Federal Income Tax and Reporting Requirements.
When a corporation’s gross income is passive, it is derived from investments or other sources not related to regular business operations. The money being placed into this mutual fund will be utilised by those running it to invest into the company, therefore classifying it as a PFIC as it generated revenues outside of its core business activities. Thus, many people do not realise they have these investments or know how to identify them and are consequently subject to unexpected federal income tax and reporting requirements.
Passive income includes:
- capital gains
How do I know if I have a PFIC?
It is difficult for U.S. taxpayers to know if they have a PFIC or not, however, there are two tests employed to identify them: the income test and asset test.
A foreign corporation is classified as a PFIC if it meets one of the following tests:
- The income test: if 75% or more of the corporation’s gross income for the tax year is generated passively.
- Asset test: if 50% or more of assets are held by the corporation to generate passive income.
However, these tests are not as simple as they sound, and much extra research is required to find what is essentially an investment through an investment.
What do I need to file if I have a PFIC?
If you discover you have one or multiple PFICs, you will need to attach Form 8621 with your tax return, or if you are not required to file an income tax return, file the form directly with the IRS. A separate Form 8621 must be filed for every PFIC in which stock is held, directly or indirectly.
A U.S. person that is a direct or indirect shareholder of a PFIC must report through form 8621 each tax year, if they:
- Receive direct or indirect distributions from a PFIC
- Are reporting information with respect to a QEF (Qualified Electing Fund) or mark-to-market election
Recognise gains from direct or indirect PFIC stock
How are PFICs taxed?
Taxation of PFICs is a very complex situation, mainly because you elect how you wish the IRS to treat your PFIC. U.S. shareholders of a PFIC are subject to special tax rules respective to realised gains on the sale/disposition of the PFIC’s shares and any of the PFIC’s excess distributions. The special rules deem the shareholder to:
- Have realised gain and excess distribution rateably over the holding period for the shares.
- Be taxed at the highest ordinary income tax rate that is in effect for the year the gain or excess is allocated.
- Be liable for an interest charge of the tax owed.
However, you may be able to avoid these rules by making a Qualified Electing Fund (QEF) or mark-to-market election. Shareholders not choosing to not elect QEF treatment, have a PFIC that is an unpedigreed QEF, or do not make a mark-to-market election, have a PFIC that is classified as a section 1291 fund.
The mark to market election
The mark-to-market election refers to U.S. individuals who are PFIC shareholders electing to recognise gains and losses from marketable stock in their tax return. A U.S. shareholder of a PFIC can elect to mark-to-market their PFIC stock if it is ‘marketable’, under section 1296. Unrealised gain within the tax year in the shareholder’s PFIC is included as ordinary income. The sale of the PFIC means sold gains are ordinary income and losses are classed as ordinary or capital.
Mark-to-market elections must be made on a timely filed tax return, and once elected remain effective for all subsequent years (Form 8621 is still required annually).
The Qualified Electing Fund (QEF) election
The QEF (Qualified Electing Fund) essentially parallels U.S. taxes applying to domestic mutual funds to create similar tax treatment for foreign funds. A PFIC is classified as a QEF once a person who is a direct or indirect shareholder has elected QEF treatment and meets the requirements in IRS section 1295 (a)(2). By making this election, the shareholder must include their pro rata share of the PFIC’s ordinary earnings and gains for the tax year in income.
A U.S. shareholder electing to treat their PFIC as a QEF would be rendering any future gains from the sale of the fund to qualify for capital gain treatment – assuming it is held as a capital asset. The Shareholder will be subject to U.S. taxes at capital gain rates rather than ordinary income rates.
Now I know I have a PFIC, what help can I get?
It can be very concerning to be taxed on something you cannot put your hands on; essentially, your unrealised gain is being taxed. Therefore, you may wonder if there are any exemptions or exclusions to tax on your PFIC. There are ways in which the shareholder can have the income taxed at a lower level, but it is dependent on each individual situation and respective income.
If you have found out that you have PFICs and want to get out of your situation, contact a specialist such as Aya as soon as possible. The earlier you call, the greater your chances at fixing the situation and/or effectively planning for the future.
It is essential to engage in advanced tax planning if you are looking to invest in foreign funds. To avoid paying taxes at a higher rate, speak to a specialist in advance. If you have identified yourself as a shareholder in a PFIC through the income test or asset test, remember to attach Form 8621 with your federal tax return. Contact a specialist for guidance on electing either a mark-to-market or QEF treatment for your PFIC, if you wish to avoid having it treated as a section 1291 fund that is subject to special tax rules.
Contact us at Expat Tax Online to learn more about Passive Foreign Investment Company.