PFIC stands for Passive Foreign Investment Company, and it is a term used by the IRS to describe certain foreign corporations.
A PFIC is any foreign corporation that meets either of the following two tests:
- The income test: At least 75% of the corporation’s gross income is passive income, which includes interest, dividends, royalties, rents, and other similar types of income.
- The asset test: At least 50% of the corporation’s assets are passive assets, which includes cash, stocks, bonds, and other investments that generate passive income.
If a foreign corporation meets either of these tests, it is considered a PFIC for tax purposes, and the U.S. taxpayers, who own shares in the corporation, may be subject to special tax rules. A foreign corporation can be a PFIC even if it is not formed or organized as a passive investment company. For example, a foreign operating company may still be considered a PFIC if it meets the income or asset test requirements, stated above.
It’s important to note that the rules and regulations regarding PFICs are complex, and it’s easy for taxpayers to make mistakes when reporting PFIC income and failure to properly report PFIC income can result in significant penalties. Therefore, to avoid penalties, it’s recommended that taxpayers consult with a qualified tax professional who is experienced with PFIC taxation to ensure compliance with the rules and regulations.
The penalties for not reporting a PFIC (Passive Foreign Investment Company) can be severe. Here are some of the penalties that the IRS can impose:
- Failure to file Form 8621: U.S. taxpayers who own shares in a PFIC must file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company, or Qualified Electing Fund, for each year they own the shares. The penalty for failing to file this form can be up to $10,000 per year, per shareholder.
- Interest and additional tax: If a U.S. taxpayer fail to report income from a PFIC, the IRS can assess interest and additional tax on the unreported income.
- Accuracy-related penalty: If the IRS determines that a taxpayer made an error on their PFIC reporting, the agency can impose an accuracy-related penalty of up to 20% of the tax underpayment.
- Criminal penalties: In some cases, failure to report a PFIC may be considered tax evasion, which is a criminal offense. Taxpayers who wilfully fail to report a PFIC can face fines and even imprisonment.
A U.S. person who owns shares in a PFIC is required to file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company, or Qualified Electing Fund, in the following situations:
- Annual filing: A U.S. person who owns shares in a PFIC during the tax year must file Form 8621 annually, regardless of whether the person received any income from the PFIC during the year.
- Excess distribution: If a U.S. person receives an excess distribution from a PFIC, they must file Form 8621 for the year in which the excess distribution occurred.
- Disposition of PFIC shares: If a U.S. person disposes of their shares in a PFIC during the tax year, they must file Form 8621 for the year of the disposition.
In addition, a U.S. person who is a direct or indirect owner of a foreign trust that owns shares in a PFIC may also be required to file Form 8621.
Market-to-market and Qualified Electing Fund (QEF) are two methods that can be used to report PFIC (Passive Foreign Investment Company) income to the IRS. Both market-to-market and QEF methods require a taxpayer to file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company, or Qualified Electing Fund, with their tax return each year.
Under the market-to-market method, a taxpayer reports the increase or decrease in the value of their PFIC investment as ordinary income or loss in the year it occurs. This means that the taxpayer would pay taxes on any appreciation in the value of the PFIC investment, even if they did not sell the investment or receive any income from it.
Under the QEF method, a U.S. shareholder of a PFIC can elect to include their share of the PFIC’s income, gains, and losses on their tax return each year, based on the PFIC’s annual financial statements. The QEF method is only available if the PFIC provides annual financial statements to its shareholders. This method allows the taxpayer to avoid the harsh tax consequences of the default rules for PFICs.
A distribution is a payment made by a Passive Foreign Investment Company (PFIC) to its shareholders. Distributions can be in the form of cash, stock, or other property. An excess distribution is a distribution that exceeds 125% of the average annual distributions made by the PFIC over the previous three years, or the shareholder’s holding period if less than three years. If a U.S. taxpayer receives an excess distribution from a PFIC, they are required to report the excess amount as ordinary income on their tax return for the year in which the excess distribution was received and pay taxes on it at their ordinary income tax rate.
The excess distribution is reported on Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company, or Qualified Electing Fund. In addition to reporting the excess distribution on this form, the taxpayer must also calculate their tax liability using the excess distribution calculation methods described in the instructions for Form 8621.
Even if you do not file a U.S. tax return, you may still be required to file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company, or Qualified Electing Fund, if you own shares in a Passive Foreign Investment Company (PFIC). The requirement to file Form 8621 is separate from the requirement to file a U.S. tax return. If you are a U.S. person and you own shares in a PFIC, you are required to file Form 8621 annually, regardless of whether you are required to file a U.S. tax return. However, if you are not required to file a U.S. tax return because your income is below the filing threshold, you may be eligible to file Form 8621 using the simplified reporting method. The simplified reporting method allows certain eligible taxpayers to file a simplified version of Form 8621 with their tax return.
