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Taxation of "Passive Foreign Investment Companies" (PFICs)

PFICs - US Tax and "Passive Foreign Investment Companies"

What are PFICs?

The PFIC acronym stands for "passive foreign investment companies" as defined by US tax legislation. Much of the material and legislation surrounding PFICs is complex, but in very general terms a PFIC is a company that is:

  1. Foreign - that is to say, investment companies based and registered outside the US, which are not controlled by the investor, and
  2. The company meets either an income or assets "passivity" test:
    • The "income test" is met if 75% or more of the foreign corporation’s gross income is passive income, or
    • The "asset test" requires an average percentage of assets held by the foreign corporation, which either produces passive income or held for the production of passive income, is at least 50% or more by value.

Some exemptions/exceptions exist in relation to companies when it comes to whether they qualify as PFICs - for example start-ups which typically do not generate business income in the first one or two years of operation may be exempt - but these are quite technical exemptions outside the scope of most retail investors.

Some example investments that might qualify as PFICs include:

  1. A cash management trust account - as distinct from a simple bank account
  2. A bond ETF
  3. A residential or commercial mortgage trust

Who is impacted by PFIC Taxation Provisions

Legislated provisions around the taxation of PFICs apply to "US persons" - and that includes both US citizens, permanent residents (green card holders) and other individuals who are "tax resident" for US purposes - such as Australian and other expatriates on work assignments in the US.

PFIC provisions date back to legislation in 1986, but in practice it has only been over the last few years - given the information now available through FATCA returns and increased tax information flows between countries - that the IRS has been in a position to identify unreported investments in PFICs. PFICs are not a significant issue for most domestic US taxpayers, given that there is relatively little retail foreign investment exposure in the US, but it is more of an issue to US expatriates who invest more extensively in foreign markets and expatriates in the US who may have extensive investments in their base country which may qualify as PFICs.

Why expatriates in the US and Americans should avoid investing in PFICs

There are two basic reasons why investment in PFICs should be avoided:

1. Punitive Taxation

"Excess distributions" from a PFIC - an excess distribution is where a distribution received by a taxpayer during the taxable year exceeds 125% of the average amount of distributions during the three preceding years - these can attract taxation at the highest US marginal income tax rate, and additional interest penalties. In total the tax rate on these investments can rise to over 50% because of (highly) complex rules applying to the timing of PFIC income recognition.

For distributions that are not "excess", income or gains are treated under normal U.S. marginal income tax rules - not as capital.

2. Exceptionally Heavy Compliance Burden

A very heavy compliance burden attaches to reporting PFIC investments - for example, a separate Form 8621 needs to be completed each and every year for each PFIC. Hours of professional time can attach to the completion of individual forms and the information provided by foreign investment firms is rarely tailored to meeting PFIC reporting requirements.

Australian expatriate on assignment to the US, US citizens and "green card holders" resident in Australia, should review their investment portfolios to ensure that they do not contain investments that qualify as PFICs unless there are clear and valid commercial reasons for retaining the investment given the tax and compliance issued mentioned above.

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