Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, FORM 8621

A foreign corporation is a PFIC if it meets either the income or asset test described below:

Income test: 75% or more of the corporation's gross income for its taxable year is passive income (interest, dividends, gains, royalties, rents & annuities).

Asset test: At least 50% of the average percentage of assets held by the foreign corporation during the taxable year are assets that produce passive income or that are held for the production of passive income.

Many bank managed accounts held abroad, including those located in offshore financial centers, invest client’s monies in foreign mutual funds.  Foreign mutual funds, based on the above tests, are classified as PFICs which fall under a complex tax regime requiring that any “excess distributions” (dividends & gain on sale of PFIC shares) are recognized on a pro rata basis over the holding period and taxed at the highest tax rate in effect for each year in the holding period regardless of the taxpayers marginal tax rate (Sec. 1291). Further, an interest charge is applied to each year and calculated through the payment date of the current year’s tax return when filed. This negative tax regime means that PFIC shares do not qualify for the preferential tax rates on qualified dividends nor the preferential rate on long term capital gains upon disposition. Additionally, PFIC losses are considered regular capital losses and do not offset PFIC gains! Many closely held foreign holding companies may also fall under the PFIC regime. Subsequent to 1997 change in the tax code (overlap rules) those PFICs qualifying as CFCs are taxed under the CFC regime.  Foreign holding companies in existence prior to 1997 are likely classified as PFICs and “once a PFIC always a PFIC” rule applies unless corrective action is taken to “purge” the PFIC taint.  There are however steps that may be taken to mitigate the negative tax ramification of the PFIC regime including the following:

  • Qualified Electing Fund (QEF) Election – If the foreign fund can provide an “PFIC Annual Information Statement” then the US shareholder can elect to recognize their respective share of the company’s income and gains on an annual basis. However, unless closely held, or a fund specifically set up for US investors, it is unlikely that an “ PFIC Annual Information Statement” will be supplied by the fund. This makes the QEF election not possible in the majority of cases.
  • Mark To Market (M-T-M) – As long as the shares of the PFIC are publicly traded on a regulated exchange a US shareholder can elect to Mark To Market (M-T-M). By making the M-T-M election the US shareholder will recognize ordinary gain or loss at the end of each year in the holding period (based on the year end share price over the adjusted basis in PFIC shares). This is on an individual share basis. Ordinary losses under the M-T-M election are only recognized to the extent of previously unreversed inclusions.  Any loss in excess of previously unreversed inclusions on an actual disposition results in a capital loss.

In the context of a voluntary disclosure with the IRS, it is important to evaluate reporting both under the default PFIC (Sec. 1291) method and the elective M-T-M (OVDI modified) method of reporting PFIC income. It should be noted that electing the M-T-M optional reporting under IRS voluntary disclosure requires that the taxpayer maintains reporting of those same PFIC shares under M-T-M until disposition.  It is also important to note that for state income tax purposes, many states may require an adjustment for PFIC income reporting at the state tax level. 

At Lancaster & Reed our many years of PFIC accounting experience means no learning curve. When it comes to complex PFIC accounting and tax calculations, put our experience to work for you!