Passive Foreign Investment Company (PFIC)

A Passive Foreign Investment Company (PFIC) is not a type of business you'd find on a company's letterhead, but rather a dreaded tax classification assigned by the U.S. Internal Revenue Service (IRS). It's a label for any foreign corporation that, from the IRS's perspective, looks more like a treasure chest of investments than an active, operating business. Specifically, a foreign company gets tagged as a PFIC if it meets either of two conditions: the majority of its income comes from passive sources (like investments), or the majority of its assets are held for the purpose of producing such income. The whole point of these rules is to stop U.S. investors from using foreign corporations, especially foreign mutual funds, to endlessly defer paying U.S. taxes on their investment gains. For the unsuspecting investor, stumbling upon a PFIC can turn a profitable investment into a tax and accounting nightmare.

A foreign corporation is branded a PFIC for a given tax year if it passes one of two tests. It only takes one to get caught in the net.

This test is straightforward: if 75% or more of the corporation's gross income for the year is `passive income`, it's a PFIC. Think of passive income as money the company makes without actively running a day-to-day business. The usual suspects include:

• Dividends
• Interest
• Rents and royalties (unless they are derived from an active business)
• Annuities
• Net capital gains from the sale of assets that produce passive income (like stocks and bonds)

This test looks at the company's balance sheet. If, on average during the tax year, 50% or more of the company's assets produce passive income or are held to produce passive income, it's a PFIC. This means a foreign company sitting on a huge pile of cash, stocks, or bonds—even if it's for a future project—can accidentally become a PFIC.

Holding shares in a PFIC is a major headache for U.S. investors because of the exceptionally harsh tax rules. The default tax treatment is designed to be so painful that it discourages these investments entirely. If you don't make a specific election, any gains or certain distributions from your PFIC are subject to a “throwback” rule that can vaporize your returns. Fortunately, there are a couple of ways out, but none are perfect.

An investor in a PFIC must generally choose one of three tax treatments.

This is what happens if you do nothing. It's the default setting, and it’s punitive.

1. Gains are not treated as capital gains. Instead, your gain is allocated pro rata over your entire holding period.
2. Each portion is taxed at the highest ordinary income tax rate in effect for each respective year. It doesn't matter what your personal tax bracket was.
3. An interest charge is added to the tax calculated for each prior year, as if you had underpaid your taxes for all those years. This combination of high tax rates and compounding interest charges can be devastating to your final return.

You can elect to treat the PFIC as a Qualified Electing Fund (QEF). Under this regime, you pay U.S. tax each year on your share of the fund's earnings, a bit like how a partnership is taxed. This allows you to recognize long-term capital gains and avoid the nasty interest charges. The huge catch? The foreign company must provide you with a “PFIC Annual Information Statement” detailing your share of its earnings. Most foreign companies, especially those not actively catering to U.S. investors, don't bother providing this. Without it, you can't use the QEF election.

If your PFIC stock is “marketable” (i.e., regularly traded on a major stock exchange), you can make a Mark-to-Market (MTM) election.

1. You include in your income each year the difference between the stock's fair market value at year-end and your adjusted basis in the stock. In simple terms, you pay tax on your paper gains, even if you haven't sold the stock.
2. The big downside is that all gains are taxed as ordinary income, not the more favorable long-term capital gains rate.
3. You can deduct paper losses, but only to the extent of previously recognized MTM gains.

For value investors, the PFIC rules are a giant, flashing red light. The complexity, paperwork (you must file IRS Form 8621 for each PFIC you own), and punitive tax consequences can turn a brilliant investment into a money-loser.

• Avoidance is the best policy. The administrative burden and tax risk often outweigh the potential rewards. For most investors, it's simpler and safer to find comparable investments that aren't PFICs.
• Beware of foreign funds. A huge number of non-U.S. mutual funds and ETFs are classified as PFICs for U.S. investors. This is the most common way people fall into the trap.
• Even operating companies can be PFICs. A foreign company that sells a division and holds the cash for a while can temporarily meet the asset test and become an “accidental” PFIC, creating a tax nightmare for its U.S. shareholders.

The ultimate lesson is the importance of due diligence. Before you invest in any foreign corporation or fund, do your homework to determine its PFIC status. If it is a PFIC, you must understand the tax implications and be prepared for the compliance burden, or simply walk away.