What Qualifies as a PFIC?
The law casts a wide net. A foreign corporation becomes a PFIC if it meets either one of two straightforward criteria:
- The Income Test: If 75% or more of the company’s gross income is considered passive. Passive income includes earnings from dividends, interest, certain rents, royalties, and capital gains.
- The Asset Test: If at least 50% of the company’s average assets are investments that produce passive income or are held for that purpose.
This definition is intentionally broad and captures far more than most investors realize. Common examples include:
- Foreign mutual funds purchased through a broker in another country.
- Non – U.S. exchange-traded funds (ETFs).
- Many foreign holding companies and investment trusts.
- Certain foreign insurance products with an investment component.
For U.S. persons, including citizens and residents, owning shares in such an entity triggers special reporting and taxation rules designed to be anything but simple.
Why PFIC Taxation is a Major Concern
The U.S. tax code treats PFICs with a default set of rules that are punitive. The intent is to discourage investment in these vehicles over comparable U.S.-registered funds. The default regime is known as the Excess Distribution rules.
Under these rules:
- Any distributions you receive from the PFIC and any gain from selling your shares are not taxed at favorable capital gains rates.
- Instead, they are taxed as ordinary income at your top marginal tax rate.
- Most burdensome is the addition of an interest charge. This charge is applied to the tax attributable to the distribution or gain, calculated as if that tax had been owed every year you held the investment. This can drastically increase your total tax liability.
Elections to Avoid Punitive Treatment
Investors are not necessarily stuck with this harsh treatment. Making a timely and proper election on Form 8621 can allow you to elect into one of two alternate tax regimes:
1. The Qualified Electing Fund (QEF) Election
This is often the preferred method when it is available. By making a QEF election, you agree to include your share of the PFIC’s ordinary earnings and net capital gain in your income each year, regardless of whether the fund actually distributes that money to you. It makes the PFIC’s tax treatment somewhat analogous to that of a U.S. mutual fund, albeit with more complex reporting. A critical requirement is that you must obtain specific annual information from the PFIC, known as a PFIC Annual Information Statement, to make the calculations.
2. The Mark-to-Market (MTM) Election
This election is available only for PFICs that are marketable—meaning their shares are regularly traded on an established securities exchange. Under MTM, you treat the PFIC investment as if you sold it at fair market value on the last day of the tax year. You report any net unrealized gain as ordinary income. Any net unrealized loss is deductible, but only to the extent of previously reported unrealized gains. This method requires annual valuation.
Choosing the right election depends on the specific PFIC, the availability of information, your holding period, and long-term tax strategy.
FIling
Form 8621 is not optional if you own a PFIC. Key procedural facts include:
- Separate Filing: You must file a separate and complete Form 8621 for each PFIC you own. Owning five different foreign funds means preparing five distinct forms.
- Attachment Requirement: The form is filed as an attachment to your annual federal income tax return (Form 1040). It has the same deadline and extension periods as your personal return.
- Initial Election Timing is Critical: The QEF election, in particular, generally must be made in the first tax year you own the PFIC shares. Missing this initial deadline does not just mean filing a late form; it can permanently lock you out of making the election for those shares, consigning you to the punitive default rules. Correcting such an error often requires a Private Letter Ruling from the IRS, which is a costly and time-consuming process.
FAQs
How can I tell if my foreign investment is a PFIC?
You must apply the income and asset tests. For publicly traded foreign funds, it is very safe to assume they are PFICs. For individual foreign stocks, it requires more analysis of the company’s primary business activities and balance sheet. When in doubt, a conservative approach and professional guidance are advisable.
What if I own a PFIC inside my IRA or other retirement account?
Holding a PFIC within a traditional IRA, Roth IRA, or 401(k) does not exempt you from the PFIC reporting rules. You are still required to file Form 8621 for the PFIC. However, the tax consequences may differ because the income inside the retirement account is not currently taxable. The interaction is complex and often requires specialist advice.
I own a small amount of a foreign ETF — just a few thousand dollars. Do I really need to go through this?
Yes. The filing requirement is triggered by ownership, not by the size of the investment. While the tax consequences might be small, the penalty for failing to file the required Form 8621 can be substantial. The IRS imposes a penalty for failure to file this form, and it can apply for each year of non-compliance.
Can I simply sell my PFIC to avoid these rules?
Selling the investment does eliminate the future reporting requirement. However, the sale itself is a reportable event on Form 8621. The gain from the sale will be taxed under whichever regime applied to your holding period (punitive default, QEF, or MTM). You cannot avoid filing the form for the year of the sale.
What information do I need from the fund to make a QEF election?
You need the fund’s PFIC Annual Information Statement or equivalent data. This statement must provide, in English and in U.S. dollars, your pro-rata share of the fund’s ordinary earnings and net capital gain for the tax year. Many foreign funds do not produce this statement, making a QEF election impossible. In such cases, you may be forced to use the Mark-to-Market election (if eligible) or remain under the default rules.
What are the actual penalties for not filing Form 8621?
The statutory penalty for failure to file Form 8621 is $10,000 per form, per year. More devastatingly, if you fail to file, the IRS can also assert that the statute of limitations on assessing tax for that year never closes for the items related to that PFIC. This means the IRS could audit that part of your return indefinitely.
Navigating the PFIC rules is a highly technical exercise with little margin for error. Given the severe financial penalties and the complexity of elections and calculations, engaging a tax advisor with specific expertise in international investments is not merely a recommendation, it is a crucial step for financial protection. Proper planning before purchasing a foreign investment can prevent a decade of complicated and costly tax filings.