The Problem with PFICs

Sometimes, however, a U.S. citizen may invest in a foreign vehicle that isn't taxed like a traditional partnership. Instead, these investments take the form of stock in a foreign corporation. When making such an investment, the investor is subject to a very different set of tax rules, and these rules create trips for the unwary that can substantially reduce after-tax returns. The traps occur if the foreign corporation is a passive foreign investment company, or PFIC, and certain essential precautions aren't taken.

A PFIC is any non-U.S. corporation with 75 percent or more of its gross income in any tax year passive income or 50 percent or more of its assets producing passive income. Once a corporation is classified as a PFIC, it remains so for the rest of its existence. Some investors don't realize that PFIC status carries some adverse tax consequences. For example, certain dividend distributions and any gain recognized upon the sale of the stock of a PFIC are called "excess distributions" and taxed at ordinary income rates-not the generally lower long-term capital gain or qualified dividend rates. These excess distribution rules even tax the return of capital distributions as if they were ordinary income. Furthermore, excess distributions are subject to a special interest charge. The interest charge is actually computed on the so-called "aggregate increase in taxes," which is the sum of the tax liabilities that would have been incurred for each year the foreign corporation was a PFIC had the amount of the shareholder's allocable excess distribution actually been included in his gross income in that year and taxed at the highest tax rate in effect. For this purpose, the excess distribution is allocated ratably over the number of years in the shareholder's holding period for his shares. The interest charge on the aggregate increase in taxes is the short-term applicable federal rate plus three percentage points. It's confusing, but the point is that the tax hit could be substantial-especially for investors who understandably find these tax issues difficult to negotiate.

Shareholders of PFICs that are publicly traded-a foreign mutual fund, for example usually avoid the onerous treatment described above by making a special mark-to market election that requires the shareholder to include any appreciation in the value of the PFIC shares into income or to deduct any decrease in the value of the shares each year.

To avoid these adverse tax consequences-for privately held PFIC shares, a shareholder may make a qualified electing fund (QEF) election, in which case the excess distribution rules do not apply. The effect of a timely QEF election is that the shareholder is treated as receiving a pro rata share of the PFIC's ordinary income and net capital gains each year. The shareholder is thus treated-in a manner similar to a partner in a partnership, and is taxed on his pro rata share of income and gain irrespective of whether or not actual cash is distributed. So it's important that these investors make sure that the agreements provide for mandatory distributions to pay taxes. Also, since foreign corporations that are not engaged in a United States trade or business generally don't have U.S. tax filing obligations, shareholders in privately held PFICs must negotiate access to the PFIC's books and records and to the information required for a U.S. investor's federal income tax return.

The bottom line? PFICs can be tricky, and if you have an investment in a foreign corporation, your tax advisor must determine whether the foreign corporation is a PFIC. In this case, what an investor doesn't know can very much hurt him.