Foreign Investments are Treated Differently

By Ann Stephan February 17, 2026

Passive foreign investment companies (PFIC)

Do you own non-U.S. mutual funds, hedge funds, pension plans, annuities, corporate stocks, or foreign partnerships interests? If your answer is “yes,” it may be worthwhile to revisit your offshore investment vehicles because you may be subject to passive foreign investment company (PFIC) reporting obligations and/or taxes. With the global economic environment, many ‘U.S. persons’  have access to different investment vehicles outside the United States. Many U.S. tax advisors focus on whether clients are subject to the controlled foreign corporation (CFC) regime but overlook the flip side of foreign investments: Passive foreign investment companies. The PFIC rules are found primarily in Sections 1291-1298 of the Internal Revenue Code and are designed to prevent U.S. taxpayers from deferring tax on passive earnings through investing in non-U.S. corporations.

What is a PFIC?

A PFIC is a non-U.S. corporation that meets either an income test or asset test:

1. Income Test – 75% or more of the corporation’s gross income for its taxable year is passive income.
2. Asset Test – 50% or more of the average assets held by the foreign corporation produce passive income or are held for production of the passive income during taxable year.

Passive income includes dividends, interest, royalties, rental income and capital gain from assets that produce passive income. The asset test is based on gross assets.  Foreign partnerships can be considered PFICs under U.S. tax principles if they are classified as corporations (e.g., via check-the-box rules) and depending on the type of income they generate. It is very easy to overlook  some PFICs that are embedded in other investment vehicles, e.g., publicly traded partnerships. Unfortunately, penalties may be incurred for improper compliance or failure to comply with the foreign information reporting required for PFICs, even if the taxpayer is unaware there was a reportable activity. If the non-U.S. investment is categorized as a PFIC in one year, it is generally treated as a PFIC for future years (commonly referred to as the once a PFIC, always a PFIC rule), even though the investment may no longer meet the income or asset test for the year in question.

Look–through rule:

When a foreign company owns 25% (by value) or more of the stock of another lower-tiered foreign corporation, then the company is treated as directly owning and receiving its proportionate share of the assets and income of that lower-tiered foreign corporation for applying the asset and income tests noted above.

In other words, when a U.S. person owns an interest in a foreign company that itself holds 25% or more of a lower‑tier foreign subsidiary, the look‑through rule applies before performing the income and asset tests to determine PFIC status. Additionally, U.S. persons may be subject to PFIC rules even with a relatively small ownership interest in a foreign corporation that meets the PFIC criteria.

Annual reporting required:

Those who have direct or indirect investments in a PFIC are required to report certain information annually with their U.S. income tax returns on a U.S. Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company.

Exception:

The IRS Regulations contain two de minimis exceptions to reporting PFICs on IRS Form 8621. First, reporting will not be required with respect to any PFIC shares in any year that the value of all PFICs stock subject to section 1291 that is owned by a shareholder directly or indirectly is ≤$25,000 ($50,000 for married filing jointly) at year-end, and no excess distributions (defined below) or gains treated as such took place. Under the second exception, reporting is not required if the shares of the PFIC subject to section 1291 are held indirectly and have a value of $5,000 or less, and no excess distributions or gains treated as such have taken place.

If a foreign corporation qualifies as both a CFC and PFIC, IRC §1297(d) provides that it is not treated as a PFIC with respect to any 10% U.S. shareholder (per §951(b)) during the qualified portion of their holding period. Such shareholders must instead comply with CFC reporting requirements.

Why is it important?

In general, a U.S. investor that holds a U.S. mutual fund invested in European stocks will pay U.S. income tax of only 15% of 20% for long-term gains generated by the investment. On the other hand, if the same investor indirectly owns the same European stocks through a foreign mutual fund, this will trigger the PFIC regime and all income and gains could be taxed in the U.S. as ordinary income at rates as high as 37%.

Alternative PFIC taxation regimes?

There are three PFIC taxation regimes: The default regime, the Qualified Electing Fund (QEF) and the mark-to-market (MTM).

1. Default regime (Section 1291) – Under the default excess distribution regime (Section 1291), which applies unless a QEF or MTM election is made, U.S. tax on PFIC shares is deferred until distributions are received or the shares are sold. An “excess distribution” is defined as the portion of any current-year distribution exceeding 125% of the average distributions received in the prior three years (or the shareholder’s holding period, if shorter), and all gains from the sale or disposition of PFIC shares are treated as excess distributions. The excess amount is allocated pro rata over each day of the shareholder’s holding period, with portions allocated to prior PFIC years subject to a deferred tax amount—calculated at the highest marginal tax rate applicable for each such year—plus an interest charge computed as if the tax had been due but unpaid in those years. All gains and distributions (typically dividends) are taxed at ordinary income rates rather than at preferential long-term capital gains or qualified dividend rates, and capital losses on PFIC shares cannot be recognized.
2. Qualified Electing Fund (Section 1293) – The QEF regime provides an alternative tax treatment for U.S. shareholders of a PFIC who make a timely QEF election. Under this regime, shareholders must annually include in gross income their pro rata share of the PFIC’s ordinary earnings (taxed as ordinary income) and net capital gains (taxed as long-term capital gains), regardless of whether these amounts are distributed, with the included amounts increasing the shareholder’s basis in the PFIC stock. The PFIC must provide shareholders with a “PFIC Annual Information Statement” detailing the ordinary earnings and net capital gains to be reported. Notably, long-term capital gain from the subsequent sale of QEF stock qualifies for preferential capital gains rates, and losses from such sales are eligible for recognition as capital losses. Distributions from a QEF are not taxed again to the extent they represent amounts previously included in the shareholder’s income under the QEF regime. This regime is generally considered to be the most tax efficient compared to the other tax regimes.
3. Mark to market (Section 1296) – The MTM regime applies to PFIC stock that is “marketable” (regularly traded on a qualified exchange). Each year-end, shareholders mark the stock to fair market value: Excess value over adjusted basis is ordinary income (MTM gain), while value below basis generates an ordinary loss limited to prior unreversed MTM gains. Basis adjusts upward for income inclusions and downward for loss deductions. Distributions are always taxed as ordinary income regardless of qualified dividend status. The MTM method generally is more beneficial than the default method.

As globalization expands investment opportunities, U.S. investors must navigate complex international tax regimes, including the U.S. cross-border PFIC rules. To avoid unnecessary compliance costs and punitive tax consequences, work with an international tax advisor experienced in PFIC rules.

Please contact Jiten Kariya at 1.800.244.7444 if you would like to discuss further.

This article was originally published on March 4, 2020. The above post reflects updated information from our international tax team as of February 2026.