The PFIC tax regime was passed in 1986 as part of the Tax Reform Act. The PFIC tax regime sought to level the playing field for U.S. mutual funds. U.S. mutual funds are required to pass-through all virtually all of the income to the investors, resulting in taxable income. In contrast, foreign mutual funds often do not have this requirement and therefore U.S. investors were able to shelter the income from taxation until it was distributed. With the passage of the PFIC regime, the advantage of the deferral of foreign funds was effectively nullified.
What is a PFIC?
Defined in Internal Revenue Code §1297, a Passive Foreign Investment Company is any foreign corporation that passes either:
INCOME TEST- 75% or more of its gross income classified as passive income (i.e., interest, dividends, capital gains, etc.), or
ASSET TEST- 50% or more of its assets are held for the production of passive income.
Most foreign mutual funds, pension funds, and money market accounts are PFICs.
A PFIC is taxed under one of three taxation regimes under the IRC.
§1293- Qualified Electing Fund-Election must be made on a timely filed Form 8621. This is the most favorable election. Taxpayer includes pro-rata share of income in taxable income (similar to partnership taxation). Income retains its characteristic. Requires an “Annual PFIC Information Statement.” This reason alone, makes it difficult to elect QEF, as most foreign funds do not report the necessary information to the taxpayer.
§1296-Mark-to-Market Election-Election must be made on a timely filed Form 8621. Taxpayer includes changes in the value of the PFIC’s trading price as ordinary income. This election can only be made for marketable funds that have a quoted market price. Dividends, mark-to-market gains, and gains on the sale of the fund are ordinary income.
§1291 Fund- This is the default treatment if no other election is made. Dividends and gains on the sale of the funds are taxed at ordinary rates. Distributions (i.e., dividends, interest, etc.) in excess of 125% of the prior 3-year average distribution, are treated as “excess distributions” and subject to throwback to the previous three years and taxed at the highest marginal rates and interest calculated upon the tax.
PFICs are “specified foreign financial assets” and are therefore reportable on Form 8938. In addition, if the funds are held in an investment account, they are reportable on FinCen Form 114 (FBAR). Lastly, and most costly, PFICs are required to be reported on Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. A separate Form 8621 is required for each PFIC.
What’s the big deal?
The passing of Foreign Account Tax Compliance Act (FATCA) in 2010, requires foreign financial institutions to report to the IRS on accounts owned by U.S. persons. Failing to file any of the required forms mentioned above can result in a $10,000 per year, per form penalty. In addition, the statute of limitations on your tax return does not begin until all required information returns are filed. So, to summarize, the IRS may soon have details regarding your assets, failing to properly report PFICs can be costly, and you could be subject to an IRS audit indefinitely.
In addition, when you combine the unfavorable tax consequences (ordinary income treatment, plus potential interest and taxation at highest marginal rates) with the additional reporting costs (Form 8621s for each fund), any earnings in the funds may quickly be diminished.
What do I do now?
Have PFICs that have not been properly reported? Making a “silent” filing by amending or filing previous returns may subject you to additional penalties. Contact us today for a free consultation.
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This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult tax, legal and accounting advisors before engaging in any transaction.