Be Careful of the Risks of Making Foreign Investments: Basic Overview of the Passive Foreign Investment Company (PFIC) Rules

The Internal Revenue Service developed and enforces rules designed to discourage U.S. investors from deferring tax on investment income by holding passive investments through non-U.S. companies that do not distribute their earnings currently. The rules impose a significant additional tax burden on gains and certain dividends derived from investments in a Passive Foreign Investment Company (PFIC) and are very broadly drafted and construed. IRC 1297(a).

PFIC rules extend anti-deferral rules to certain foreign corporations, regardless of the level of U.S. stock ownership. A U.S. person who owns any percentage of PFIC shares is potentially subject to these rules.

A foreign corporation is generally a PFIC if it meets either the Income Test (IRC 1297(a)(1)) or the Asset Test (IRC 1297(a)(2)). To meet the Income Test, at least 75% of its gross income for the tax year is passive income (defined in IRC1297(b)). To meet the Asset Test, at least 50% of its assets by value generate (or are held for the production of) passive income (determined under 1297(e)). For these purposes, passive income includes interest, dividends, certain rents and royalties, and gains from the sale of investment property.

It is not difficult for a foreign corporation to be classified for a taxable year as a PFIC under either of the above-mentioned tests. The Income Test is based on gross income, rather than net income, and the Asset Test is also extremely broad.

The PFIC rules create a punitive scheme for taxing deferred income, by eliminating the lower rates on capital gains and any deferral benefit through the imposition of the interest charge.