## Passive Foreign Investment Company (PFIC)
### Definition
A Passive Foreign Investment Company (PFIC) is a foreign corporation that meets specific criteria under the Internal Revenue Code (IRC). It is characterized by its passive income streams and lack of active business operations.
### Identification Criteria
To be classified as a PFIC, a foreign corporation must meet the following criteria during a tax year:
– **75% Passive Income Test:** At least 75% of its gross income is derived from passive income, such as dividends, interest, rents, and royalties.
– **50% Stock Ownership Test:** More than 50% of its stock, by value, is owned or held by U.S. shareholders who own 10% or more of its stock.
### Passive Income Sources
The passive income sources that contribute to a PFIC’s income include:
– Dividends and interest from passive investments
– Rents and royalties from leased or licensed property
– Gains from the sale of capital assets that are not inventory or held for business use
– Certain types of income from partnerships or trusts
### Exclusions
The following income sources are not considered passive income for PFIC purposes:
– Business income from active operations
– Income from real property held directly or through a partnership
– Gains from the sale of real property or other assets held for business use
– Income from certain banking or insurance companies
### Tax Consequences
**Ordinary Income Taxation:** PFICs are subject to ordinary income tax rates on their undistributed earnings. This means that U.S. shareholders are taxed on the PFIC’s income as if it were received as a dividend, even if it is not actually distributed.
**Excess Distribution Tax (EDT):** If a U.S. shareholder receives a distribution from a PFIC that exceeds the amount of current-year income and previously undistributed earnings, the excess is subject to an additional 7.5% tax.
**Additional Interest Charge (AIC):** U.S. shareholders may also be subject to an additional interest charge related to undistributed PFIC earnings. The AIC is calculated based on the excess of the PFIC’s post-1986 undistributed earnings over the shareholder’s investment in the PFIC.
### Mark-to-Market (MTM) Election
To mitigate the tax consequences of a PFIC, U.S. shareholders can elect to mark their PFIC stock to market. This allows them to pay ordinary income tax on any unrealized appreciation in the PFIC’s value each year, rather than upon distribution or sale of the stock.
### Reporting Requirements
U.S. shareholders who own or invest in PFICs must file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. This form requires detailed information about the PFIC’s income, distributions, and related transactions.
### Tax Avoidance Strategies
To avoid the harsh tax consequences associated with PFICs, taxpayers can consider the following strategies:
**Active Business Exception:** Investing in PFICs that generate income from active business operations, rather than passive investments.
**Qualified Electing Fund (QEF):** Investing in foreign corporations that elect to be treated as QEFs under the IRC. QEFs are exempt from PFIC status and are taxed at capital gains rates.
**Foreign Investment Fund (FIF):** Investing in foreign corporations that are classified as FIFs under the IRC. FIFs are also exempt from PFIC status but are subject to an additional 35% tax on their earnings.
**Foreign Trust:** Utilizing a foreign trust to hold investments in PFICs. Trusts are not subject to PFIC rules, but distributions to U.S. beneficiaries may be taxable as income.
### Conclusion
Passive Foreign Investment Companies (PFICs) are complex investment vehicles that can lead to significant tax consequences for U.S. shareholders. Understanding the identification criteria, income sources, and tax implications of PFICs is crucial for informed decision-making when investing in foreign corporations. Taxpayers should carefully consider the potential tax risks and utilize available strategies to mitigate their exposure to PFIC-related taxes.