Passive foreign investment companies.

• Author: Fox, Stephen C.

U.S. shareholders of passive foreign investment companies (PFICs) face interest charges on the "deferred" tax on a PFIC's earnings and appreciation. This harsh treatment applies to share-holders of operating companies as well as investors in offshore funds. The PFIC rules contain many potential pitfalls requiring careful monitoring of foreign companies. (For instance, see the Tax Clinic item, "PFICs: Some New Twists to Old Rules," TTA, June 1992, at 362.)

Definition and background

A PFIC is any foreign corporation that meets either of the following tests under Sec. 1296(a):

*Passive income is 75% or more of gross income.

*The value of assets (including cash) that produce or could produce passive income is 50% or more of total assets.

Passive income generally means foreign personal holding company income (as defined in Sec. 954(c)), such as dividends, interest, rent and royalties. However, dividends and interest from "same-country" related corporations, rents and royalties on "same country" property from related corporations, and active business rents and royalties from unrelated persons are not passive income (Temp. Regs. Sec. 1.954-2T(b)(3), (4) and (5)).

There is no minimum U.S. ownership required for a PFIC. Indeed, a foreign corporation can be a PFIC without having any U.S. shareholders, although there is no practical effect until there are U.S. shareholders. If a U.S. person purchases shares in a foreign corporation that is a PFIC and retains those shares while the corporation continues to be a PFIC, the corporation will be a PFIC as to that shareholder. Once a corporation becomes a PFIC with respect to a shareholder, it will continue to be a PFIC with respect to that shareholder until either of two elections purges the PFIC taint (Sec. 1297)(b)(1)).

Effects of PFIC status

The PFIC rules have no direct impact on foreign corporations; they affect only U.S. shareholders.

A PFIC's shareholders must pay an interests charge on "excess distributions" relating to income earned by the PFIC for post-1986 years. An "excess distribution" is the gain on any disposition of shares plus that portion of any distribution exceeding 125% of the average distributions for the three preceding tax years. Distributions include any money or property distributed to a share-holder in respect of his stock and cover both taxable and many types of otherwise nontaxable transactions. Thus, the principal effect of PFIC status is to change the timing of income...