Foreign Investments are Treated Differently

International Tax Provisions of the Tax Cuts & Jobs Act

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 (PFIC). The PFIC rules are designed to prevent U.S. persons 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.1
  2. Asset Test – 50% or more of the average assets held by the foreign corporation produce passive income during taxable year.2

Passive income includes dividends, interest, royalties, rental income, foreign currency gains and capital gain from assets that produce passive income. The asset test is based on gross assets. Foreign partnerships can be considered PFICs by U.S. reporting standards depending on what type of income they generate. It is very easy not to pay attention to some PFICs that are imbedded in other investments vehicles, i.e. publicly traded partnerships. Unfortunately, penalties may be incurred for improper or failing 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 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 and such corporation is a PFIC, then the company is treated as directly owning and receiving its proportionate share of the income of that lower tiered foreign corporation for applying the asset and income tests noted above.

In other words, if a U.S. taxpayer owns part of a foreign company which  has a 25% or more interest in a lower tiered foreign subsidiary, the U.S. taxpayer will apply the look-through rule first before applying the income and asset tests to determine if PFIC status is applicable to the U.S. individual taxpayer. U.S. taxpayers, including corporations, should be aware of the potential to be subject to PFIC rules simply by owning a portion of another company that meets the criteria of a PFIC.

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 an IRS form 8621. First, reporting will not be required with respect to any PFIC shares in any year that the value of all shares of all PFICs (including section 1291 funds, QEF’s and MTM’s) owned by a shareholder directly or indirectly is $25,000 or less.3 Under the second exception, reporting is not required if the shares of the particular PFIC are held indirectly and have a value of $5,000 or less.4

If a PFIC is also a CFC and its shareholder is a 10% U.S. shareholder of the CFC then the CFC is not treated as a PFIC. This is known as the CFC overlap rule5. Reporting will be required under the CFC reporting regime.

Why is it important?

Why is it important to revisit offshore investments? In general, a U.S. investor that holds a 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 are 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) – absent an election to tax the PFIC either as a QEF or MTM, the PFIC usually is taxed under section 1291 under the default method. The default method taxes all distributions and realized capital gains as ordinary income; prior years PFIC (pre-PFIC period) excess distributions are taxed at the highest U.S. tax rate.
  2. Qualified Electing Fund (Section 1293) – A U.S shareholder who has made a QEF election which will include the pro rata share of PFIC’s ordinary income and net capital gain in his/her income for each taxable year as ordinary income. Any actual distribution of cash will be excluded from income since that income already would have been taxed when earned prior to distribution. However, there is no deduction allowed if a loss is incurred in the taxable year. Any realized gain or loss from sale of a PFIC will be treated as capital gain or loss. The QEF election may be a valuable option for a U.S. shareholder.
  3. Mark to market (Section 1296) – if the PFIC stock is marketable and traded on a public exchange, an election can be made to calculate income based on annual changes in market value. Annual gain or loss is treated as ordinary income (loss); however, the loss is limited to the extent of previous years’ gains. The MTM method generally is more beneficial than the default method.

As the world becomes smaller, all U.S. investors need to understand the complication of international investment planning, which is magnified by the existence of numerous tax regimes. The U.S. cross border-PFIC regime is just one of them. Don’t leave your financial position to chance; make sure you are working with an international tax expert or financial planner who is experienced with PFICs who can help you to avoid unnecessary fees and taxes.

Please contact Stuart Lyons, lead of BNN’s international tax practice, at 1.800.244.7444 if you would like to discuss further.

1 Section 1297 (b)

2 Section 1297 (e)

3 Section 1.1298- 1 (c ) (2)(i)(A)(1)

4 Section 1.1298-1( c) (2)(i)(A)(2)

5 Section 1297 (d)

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.

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