The Passive Foreign Investment Company (PFIC) rules have been in force for many decades, yet they remain a persistent source of angst for US taxpayers, particularly those in the financial services world.
PFIC rules were introduced in 1986 as part of the Tax Reform Act of 1986. Congress felt these rules were necessary to address US taxpayers who could easily move their liquid assets into offshore corporate structures and generate passive income. This passive income would be sheltered from US tax until the earnings would be repatriated to the US. The nature of passive income makes it easier to migrate out of the US to avoid US taxes.
Hence the PFIC regime — an anti-deferral mechanism that prevents US taxpayers from using offshore corporate structures to avoid paying US taxes on passive income.
What is a PFIC?
A PFIC is a foreign corporation primarily earning passive income or holding assets generating passive income.
Specifically, if more than 75% of a foreign corporation’s income is passive or more than 50% of a foreign corporation’s assets generate passive income, then the foreign entity would be considered a PFIC for US tax purposes.
For PFIC purposes, passive income generally includes the following types of income:
- Dividends
- Interests
- Rents
- Royalties
- Capital gains
Impact of Owning a PFIC
Income from distributions and gains on dispositions of PFICs are subject to the highest tax rate applicable to the taxpayer type, regardless of the taxpayer’s tax rate bracket. In addition to imposing a higher rate of tax on many taxpayers, this also eliminates the qualified dividend and capital gains beneficial tax rates. An interest charge is also applied to the amount of recognized income considered to have been deferred.
Planning Considerations
Some planning opportunities are available to mitigate the harsh impact of PFIC ownership, but administratively, they can be challenging. Another burden of owning a PFIC is the additional disclosures and filing requirements related to PFIC ownership.
Taxpayers who invest directly in PFICs must address these issues at the more basic level. Venture capital or private equity fund investors encounter even more significant challenges, including layered compliance burdens, limited access to required tax information, and increased filing obligations.
Things got worse for investors in this space with the 2017 Tax Cuts and Jobs Act (TCJA). Prior to the TCJA, many foreign portfolio companies relied on a fair market value method to value their assets, allowing them to consider the fair market value of the enterprise and treat it as a goodwill asset. This was particularly helpful when the foreign portfolio company would have stores of cash from investors sitting on the balance sheet but no other significant assets. Cash is considered an asset that generates passive income and would quickly put the company’s assets over the 50% threshold, making it a PFIC. The fair market value method allowed the company to take credit for the company’s value, which is an asset not reflected on the balance sheet, and treat that enterprise value as “goodwill” or some similar type of intangible asset that does not generate passive income – thereby keeping the passive assets below the 50% threshold.
This election to use the fair market value is not available if the foreign corporation is a Controlled Foreign Corporation. The TCJA provision that reintroduced “downward attribution” caused many more foreign portfolio companies to be considered CFCs and even more to have to undertake additional administrative burdens to determine if they were indeed CFCs under these new rules.
Fortunately, in 2019, the IRS introduced a safe harbor rule with respect to the downward attribution rule, providing some relief for foreign portfolio companies dealing with this issue. While the guidance provided some relief,, it still required additional analysis.
In January 2022, the IRS issued proposed regulations (REG-118250-20) addressing the treatment of domestic partnerships and S corporations owning stock in PFICs.
These regulations suggest an aggregate approach where the partnership and S Corp would not be considered shareholders. Rather, each partner or shareholder of these domestic entities would be responsible for making PFIC-related elections and calculations for PFICs in which they were not directly invested but rather through S Corps and partnerships.
Understandably, the financial services industry met these proposed regulations with some hysteria. The current approach is to allow the S Corp or partnership to file the PFIC-related disclosures, make the relevant elections, track these elections and attributes, and perform necessary calculations. Requiring that the individual partners and shareholders take on this function tremendously increases the administrative burden on taxpayers in the financial services industry.
On a positive note, the current status of these rules is only ‘proposed’ and not binding; many have chosen to carry on as they have until now.
Given these considerations, there remains uncertainty in this area, particularly affecting taxpayers and those in the financial services industry. It is prudent to stay informed, act proactively, and consult with professionals to minimize risk, and ensure compliance.
This material has been prepared for informational purposes only, and is not intended to provide or be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
