Unraveling PFIC Complexities: Tax strategies for U.S. shareholders of foreign funds and entities

By Jiten Kariya February 16, 2026

Passive Foreign Investment Companies (“PFICs”) pose significant tax challenges for U.S. persons investing in foreign entities, whether through direct ownership or indirectly via vehicles like foreign funds, partnerships, or trusts. Enacted as part of the Tax Reform Act of 1986, the PFIC regime aims to prevent U.S. taxpayers from deferring U.S. tax on passive income earned through foreign corporations and converting ordinary income into capital gains upon disposition.

This article explores the PFIC rules and how ownership of foreign mutual funds or exchange-traded funds (“ETFs”), or corporations creates PFIC exposure for U.S. persons.

Background and definition of a PFIC

Congress enacted the PFIC regime to curb U.S. taxpayers’ ability to defer U.S. tax through foreign corporations and to prevent conversion of what is economically ordinary income into capital gains on disposition of those shares. The regime targets both deferral and character-conversion concerns through Internal Revenue Code (“IRC”) sections 1291-1298.

A PFIC is defined as any foreign corporation (hereinafter sometimes referred to as the “Tested Foreign Corporation”) if, for the taxable year: (1) 75% or more of its gross income is passive income (the “PFIC Income Test”); or (2) at least 50% of the average value of its assets, determined on a quarterly basis (or, where applicable, by adjusted basis), is held for the production of passive income (the “PFIC Asset Test”). The PFIC Income Test and the PFIC Asset Test are jointly referred herein to as the “PFIC Tests”.

The PFIC Income Test is determined by taking into account all gross income of the Tested Foreign Corporation for its taxable year. The PFIC Asset Test is determined by taking into account the average quarterly value of the assets of the Tested Foreign Corporation, as measured on the last date of each quarter of the corporation’s taxable year. The PFIC rules, however, alternatively require or permit (as the case may be) a Tested Foreign Corporation to use the adjusted basis of its assets rather than their fair market value for purposes of the PFIC Asset Test. Liabilities are not taken into account for purposes of the PFIC Asset Test. Thus, the PFIC Tests are applied on a gross basis, a feature that creates a number of technical issues in the application of the look-through rules.

Look-Through Rules for Applying the Income and Asset Tests

Related Person Look-Through Rule (§1297(b)(2)(C))

The rules exclude passive income (interest, dividends, rents, royalties) from related persons if allocable to the payor’s non-passive income. “Related” means >50% control (vote or value). For these purposes, a person is a “related person” with respect to a foreign corporation if: (a) such person is an individual, corporation, partnership, trust, or estate which controls, or is controlled by, the foreign corporation; or (b) such person is a corporation, partnership, trust, or estate which is controlled by the same person or persons which control the foreign corporation. “Control” means, with respect to a corporation, the ownership, directly or indirectly, of stock possessing more than 50% of the total voting power of all classes of stock entitled to vote or of the total value of stock of such corporation. In the case of a partnership, trust, or estate, “control” means the ownership, directly or indirectly, of more than 50% (by value) of the beneficial interests in such partnership, trust, or estate.

General Look-Through Rule (§1297(c))

If the tested corporation owns ≥25% (by value) of another entity (a “look-through subsidiary”), it is treated as holding proportionate assets and receiving proportionate income from that subsidiary. When determining whether the foreign corporation directly or indirectly owns 25 percent of the other corporation for purposes of section 1297(c), the principles of section 958(a) and the regulations under that section are applicable.

Domestic Look-Through Rule (§1298(b)(7))

A foreign corporation subject to the §531 accumulated earnings tax, owning ≥25% (by value) of a U.S. corporation’s stock, treats stock in that U.S. corporation’s non-REIT/RIC/S corp subsidiaries as nonpassive assets/income under §1298(b)(7).

Exceptions to PFIC Regime

Certain exceptions prevent a foreign corporation from being classified as a PFIC despite meeting the income or asset tests. Notably, a startup foreign corporation qualifies for exclusion in its first taxable year of gross income if the requirements stated under §1298(b)(2) are satisfied. Failure of any condition results in retroactive PFIC classification for the startup year. In addition, for taxable years beginning after 1997, a corporation that is treated as a controlled foreign corporation (“CFC”) with respect to a U.S. shareholder (as defined in section 951(b)) generally is not treated as a PFIC with respect to that shareholder.

Taxation under PFIC Regime to Shareholders

The PFIC regime provides three alternative tax frameworks for U.S. shareholders of a PFIC. Under the default regime, U.S. shareholders owe tax and an interest charge when they dispose of appreciated PFIC stock or receive an “excess distribution.” The gain or excess distribution is spread over the shareholder’s holding period, with the portion allocated to each prior year taxed at that year’s highest applicable ordinary income tax rate for that shareholder, plus an interest charge on the deferred tax.

A shareholder may instead elect qualified electing fund (“QEF”) treatment, which requires annual inclusion of the shareholder’s pro rata share of the PFIC’s ordinary income and net capital gain, thereby avoiding the excess-distribution interest charge and preserving capital gain treatment where applicable. In addition, for post-1997 years, a shareholder in certain PFICs whose stock is “marketable” can elect mark-to-market (“MTM”) treatment, recognizing each year the unrealized gain or loss in the PFIC shares in current income.

The alternative PFIC tax regimes are summarized below:

Excess distribution regime (section 1291)

Under the default rules, a U.S. shareholder is subject to a special tax and interest charge when there is either an “excess distribution” or a gain on disposing of PFIC stock. The total excess amount is spread ratably over the shareholder’s holding period, with the portion allocable to the current year (and certain pre‑PFIC years) taxed as ordinary income, and the portions allocable to prior PFIC years generating an additional tax and interest “deferral charge” rather than current‑year income.​

The extra tax (the deferred tax amount) is determined by applying, for each prior PFIC year, the highest applicable individual or corporate rate to the slice of excess distribution assigned to that year, and then layering on interest as if the shareholder had underpaid tax in those earlier years. Any part of an actual distribution that is not classified as an excess distribution is taxed under the normal section 301 rules in the year received.​

An “excess distribution” is the portion of current‑year distributions on PFIC stock that exceeds 125% of the average annual distributions received by that shareholder on the same stock during the preceding three taxable years (or the shorter holding period, if applicable). If the holding period is less than three years, only the prior years in that holding period are used, and in the first year of the holding period there is automatically no excess distribution. On a disposition of PFIC stock, the entire gain is treated as an excess distribution and run through these allocation and charge rules.​

Illustration

Assume USCo, a calendar‑year U.S. corporation, buys one share of PFIC stock in FCo on January 1, Year 1, for $60. On December 31, Year 2, USCo sells the share for $120, realizing a $60 gain. The entire $60 is treated as an excess distribution and allocated evenly over the two‑year holding period: $30 to Year 2 (the current year) and $30 to Year 1. The $30 assigned to Year 2 is included in USCo’s ordinary income for that year. The $30 assigned to Year 1 is not added to current‑year income; instead, USCo computes a deferred tax amount by applying the highest corporate rate in effect for Year 1 to that $30, and then adds an interest charge from the due date of the Year‑1 return to the due date of the Year‑2 return.​

Qualified electing fund (“QEF”) regime

Instead of the excess distribution regime under section 1291, a U.S. shareholder may elect to treat a PFIC as a QEF. With a QEF election in place, the shareholder must annually include in income its pro rata share of the PFIC’s ordinary earnings and net capital gain, thereby avoiding the excess‑distribution interest charge and preserving capital‑gain treatment for the PFIC’s net capital gain.​

Illustration

Suppose U.S. individual A owns 10% of a non‑CFC PFIC, YCo, and has a QEF election in effect. In Year 1, YCo has $2,000 of earnings and profits, of which $200 is ordinary earnings and $1,800 is net capital gain. A must include $200 of income for Year 1, consisting of A’s 10% pro rata share of YCo’s ordinary earnings ($200 × 10% = $20) and A’s 10% pro rata share of YCo’s net capital gain ($1,800 × 10% = $180). The inclusion increases A’s basis in the YCo shares by the same $200.​

Mark‑to‑market regime (section 1296)

A third option, available for post‑1997 years, allows U.S. shareholders of “marketable” PFIC stock to elect mark‑to‑market treatment. Marketable PFIC stock generally includes stock that is regularly traded on a qualified exchange or market. Under this regime, at each year‑end the shareholder recognizes as ordinary income the excess of the stock’s fair market value over its adjusted basis and may claim an ordinary deduction when fair market value falls below basis, subject to a cap equal to the shareholder’s unreversed prior mark‑to‑market inclusions.​

“Unreversed inclusions” are the cumulative prior gross income inclusions under section 1296, reduced by the aggregate mark‑to‑market loss deductions previously allowed. Both income and loss recognized under this regime are ordinary, and the stock basis is stepped up for inclusions and stepped down for deductions. For a CFC that owns PFIC stock and makes a mark‑to‑market election, the resulting inclusions are generally treated as foreign personal holding company income, subject to applicable exceptions.​

Illustration

Assume U.S. individual C buys 5% of PFIC ZCo’s marketable stock on January 1, Year 1, for $200 and elects mark‑to‑market. On December 31, Year 1, the fair market value of the ZCo stock is $230, so C has $30 of ordinary income and increases basis to $230. On December 31, Year 2, the fair market value dropped to $190. C may take an ordinary loss of $30, which is the lesser of (a) basis minus fair market value ($230 − $190 = $40) or (b) unreversed inclusions ($30 of prior‑year mark‑to‑market gain). C’s basis after the Year‑2 deduction is $200.​

The election generally continues in effect for subsequent years unless revoked with IRS consent or the stock ceases to be marketable.

Holdings in Foreign Mutual Funds and ETFs

Foreign mutual funds and ETFs are among the most common types of PFICs, although debate continues about whether these vehicles should consistently fall under the PFIC regime, particularly when they are organized as trusts under local law rather than as corporations. Under U.S. tax law, the entity classification rules in Treasury Regulations §§ 301.7701‑1 through §§ 301.7701‑4 determine whether a foreign mutual fund or ETF is treated as a corporation and therefore potentially a PFIC. These rules classify foreign entities based on whether the entity is treated as a business entity for U.S. tax purposes and, if so, whether it has corporate status by default or qualifies as an eligible entity whose owners possess limited liability.

This issue is especially relevant for trust‑structured funds, such as Canadian mutual fund trusts or Indian mutual fund schemes, which may not resemble corporations under domestic law. Nevertheless, if such a trust functions as a separate business entity and qualifies as an eligible entity with limited liability, U.S. rules may classify it as a corporation, thereby subjecting it to PFIC treatment.

Conclusion

The PFIC regime remains a critical consideration for U.S. persons with foreign investments, imposing stringent rules to eliminate tax deferral and character conversion advantages. By understanding the PFIC tests, look-through provisions, exceptions, and available elections such as QEF or MTM, U.S. shareholders can timely file Form 8621, mitigate punitive interest charges, and optimize their tax outcomes.

If you would like to discuss these matters further or are looking for tax advisory for PFICs, contact Jiten Kariya, principal in BNN’s  international tax practice, to start a conversation.

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BNN’s International Tax Practice advises businesses, funds, and high-net-worth individuals across the full spectrum of international tax issues—from structuring and compliance to controversy and treaty matters. Our team blends technical depth with practical insight to help clients navigate an evolving tax landscape.