Passive Foreign Investment Companies (PFICs)
In this post:
- What is a PFIC?
- Definition of PFIC
- Deep dive into PFIC definition
- Gross Income Test
- Asset Test
- Exceptions – What is not PFIC?
- Controlled Foreign Corporations (CFCs)
- Limited exceptions
- Changes in business
- Once a PFIC, Always a PFIC
- PFIC Look-through rules
- Tax Consequences of PFIC
- How PFICs are taxed?
- Excessive distribution regime
- Qualifying Electing Fund (QEF) regime
- Mark-to-Market (MTM) regime
- Late QEF Elections
- Form 8621 and penalties
- Final Word
If you are an American living in Canada, it is most likely that you have come across the term PFIC. PFIC is an acronym used for Passive Foreign Investment companies. Many U.S. citizens or resident aliens, often unintentionally fall into this PFIC trap just because they simply did not know that the PFIC regime exists altogether.
Since TCJA in 2017, there is more and more awareness around the foreign corporations of U.S. persons. Most U.S. persons (U.S. citizens, green card holders, or U.S. resident aliens) are now aware of the Controlled Foreign Corporations (CFC) regime, Subpart F Income, or GILTI inclusion to some extent. It is important to know that if a foreign corporation is both a CFC and a PFIC, you apply CFC rules first.
In this post, we will look at PFIC rules at a very high level! Readers must exercise caution and not consider this as tax advice. Always consult your Cross-border tax accountant in Canada or the United States to get the most up-to-date information on foreign assets reporting requirements.
What is a PFIC?
The definition of a Passive foreign investment company is provided in IRC § 1297.
PFIC is a non-U.S. (foreign) corporation, that meets either a gross income test or a passive assets test.
PFIC determination is made on annual basis, i.e. a corporation that is not a PFIC in 2021 may become a PFIC in 2022.
Ownership Requirement for a PFIC
There is no minimum ownership requirement for a foreign corporation to be classified as a PFIC. So, if you have a Canadian corporation and escaped the CFC regime, bear in mind that the corporation may become a PFIC!
That’s why it is very important to pay close attention to the income and assets mix of foreign corporations.
Gross Income Test
The gross income test is one of the two tests provided in IRC § 1297. If a corporation meets the Gross income test, it is a PFIC. If it does not meet the gross income test, the asset test is next!
Per IRC § 1297 (a)(1) …that if 75 percent or more of the gross income of such corporation for the taxable year is passive income. IRC § 1297 (b)(1) further defines passive income whereas 1297(b)(2) provides exceptions to passive income.
What is Passive Income
Passive income is defined as income of any kind that can be classified as foreign personal holding company income under IRC § 954(c):
- Dividends, rents, royalties, interests, and annuities.
- Certain Property transactions that involve the excess of gains over losses from the sale/exchange of the property, or an interest in a partnership, trust REMIC and it does not give rise to more income.
- Commodities Transactions
- Foreign currency gains
- Income equivalent to the interest which includes income from commitment fees or for actuals loans.
- Income from notional principal contracts
- Payments in lieu of dividend
- Personal service contracts
Exceptions to Passive Income
There are a few exceptions to passive income. § 1297(b)(2) provides some exceptions whereas § 954(c) some more exceptions.
§ 1297(b)(2) exceptions:
- Income from the active banking business, or qualified insurance corporation, that would otherwise be classified as passive income.
- If passive income is in the form of rent, interest, royalties, or dividends from a related person and such income are allocable to the active business of that person.
§ 954(c) exceptions cover four major exceptions
- Active rents and royalties income
- Certain export financing interests derived from the banking business
- Dealer’s exception
- Certain income from related persons
How to Measure Gross Income
IRC § 1296 does not add a lot of details on the measurement of gross income. There is, however, a private letter ruling (PLR 9447016) that provides some clarification to apply Section 11 and Section 61 for this purpose.
Under Section 61, gross income is the sum of two numbers:
- Gross Margin (Gross receipts less cost of goods sold). Please note that § 162 deductible expenses, such as salaries, interest taxes or depreciation, that are not included in the cost of goods sold are not taken into account for gross income test purposes.
- Interest, dividends, and other items of income.
The asset test is the second test provided in IRC § 1297 to determine the status of a PFIC.
Per IRC § 1297 (a)(2) that …the average percentage of assets (as determined in accordance with subsection (e)) held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50 percent.
If a corporation meets the asset test (and not the passive income test) it may be still classified as a PFIC.
Measuring Passive Assets
The definition of passive assets is simple i.e. if the assets produce passive income, then they are passive assets. Even if assets are reasonably expected to produce passive income, they are passive assets.
Furthermore, there are 2 directives, to measure the value of the asset:
Based on Fair Market Value with respect to Publicly traded and non-publicly traded companies as they do not elect to use an adjusted basis.
Based on an Adjusted basis with respect to CFCs and non-publicly traded companies. It is measured quarterly and then averaged (quarter-end amounts). Also, while mearing the passive assets, the liabilities are not considered.
For measuring passive assets under the PFIC regime, IRS clarified the following Asset classes under Notice 88-22:
- Depreciable property used in trade or business which itself is non-passive and produces non-passive income is non-passive.
- Trade or service receivables could be either passive or non-passive depending on the nature of the business.
- Intangible Assets could be either passive or non-passive depending on the nature of the business. Patents, licenses, goodwill, etc.
- Working Capital includes cash and assets that are convertible into cash are passive.
- Stock and Securities are passive unless held by a dealer as inventory. However, they are subject to the Look-through rule.
- Tax-exempt assets are securities that produce tax-exempt income unless held by a dealer as inventory or the active bank exception also applies.
Examples of PFICs
Common examples of a PFIC include pension funds, hedge funds, and insurance companies based outside of the US.
In the Canadian context, Candian-domiciled mutual funds, or exchange-traded funds (ETFs) are PFICs.
Canadian corporations, whether CCPC or OPC who are not CFCs may be subject to PFIC rules if they meet either income or asset test. Rember, there is no minimum ownership rule for a PFIC.
When a Canadian individual moves to the United States and becomes a U.S. resident for tax purposes, it is extremely important to plan the move well ahead. First CFC rules are applied and if the corporation is not a CFC, PFIC rules are applied. The mere holding of cash in the corporation may push it into a PFIC category.
PFIC – Exceptions
So far, we can see how easy is it for a corporation to become a PFIC. However, there are three exceptions to PFIC rules:
It is possible for a corporation to be both a CFC and a PFIC. In this case, only CFC rules are applicable. Since CFC determination is done for each U.S. shareholder, it is quite possible that the same foreign corporation is a CFC for some shareholders whereas a PFIC for others.
Keep in mind in future years PFIC rules may apply to pre-CFC or post-CFC based on the PFIC proposed regulations issued in 2019.
Start-up Year Exception
IRC § 1298(b)(2) provides a limited exception for the startup year of a foreign corporation.
Under this exception, PFIC rules do not apply to a foreign corporation for the first taxable year it has gross income and no predecessor corporation of it was a PFIC. Further, the foreign corporation is not a PFIC for either of the next two years.
Change of Business Exception
This exception, normally known as the Change of Business exception, is applicable when a foreign corporation changes its business and has not been a PFIC. IRC § 1298(2)(3) further clarifies if the same foreign corporation was not a PFIC (or its predecessor) and it meets the passive income test due to the disposition of one or more active trades in the taxable year, and the corporation is not a PFIC for either of two next years,
Once a PFIC, always a PFIC
A corporation that is considered a PFIC for one tax year, is always a PFIC for U.S. tax purposes!
There are two ways to avoid this:
- Make the Qualified Electing Fund Treatment election in the first year of the taxpayer’s holding a foreign corporation that is a PFIC.
- Purging election, the deemed dividend or the deemed-sales elections, can be generally done within one year following the first year when the foreign corporation became PFIC.
PFIC Look-through Rules
Three important look-through rules are below:
- General subsidiary look-through rules – IRC § 1297(c). Generally applies to all tiers where there is 25% or more ownership.
- Related person look-through rules – IRC § 129(b)(2)(c). Related persons are where there is a control or common control under 954(c).
- Domestic subsidiary look-through rules – IRC § 1298(b)(7). The foreign corporations owned 25% or more of a domestic corporation that owns qualified stock in a domestic subsidiary, and that foreign corporation is subject to accumulated earnings tax subject to treaty protection.
For more details on these look-through rules, refer to the IRC sections mentioned above.
PFIC – Tax Consequences
Though there might be some advantages, a PFIC generally results in a disadvantageous tax outcome for its owners.
There are four major disadvantages:
- Long-term capital gains are not available for the gains on the disposition of PFIC shares.
- The dividends received by individual shareholders are not eligible for a qualified dividend rate of 20%.
- If a PFIC realizes losses, these losses do not pass on to its individual shareholders.
- The deferred tax amount may even exceed the gain or the actual value of the PFIC shares. This happens in case of the excess distribution of unpedigreed PFIC.
As mentioned before there are some advantages that may happen if a QEF election is timely filed:
- PFIC, when QEF election is filed on time, qualifies as a pedigreed QEF. Capital gains of a pedigreed QEF are passed on to the shareholders and are taxed at applicable rates.
- When an individual disposes of QEF stock, Sec 1248 re-characterization of the gain as dividends is not applicable.
- Investment expenses at the fund level are deductible to reduce the ordinary income flowing to shareholders.
Taxation of PFIC – U.S. Owners
There are three distinct tax regimes applicable to the U.S. owners of a PFIC:
- Excess Distribution Regime – Default classification unless QEF or MTM election is made
- Qualified Electing Fund (QEF) Regime – to purge the PFIC
- Mark-to-market Election (MTM) Regime
Excess Distribution Regime
By default, the distributions from PFICs are taxed using Excess Distribution Regime.
The treatment under Excess Distribution Regime can be highly complex and punitive in terms of tax calculation. These rules charge special tax and interest using ordinary income tax rates. The interesting part is the fact that whether at the time of distribution, there are any Earning & Profits or Section 301 dividends or not is irrelevant. If there is an Actual Disposition, the Excess distribution is the one that is more than 125% of the past three years’ average distributions.
An actual distribution or even a gain on the disposition of PFIC stock can result in excess distribution.
For the purpose of calculating excess distributions, please note that excess distributions (i.e. > 25% of the prior 3 years’ average) for each prior year are not part of the calculation to determine average distributions. It also does not include income inclusions under Subpart F, or inclusions under Qualifying Fund Election (QEF).
When a PFIC stock is disposed of, the resulting gain is an excess distribution. If a PFIC stock is purchased and disposed of within the same year, it is still an excess distribution but no interest. Subject to certain exceptions, deemed transfers in addition to actual transfers are also dispositions.
If you hold shares of a PFIC, it is very important to discuss this with your cross-border tax professional every year. Many U.S. persons (Citizens, green cardholders or resident aliens) sometimes try to avoid income inclusion under GILTI by altering the ownership structures. Such decisions should be carefully evaluated. If your corporation avoids being a CFC it may become a PFIC, and then you’d wish it was a CFC!
So, if you are holding PFIC stock and realized sooner or later that there is a lot of fun involved with both reporting and tax costs, there might be some ways to manage it.
Next, we can quickly go over at a very high level, three important options available that may not decrease the complexity but reduce the tax burden.
Qualifying Electing Fund Election (QEF)
Qualifying Electing Fund (QEF) election allows a U.S. taxpayer to avoid the default application of the excess distribution regime previously mentioned.
The election is made under Sec 1295, and taxation is as per Sec 1293 rules. The U.S. shareholder of a PFIC stock is taxed on the current basis on her pro-rate shares of ordinary income and net capital gains. As the income is included every year regardless of distribution, the shareholder may elect to defer the tax on this income (Subpart F exception applies) but have to pay the interest (normal late payment) on such taxes. This income inclusion also gives rise to “previously taxed income (PTI)”, and which is tax-free at distribution.
QEF election is the best alternative to the default taxation regime but shareholders often run into challenges in getting PFIC Annual Information Statements from the PFIC. These statements specifically require the shareholder’s pro-rata share of earnings and gains, information related to the calculation of income inclusion, permission to examine books and records, and cash distributions or FMV of deemed dispositions during the year. This is a must-have requirement and not every PFIC management is interested in providing this information. Many Canadian-domiciled mutual funds or ETFs may already publish this information every year recognizing the need for their U.S. shareholders. It’s best to check with your financial advisor before making such investments.
The due date for the election is the same as the U.S. federal income tax return. The U.S. shareholder must file form 8621. You cannot revoke the QEF election without IRS’s consent once it is made and it is applicable for all subsequent years. The election must be filed for each PFIC separately. For lower-tier PFICs in the corporate chain, separate elections must be filed for them as well.
Mark-to-Market (MTM) Regime
PFIC shareholders who do not qualify to make the QEF election but at the same time do not want default excess distribution regime as well can make a mark-to-market (MTM) election.
This election can apply to the PFIC shares that trade on a qualified stock exchange. This can be a good option for the shareholders of Canadian domiciled ETFs (or any Non-US ETF). Only U.S. shareholder needs to make this election and nothing is required from the PFIC side. Form 8621 is required for making this election for any of the tax years and is valid for all subsequent years except if the stock stops trading on the stock or the shareholder revokes it with IRS approval.
Section 1296 requires U.S. shareholders to recognize income or loss equal to an increase or decrease in the FMV of the PFIC stock. Income is taxed at ordinary rates for the increase in FMV over the basis of the stock. In case of a decrease in FMV, a deduction is also allowed limited to the shareholder’s basis in the stock. Gain on the disposition of PFIC stock is also ordinary income. Losses are ordinary only up to the limit of previously recognized ordinary income and the remaining as a capital loss. Taxpayers cannot defer the tax on MTM income inclusion. There are no taxes on the actual distribution.
For those doing D-I-Y U.S. tax returns, it might be easier to prepare IRS form 8621 for this purpose.
Late QEF Elections
Many would ask if there is a retroactive relief in the form of a late QEF Election.
Yes, late QEF elections are not out of ordinary! It happens a lot.
Without getting into too many complexities and nuances of code and regs, here are three possibilities:
- File a protective statement to extend the statute of limitation on tax returns. Applicable only if there was a “reasonable belief” that the shares of a foreign corporation at the time of ownership were not PFIC shares. This is something taxpayers should not attempt to do themselves. This is best to involve the tax accountant and a U.S. tax lawyer specializing in cross-border taxes, just to ascertain the threshold of reasonable belief.
- The second option, with generally difficult-to-meet requirements, is available to U.S. shareholders with less than 2% of ownership where the subject foreign corporation indicates in a public filing that it was not or more than likely not a PFIC. There is no reasonable belief and protective statement filing requirement.
- A final, consent regime, where taxpayers reasonably relied on a tax adviser. This is the most common option, the taxpayer must demonstrate that there will be no prejudice to government interest if the consent was granted i.e. there will be no lower taxes and the shareholder agrees to pay the difference. . It must follow the procedural steps.
Late QEF Election – Purging Election
If there is no other relief, PFIC shareholders can always file a purging election. A purging election allows the shareholder to file an election if there was no first-year QEF election. The shareholder deems its PFIC shares as sold on a day before this election date, and applies an excess distribution regime up to that point. Moving forward tax treatment is available under QEF regime.
Form 8621 – Information Return for PFICs
Form 8621, is Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. The U.S. taxpayers must file form 8621 to make elections and report income or distributions, or dispositions of PFIC shares.
There is no penalty on late filing of form 8621 as such but not filing it with a U.S. federal income tax return can suspend the statute of limitation on those tax years. Those assets must be reported on form 8938 to avoid a foreign asset reporting-related penalty of $10,000.
If form 8621 is not filed on time different elections might also not available and the default excess distribution regime applies. Since the statute of limitation never run on those tax returns, IRS can come back for an audit of those years in any foreseeable future.
Passive Foreign Investment Company (PFIC) rules can be complex. Further, the determination of a PFIC or distinguishing it from a CFC can become challenging at times.
If you are a U.S. taxpayer subject to PFIC reporting requirements living in Canada, or in the United States, make sure to understand the complexities before making investment decisions. It is not uncommon for advisers at Canadian banks to sign up an unsuspecting U.S. person for Canadian mutual funds or Canadian-domiciled ETFs. Always ask about the U.S. tax implications for those investments.
If you have already invested in PFICs, it’s time to get your ducks in a row and ensure everything is reported accurately and on a timely basis.
At Maroof HS CPA Professional Corporation, we help U.S. taxpayers with both Canadian and U.S. income tax preparation and planning services. Get in touch with us today!