Passive Foreign Investment Company (PFIC): How the Tax Rules Apply to Foreign Mutual Funds

What Is a PFIC?

Under Internal Revenue Code §1297(a), a foreign corporation is a PFIC for a taxable year if it meets either of two tests:

Income test: 75 percent or more of its gross income for the year is passive income, such as dividends, interest, and gains from investment assets.

Asset test: on average during the year, at least 50 percent of its assets produce passive income or are held for the production of passive income.

Foreign mutual funds, foreign exchange-traded funds, and similar pooled investment vehicles commonly meet one of these tests. A fund organized in the United States is not a PFIC, even if it invests entirely in foreign securities, because it is not a foreign corporation.

Some special rules narrow the regime. A U.S. shareholder of a controlled foreign corporation (CFC) is generally not treated as a PFIC shareholder of that corporation for the period it is a CFC (§1297(d)). Under the Form 8621 instructions, a person who holds PFIC shares through an IRA or certain other tax-exempt accounts or organizations is generally not treated as a PFIC shareholder.

The Default Rules: Excess Distributions

If no election is in place, the excess distribution rules of §1291 apply. Growth inside the fund is generally not taxed to the shareholder until the shareholder receives an excess distribution or disposes of the shares. At that point, the tax can be considerably higher than for a comparable U.S. fund.

An excess distribution is generally the part of a year’s distributions that exceeds 125 percent of the average distributions received in the three preceding years. Gain on a sale or other disposition of PFIC shares is treated as an excess distribution.

The excess distribution or gain is allocated ratably to each day of the shareholder’s holding period. Amounts allocated to the current year, and to any period before the company was a PFIC, are taxed as ordinary income in the current year. Amounts allocated to each earlier PFIC year are taxed at the highest rate in effect for that year, plus an interest charge computed at IRS underpayment rates from that year’s return due date.

Because sale gain is treated as an excess distribution, it does not qualify for long-term capital gain rates, and the interest charge increases with the length of the holding period.

For example, assume a fund that was a PFIC for the entire holding period is sold at a gain after exactly five years, with no election in place. The gain is spread evenly over the five years. One-fifth is ordinary income in the year of sale, and each earlier year’s share is taxed at that year’s highest rate, with interest.

Elections That Change the Treatment

Qualified Electing Fund (QEF) Election

With a QEF election, the shareholder includes in income each year a pro rata share of the fund’s ordinary earnings, as ordinary income, and of its net capital gain, as long-term capital gain, whether or not anything is distributed. This avoids the interest charge, but the fund must provide a PFIC Annual Information Statement or enough information for the shareholder to compute those amounts. Not every foreign fund provides this statement, so the election is not available for every investment.

The election works best when it applies from the first year the shares are held. If it is made later, the default rules can continue to apply to the earlier years unless the shareholder also makes a purging election, such as an election to treat the shares as sold at fair market value on the first day of the first QEF year, with that gain taxed under the default rules.

Mark-to-Market Election

For PFIC shares that are “marketable stock,” which generally means stock regularly traded on a qualifying exchange, a shareholder can elect under §1296 to include each year’s increase in value as ordinary income. A decline in value is deductible as an ordinary loss only to the extent of prior mark-to-market inclusions that have not been reversed. Gain on a sale while the election is in effect is also ordinary income. The election generally avoids the interest charge for the years it covers, but it does not produce capital gain treatment.

Annual Reporting on Form 8621

A U.S. person who is a direct or indirect PFIC shareholder generally files Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. A separate form is filed for each PFIC, attached to the federal income tax return and filed by its due date, including extensions. The form reports distributions and dispositions, QEF and mark-to-market elections, and the annual information required by §1298(f).

Limited exceptions apply. Under Treasury Regulation §1.1298-1(c)(2), for example, the annual report is generally not required for a fund with no QEF or mark-to-market election if the total value of the shareholder’s PFIC stock is $25,000 or less at year-end ($50,000 on a joint return) and the shareholder had no excess distribution or disposition gain from that fund during the year.

If a required Form 8621 is not filed, the period for assessing tax on the related return generally stays open until three years after the information is furnished (§6501(c)(8)). If the failure was due to reasonable cause and not willful neglect, the extended period applies only to the items related to the failure.

Practical Considerations

Before buying a fund, it helps to confirm where it is organized. Taxpayers who already hold foreign funds can review whether a QEF or mark-to-market election is available, whether Form 8621 was required in earlier years, and how a sale or distribution would be taxed under each regime. These questions are easier to address before a sale than after.

The Bottom Line

The PFIC rules make foreign fund investments a specialized area of U.S. tax compliance. Knowing whether a holding is a PFIC, which regime applies, and whether Form 8621 is required allows a taxpayer to evaluate options before a sale or distribution.