PFICs (Passive Foreign Investment Companies)
When it comes to international reporting of foreign accounts, assets, investments and income, one of the most complicated aspects is the reporting of PFICs. A PFIC refers to a passive foreign investment company and what makes it so complicated is just how broad the definition can be. For example, if a person sets up their own foreign company which is used to generate dividends and capital gains, then they would be considered a PFIC. Conversely, even when a person simply invests in a foreign mutual fund, it may also be considered a PFIC. In the first case, the person proactively creates a business knowing that they are designing their own entity to generate passive income (which is an intentional act). In the second scenario, the person simply invests in a foreign mutual fund to avoid creating their own investment structure, and this is usually done without worrying about reporting that investment as a PFIC. Beyond the complications of reporting a PFIC, there is the issue of tax rules, which are also incredibly complicated, especially each year the person has an excess distribution. Let’s take a look at five introductory facts about a PFIC.
What is a PFIC? Form 8621?
A PFIC is a passive foreign investment company. US taxpayers are required to report their PFIC on Form 8621. Unlike other forms such as Form 8938, Form 8621 must be filed even if the taxpayer does not have a tax filing requirement. It works similarly to FBAR in this respect. To qualify as a passive foreign investment company, it must pass either the income test or the asset test, but not both. In order to meet the income test, at least 75% or more of the income must qualify as passive income as defined in Section 1297(b) of the Internal Revenue Code. Alternatively, under the asset test, at least 50% of the average percentage of assets are held for the generation of passive income.
No majority ownership required
Unlike other international reporting of foreign companies, a U.S. person does not need to own at least 50% of the PFIC to have to disclose the information to the Internal Revenue Service. On the contrary, the co-ownership may still require the filing of the form. However, there are some exceptions, such as if the person has less than $25,000 or $50,000 MFJ and no excess distributions. There is some discrepancy between the instructions (which appear to state that the top portion of Form 8621 is always required) and the regulations (where it appears that no report on Form 8621 is required for this exception).
Distributions vs Excess Distributions
When a person has excess distributions from a PFIC, reporting becomes infinitely more complicated. Depending on whether the excess distributions come from capital gains or dividends will affect the complexity of the analysis and the equation. For the most part (particularly when dealing with dividends) this is usually a hybrid distribution/excess distribution calculation where the excess distribution is taxed at the highest tax rate (other than the current year in which it is taxed at the progressive tax rate).
Elections and late elections
In an attempt to minimize the tax implications of having a PFIC, the taxpayer may choose to be treated either as a Mark-to-Market or as a Qualified Electing Fund. The latter is the preferred choice (because of the tax benefit it can provide) although it requires significant information from the foreign investment company which may not be viable and quite frankly , can lead to the foreign investment company wanting to kick you (the US taxpayer) out of the investment because they just don’t want to deal with the headache of having a US person as part of the investment , particularly where it requires the FFI to comply with US FATCA statements. If a person misses the initial time window to make the election, they can try to make a retroactive election with reasonable cause (but there are very strict requirements for doing so and it’s hard to qualify). Alternatively, they can make a late election also known as a purge election, where they will have to “clean up the filth”, but this can be a complicated and expensive process and can lead to significant tax liability.
Form 8621 reporting failure and interaction with Form 8938
When an individual fails to report PFIC on Form 8621, the penalty is primarily that the tax return does not close within the typical 3-6 year statutory window. But, another issue to consider is that if Form 8621 is not filed and the IRS does not know it is a PFIC, the IRS can simply assume it is a PFIC. a FATCA reporting asset and since the 8621 has not been filed, the taxpayer may be affected by the form. 8938 penalties.