Passive foreign investment companies.

• Author: Wong, Alan

Before investing in foreign equities, U.S. taxpayers should consider the tax consequences that may apply to them. Foreign investments by U.S. taxpayers can be subject to the punitive tax consequences of investments in passive foreign investment companies (PFICs). Under the default Sec. 1291 PFIC taxation regime, excess distributions received from PFICs are allocated pro rata to each day in the investor's holding period and are subject to interest charges on taxes deemed to be owed in preceding tax years (Sec. 1291(a)(1)). In order to avoid Sec. 1291, U.S. taxpayers can make timely qualifying electing fund or mark-to-market elections. Other various planning alternatives are also available to help U.S. taxpayers avoid the punitive aspects of the PFIC regime.

Determining PFIC Status and Identifying Unexpected PFIC Traps

The IRS implemented regulations on PFICs in 1986 to prevent U.S. taxpayers from deferring tax on passive income earned by entities organized in low-tax jurisdictions. PFICs are foreign corporations that generate 75% or more of their gross income from passive sources or that own assets that are primarily held for the production of passive income (i.e., more than 50% of the entity's asset value is represented by assets that generate passive income) (Sec. 1297(a)). For purposes of PFIC determination, passive income is foreign personal holding company income (FPHCI) as defined in Sec. 954(c). Principal forms of FPHCI are interest, rents, royalties, capital gains, currency gains, and dividends (Sec. 954(c)). Active banking and insurance income, as defined by Sees. 954(h) and (i), is excluded from passive income for purposes of PFIC de-termination (Sec. 1297(b)(2)).

When using the asset test to determine PFIC status, assets that produce both non-passive and passive income are classified based on the relative proportion of income produced in each category (Notice 88-22). Despite their mixed character, certain assets such as working capital will always be considered passive assets, according to Sec. 1296(a)(2). It should also be noted that assets must be valued on a quarterly basis and, more importantly, on a gross basis, disregarding any liabilities that can be traced to particular assets (Notice 88-22). For example, a building used in a trade or business with a fair market value (FMV) of $2 million and with an existing mortgage of $1,500,000 will be valued at $2 million under the asset test for PFIC determination. Due to the inherent...