Passive Foreign Investment Company Definition
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.
A Little More on 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
- Income from notional contracts
- Payments in lieu of dividends
- Net foreign currency gains
- Net gains from commodity transactions
- Income equivalent to interest
To apply the asset test, the fair market value of the foreign firm’s assets are used, which are based on the assets’ value by the end of each quarter.
References for Passive Foreign Investment Company
Academic Research on Passive Foreign Investment Corporation (PFIC)
Structuring an exemption system for foreign income of US corporations, Graetz, M. J., & Oosterhuis, P. W. (2001). National Tax Journal, 771-786. The authors investigate the possible structure of an exemption system for the U.S. that is like the exemption structure for half of the OECD countries. The goal is to avoid double international taxation without prompting U.S. taxpayer to move operations, earnings, or assets abroad. Changing over to an exemption system might make U.S. international income tax law simpler but simplification has to be a priority.
Back to the Future: A Path to Progressive Reform of the US International Income Tax Rules, Peroni, R. J. (1996). U. Miami L. Rev., 51, 975.
Credit and deferral as international investment incentives, Hines Jr, J. R. (1994). Journal of Public Economics, 55(2), 323-347. Many governments tax firms’ foreign income with a system that gives credits for the paid foreign taxes and allows for a deferral of taxes for income that has been brought back the taxpayer’s country. This paper demonstrates how this system promotes the restriction of a company’s equity stakes in new foreign investments and to provide funding for their new investment with significant debt.
Tax Planning for Offshore Hedge Funds-the Potential Benefits of Investing in a Pfic, Gross, P. S. (2004). This article addresses the tax issues a U.S. investor should think about when making investments in an offshore fund and also what a manager of a hedge fund should think about when organizing funds, with specific attention to the PFIC elections possibly accessible to investors in the U.S. and focuses on the tax benefits of not investing in domestic funds.
Anti-Deferral Deferred: A Proposal for the Reform of International Tax Law, McDonald, J. (1995). Nw. J. Int’l L. & Bus., 16, 248. Income tax provisions concerning the U.S. ownership of offshore companies have a complex Code. The functioning of the tax law relating to this area requires the uses of sophisticated software to make calculations. The price to comply with the Code provisions has begun to impact the competitiveness of the applicable companies. The complexity of these tax laws may make it hard for tax professionals to advise their clients. The essence of the debate going on over the U.S. system of international taxation needs to be understood in order to define the reasons for the complexity of the Code in this area.
Structure of International Taxation: A Proposal for Simplification, Avi-Yonah, R. S. (1995). Tex. L. Rev., 74, 1301.
Understanding PFICs and QEFs, Jelsma, P. (1988). Int’l Tax J., 14, 317. There is congressional interest in the United States taxpayers’ capability to bypass specific rules efficiently of the IRS Code has resulted in the instituting of passive foreign investment company provisions as a component of the Tax Reform Act of 1986. Before the provisions, a U.S. investor could get a major tax benefit by investing in a foreign company instead of a domestic one. U.S. investors do not ordinarily have a connection to records of the foreign investment company and lack adequate voting power to urge dividend distributions. That’s why Congress implemented a taxing mechanism so that investors can calculate their income according to specific reasonable assumptions.
Whether, When, and How to Tax the Profits of Controlled Foreign Corporations, Steines Jr, J. P. (2000). Brook. J. Int’l L., 26, 1595. The U.S. could tax earnings of controlled foreign corporations by deferring taxation until profits are sent back the U.S. and permit deduction or credit for foreign taxes then, or exempt the earnings from tax permanently or accumulate the present earnings and allow either deduction or credit for foreign taxes. David Rosenbloom believes that a considerable amount of the controlled foreign corporation profits should have U.S. tax exemption with a deduction for foreign taxes of the balance taxed currently.
Capital Flows between Countries: Reciprocal Arrangements for the Sale of Shares in Mutual Funds, Francke III, A. (1987). Colum. Bus. L. Rev., 365. Qualified advisers in a foreign country of investment manage a pool of diversified transferable securities through which investments in foreign companies are most times made. Investors diversify their risk this way and limit the disadvantages brought about by not being familiar with foreign markets. The pools are known as unit collective investment trusts or UCITs. The UCIT distributes share-like units to public investors which result in transnational cash flows that help the financing of trade and industry from the investments made in a pool of transferable securities. The absence or presence of government regulations in the investor’s country and the country of the investment is a significant element that affects the freedom of that capital flow.
Shifting the burden of taxation from the corporate to the personal level and getting the corporate tax rate down to 15 percent, Grubert, H., & Altshuler, R. (2015, January). In Proceedings. Annual Conference on Taxation and Minutes of the Annual Meeting of the National Tax Association (Vol. 108, pp. 1-53). National Tax Association. To get to a major reduction in the corporate tax rate, the authors look at three plans that will shift the tax on company income to the personal. One plan gets rid of corporate tax and the yearly adjustment in the value of publicly traded securities at regular rates. The second plan integrates shareholder and corporate taxes. The third plan reduces the corporate to 15 percent and capital gains and taxes dividends as ordinary income. When an asset is sold, deferral on interest charge on taxes during the holding period will be enforced to prevent huge reductions in dividend payouts and capital gains realizations.
International Tax, Act, S. T. H. A. (2009). Senator Carl Levin introduced the Stop Tax Haven Abuse Act in 2009. The bill is similar to the bill cosponsored by at the time, Senator Barack Obama, which didn’t get much support. Levin’s bill would tax foreign companies that traded publicly or have $50 million or more in assets and are controlled as U.S. corporations in the United States. The bill would also demand tax withholding on dividend-equivalent payments and replace dividend payments to a person, not in the U.S. who maintain specific kinds of equity derivatives. Lastly, the bill would make it mandatory to report passive foreign investment company by the owners and by those receiving property or money from, transferred assets to, benefited from or formed a PFIC.
A Tisket, a Tasket: Basketing and Corporate Tax Shelters, Lederman, L. (2010). Wash. UL Rev., 88, 557. This article suggests extending the passive/active distinction that is already in place for individuals to domestic corporations. Many abusive tax shelters including financial products would not work if corporations’ passive-source losses and expenses were enforced to be grouped with their passive income, such as dividends, rents, and interest. This article also recognizes three primary objections to the proposal which are that it is too complex, under-inclusive and overbroad.