Many people who receive income from passive foreign investment companies, or “PFICs,” have no idea that they hold an interest in an investment that may trigger additional filing requirements and tax payments on their U.S. returns.
Most Americans work hard to file accurate tax returns and pay the correct amount owed to the government. They may not be happy about taxes, they may complain about them, but some combination of patriotism and fear of consequences keeps most taxpayers in line.
One of the most serious tax problems that can arise for people who make an honest effort to comply with U.S. tax obligations is a tax that they didn’t know existed. Passive foreign investment companies, or “PFICs,” are an excellent example of this problem, and there are steps you can take to protect yourself against it.
What Is a PFIC?
A PFIC is a business or fund based outside of the United States that generates passive investment income to its owners/shareholders. If the business or investment meets either of 2 tests, it should be treated as a PFIC for U.S. tax purposes.
- The first test is an “income test.” The investment meets the income test if 75% or more of the income it generates in a given year is passive income, such as dividends, interest, rents and royalties.
- The second test is an “asset test.” The investment meets the asset test if more than 50% of the business’ average asset value consists of assets held to produce passive income.
The most common type of PFIC that causes problems for U.S. taxpayers is a foreign, or non-U.S., mutual fund. When a mutual fund is based in the U.S., the government requires it to report information about what it pays to its investors in order to match that against the tax returns those investors file. The government also maintains certain requirements on what the funds must distribute annually. Non-U.S. mutual funds aren’t subject to these reporting and distribution requirements. So, in an effort to avoid income deferral, these foreign mutual funds are treated as PFICs for U.S. tax purposes. Therefore, taxpayers who own foreign mutual funds may be subject to additional taxation and reporting under the PFIC regime.
Who Has to File?
The first requirement is that the taxpayer needs to be a “U.S. tax person,” as discussed in a previous post, Know Before You Go—The 3 Ways That Nonresidents Incur U.S. Tax Obligations. An individual or business that qualifies as a U.S. person then needs to determine if they have ownership of any companies or investments that meet either of the two tests discussed above. If yes, the taxpayer may be subject to additional reporting requirements and taxation.
There are some exceptions to PFIC reporting. For example, in some circumstances there may be an exception to the annual reporting requirements if the total value of all PFICs owned is $25,000 or less ($50,000 or less for married filing jointly) at the end of the year. Other exceptions exist, including an exemption for the first year of a corporation that might otherwise be treated as a PFIC, if certain conditions are met. This exception helps certain start-up businesses that begin operations with a significant investment but have yet to spend as much capital on operating assets as planned by the end of the tax year. Without this exception, these businesses might be PFICs under the asset test because cash is considered to be a passive asset under the test.
What Has to Be Filed?
The short answer to this question is, if you think that you might have a filing requirement based on the discussion above, you should probably consult a tax professional with experience in the area before trying to figure out this part of your tax return. The information you report and the calculation of any tax you might owe can be very complicated. There are several different ways a PFIC may be taxed depending on elections that can be made for treatment of the PFIC.
If you believe that you may have an obligation related to a PFIC, you should contact our International Tax Team at Freed Maxick for additional information about these rules.