Income tax liability from a Passive Foreign Investment Company (PFIC) may apply to more people than you think.
We all love Grandma. How many Thanksgiving meals did Grandma cook for you? After your older brother picked on you, nobody could comfort you like Grandma could with a hug, a glass of milk, and a plate of warm cookies.
Now it is your time to help Grandma. She read in the business section of the local paper (she still reads the print version) that mutual funds are the way to diversify her investments and Grandma has decided to further diversify by putting $10,000 in a European‑based mutual fund.
What Grandma does not realize is that she now owns shares of a passive foreign investment company (“PFIC”). In general, U.S. persons do not have to pay tax on income earned by the foreign corporations that they own ‑ the income is deferred from U.S. tax ‑ until repatriated, typically in the form of a dividend. The Internal Revenue Code contains two anti‑deferral regimes, Subpart F and PFIC. Subpart F typically applies when 10% U.S. shareholders collectively control a foreign corporation (“CFC”). Because Grandma has only invested $10,000 in a publicly-traded mutual fund, chances are that the European‑based mutual fund is not a CFC that would implicate the Subpart F regime. However, the determination of whether a foreign corporation is a PFIC has nothing to do with the percentage of shares owned by U.S. persons.
How to know if you own a PFIC.
There are two tests by which a foreign corporation can be a PFIC. First, under the income test, a foreign corporation is a PFIC if 75% or more of the corporation’s gross income for the taxable year is passive income. In the alternative, the assets test provides that a foreign corporation is a PFIC if more than 50% of the foreign corporation’s total assets are passive. Considering that the European-based mutual fund merely makes portfolio investments throughout the European Union, Grandma probably owns a PFIC.
In the past, you would not worry about Grandma’s return being properly prepared. Ever since she was your biggest customer for buying Girl Scout Cookies, she had her return prepared by a gentleman who studied at Oxford and worked for Lloyds of London. However, you recently learned that he actually studied at the Oxford Barber College and worked for Lloyds Bar & Grill in London, Kentucky. Accordingly, you convince Grandma that you should now prepare her return for which, of course, you do gratis.
You explain to Grandma the two primary methods by which deferral ends for income earned by her PFIC. You also explain that she must file a Form 8621.
The first method is the qualified electing fund method (“QEF”) election. Shareholders who can obtain the necessary information can elect to pay tax on their pro rata share of the PFIC’s current earnings. In essence, Grandma pays tax on the foreign income as earned annually.
Clients may need your help with prior year PFIC tax compliance.
What if Grandma, who relied on her previous preparer, never made a QEF election? Grandma would be stuck with the excess distribution method, which many consider to be the full-employment regime for international tax accountants. The excess distribution method applies when the PFIC distributes cash that exceeds 125% of the average distribution during the three previous years. The amount of an excess distribution is thrown back over her holding period for the PFIC’s shares and the tax for each thrown back year is computed by using the highest tax rate in effect for each year (and do not forget interest). Moreover, to prevent U.S. persons from deferring their income and then realizing gain taxed at favorable capital gains rates, the gain on any sale of a PFIC’s shares also constitutes an excess distribution.
You need to understand Form 8621 and the PFIC rules to properly advise Grandma. After all, Thanksgiving is just around the corner.
If you would like to meet Robert Misey and learn more about international taxation, please join us by registering for this years CCH Connections: User Conference 2017.
Robert Misey is Chair of the International Department at Reinhart Boerner Van Deuren s.c. and Chair of the International Tax Committee of the American Bar Association. His program entitled Passive Foreign Investment Companies and Form 8621 is available in the Tax Track.