Foreign national tax planning to avoid PFIC trap.

• Author: Madden, David
• Position: Passive foreign investment companies

As part of the Tax Reform Act of 1986, Congress enacted legislation on the taxation of a U.S. shareholder's interest in a passive foreign investment company (PFIC). To offset potential tax deferrals, the PFIC rules impose a punitive interest charge on U.S. shareholders of a foreign corporation that queries as a PFIC, for certain distributions by the PFIC and dispositions of PFIC stock.

When a shareholder receives an excess distribution, the PFIC regime allocates the stock's excess distributions ratably to each day in the taxpayer's PFIC stock holding period. The amounts allocated to the current year or any pre-PFIC years are included in the taxpayer's current-year gross income as ordinary income. Further, the "deferred tax amount" of the excess distribution allocated to prior PFIC years increases the current-year tax (Sec. 1291(a)). The deferred tax equals the tax imposed on the excess distribution allocated to the prior PFIC years, computed at the highest marginal rate in effect for the tax year in question, plus interest on such tax increase (Sec. 1291(c)).

While Congress originally enacted the PFIC regime to eliminate the tax-deferral advantage enjoyed by savvy U.S. investors who were investing in foreign (rather than domestic) investment funds, the PFIC regime can spring a trap on a different group of unsuspecting investors: foreign nationals. When a foreign citizen comes to the U.S. to work, he is commonly a shareholder in a foreign corporation. As a result, unsuspecting foreign nationals with no intention of deferring taxes may be subject to the PFIC regime and face harsh U.S. tax consequences. However, with the proper tax planning, foreign nationals who hold stock in a foreign corporation can avoid the harsh consequences of being caught in the PFIC trap.

Observation: Foreign nationals can be easily caught in the PFIC trap, as a PFIC might include something as common as a foreign mutual fund.

In tax planning, the importance of properly classifying a foreign corporation cannot be understated and this requires a particular analysis. Determining whether a corporation is a controlled foreign corporation (CFC) (by applying the laws defining CFCs (as found in Sec. 957)) is the first step. Determining whether the foreign corporation is a foreign personal holding company (FPHC) (as defined in Sec. 552) comes next. The RKS generally does not treat a foreign corporation that would otherwise be a PFIC as such if it were also a CFC. Additionally...