What is a PFIC?

A PFIC is a passive foreign investment company.

The tax rules relating to PFICs were written as anti-avoidance for US citizens deferring tax, by placing passive assets into company structures. Unfortunately, the rules have some unintended consequences.

Most collective investments fall within the definition of a PFIC. This includes managed and index funds, unit trusts and ETFs to name a few.

There are elections that can be made to alleviate the impact of the PFIC rules and these can be made on a timely filed return in the first year an investment is made. IE the election can only be made for a new investment on a current year tax return, prior year elections are not allowed.

Without an election, the tax treatment of PFICs is punitive compared to the tax treatment of similar investments that are incorporated in the U.S.

By way of example, US investor holding a U.S. incorporated mutual fund invested in European stocks pays the low long-term capital gains rate of 15% if the fund is held for more than one year. The same US investor who buys a nearly identical fund listed in Australia (or any place outside the US) will find their investment subject to the PFIC taxation regime, which counts all income (including capital gains) as ordinary income and automatically taxes it at the top individual tax rate (39.6%). Capital losses cannot be carried forward or used to offset other capital gains.

In addition to applying the top rate of tax, the regime looks at penalising “excess distributions”. An excess distribution is the part of the current year distribution that is greater than 125% of the average distributions received during the three preceding tax years, or any capital gains resulting from the sale of PFIC shares. The amount considered an excess distribution is apportioned evenly over the entire holding period of the fund with an amount of distribution assumed taxable in each year. The maximum rate of tax is then applied to each year with an interest charge running from the date the tax return for that year was due until the date of filing.

Form 8621 is required need to be filed to report the holding and activities of each PFIC in each year.

A copy of Form 8621 can be found here: https://www.irs.gov/pub/irs-pdf/f8621.pdf