Passive foreign investment company
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Within taxation law of the USA, a passive foreign investment company (or "PFIC") is a foreign company with predominantly investment income, or whose assets are primarily intended to generate investment income. The Internal Revenue Service handles the profits of investments in PFICs differently than their domestic counterparts, so U.S. investors face significant tax implications should they hold ownership of a PFIC. Unlike the controlled foreign corporation provisions, which focus more on tax havens, the PFIC provisions focus on foreign investment structures. Classification as a PFIC occurs when 75% or more of the company's income is passive, or when more than 50% of the company's assets exist in investments earning interest, dividends, and/or capital gains.
The drawback to this tax is natural resource exploration companies tend to be PFIC's because their main assets are the cash they are using to explore with. That cash is earning more interest than the company earns from any other business which brings them under the PFIC definition that was set up to close a tax avoidance loophole.
[edit] Classification as a PFIC
Tax code sections 1291 through 1297 provide the rules for U.S. persons who invest in passive foreign investment companies. A foreign corporation is considered a "passive foreign investment company" for these purposes if either one of two tests is satisfied: the Income Test or the Asset Test.
- Under the Income Test, a foreign corporation is considered a PFIC if 75 percent or more of the foreign corporation's gross income for the taxable year consist of passive income. Passive income includes dividends, interest, royalties, rents, annuities, net gains from certain commodities transactions, net foreign currency gains, income equivalent to interest, payments in lieu of dividends, income from notional contracts, and income from certain personal service contracts. Note that the active business of a licensed bank or insurance business is considered active income; similarly, certain foreign trade income and income allocated to a related person's non-passive income is also excluded.
- Under the Asset Test, a foreign corporation is considered a PFIC if 50 percent of the foreign corporation's assets produce - or are held to produce - passive income. In applying the Asset Test, the fair market value of the assets is generally used (the "FMV Method"). The general exception is a foreign corporation that is not publicly-traded and is a [controlled foreign corporation], which must use the adjusted basis of its assets in applying the Asset Test (the "Basis Method"). A taxpayer may also elect to utilize the basis method, but, once this is done, may not change back to the FMV method without IRS consent.
There are two important exceptions to these rules for calculation. First, Congress has recognized that newly-formed corporations frequently hold short-term investments that may create a significant percentage of income prior to the business truly commencing. As such, in the first taxable year in which a foreign corporation has gross income (the "Start-Up Year"), the company will not be considered a PFIC. For this to be the case, the following conditions must be met:
- Any predecessors to the company must not have been PFICs.
- The company must establish that it will not be a PFIC for either of the first two taxable years following the Start-Up Year.
- The company must not, in fact, become a PFIC during the first two years following the Start-Up Year.
Likewise, Congress has recognized that a firm that undergoes a change in its business may hold significant temporary assets that generate income, creating a similar situation as a fledling start-up company. As a result, a foreign corporation is not considered a PFIC if it meets the following criteria:
- The company and its predecessors must not have been classified as PFICs in previous years.
- The company must establish that substantially all of the passive income for the taxable year is attributed to proceeds from the disposition of one or more active trades or businesses, and that it will not be a PFIC for either of the two years following the current year.
- The company must not, in fact, be classified as a PFIC during the subsequent two years.
[edit] Consequences of Ownership of a PFIC
A U.S. holder of ownership in a passive foreign investment corporation must include as ordinary income the allocated gains or excess distributions in its gross income for the taxable years in which the allocations are made. The tax liability is determined at the highest rate of tax in effect for the applicable taxable year. Additionally, the deferred tax liability from the allocations are treated as underpayments of tax, and interest charges are imposed on the deferred taxes on the allocated gains and excess distributions!
