earnings can be taxed and often involve taxation under a penalty regime.

The PFIC provisions define certain foreign companies as PFICs using what are known as the income and asset tests. The provisions subject any U.S. person with ownership of a PFIC to taxation on distributions, whether or not reinvested, and disallow capital gain treatment on the sale of PFIC shares.

As mentioned above, an entity or fund is defined as a PFIC if it meets either the income test or the asset test. The income test is met if 75% or more of income from the fund is from passive sources. Examples of passive income are interest, dividends, and capital gains. Under the asset test, a fund is a PFIC if 50% or more of the assets within the fund produce passive income or are reasonably expected to produce passive income. There are some exceptions to these rules, but most will fall within the boundaries of the income or the asset test. The most common type of PFIC held by U.S. persons is a foreign mutual fund.

So what does ownership of a PFIC mean to U.S. taxpayers? There are several ways a PFIC can be taxed, which is determined by what method a taxpayer chooses. These methods obligate the PFIC owners to report undistributed earnings or be subject to harsh tax consequences when earnings are distributed or the investment is sold. There are rules and limitations imposed by the IRS on each method that can potentially be selected, which we will discuss in the next post in this series.

If you are invested in a PFIC or have questions related to the classification and taxation of PFICs, we recommend you contact a tax professional to ensure you are abiding by all reporting requirements.

Over the next few weeks we will discuss PFIC reporting issues in more detail.