What is a Passive Foreign Investment Company?

A passive foreign investment company or PFIC is an offshore corporation with 75 percent of its gross income comes from investments instead of regular business operations and 50 percent of its assets are investments that generate earnings in the form of capital gains, dividends, or earned interest.

What Qualifies as a Passive Foreign Investment Company?

According to the IRS tax code, Passive Foreign Investment Companies involve foreign-based partnerships, mutual funds, and other investment vehicles that are pooled with at least one U.S. shareholder. Most of the PFIC investors have to pay an increased personal income tax rate on capital gains and distributions that come from rises in share values, even if the lower capital gains tax rate would typically be applicable to that income if it came from U.S.-based corporation investments. 

There was a tax loophole that allowed some U.S. taxpayers to shelter foreign investments from taxation in the U.S. that brought about the recognition of PFICs in 1986 tax reforms. The established tax reforms aimed to close the loophole but also when the investment was brought under U.S. taxation, tax them at rates so high that it would discourage U.S. taxpayers from making them. To be considered a Passive Foreign Investment Company, the U.S. Internal Revenue Code has set up two tests, the income test or the asset test, of which the foreign company has to meet one of them: 

Income test: 75 percent of the company's gross income is passive income for a taxable year. 

Asset test: 50 percent of the company's assets retained produced passive income or are retained for the generation of passive income for a taxable year. 

Passive income can include:

• Income earned from specific contracts for personal service
• Interest
• Income from notional contracts
• Dividends
• Payments in lieu of dividends
• Royalties
• Net foreign currency gains
• Annuities
• Net gains from commodity transactions
• Income equivalent to interest
• Rents

To apply the asset test, the fair market value of the foreign firms assets are used, which are based on the assets value by the end of each quarter.