Passive Foreign Investment Corporation (PFIC) Planning for U.S. Heirs or Before Becoming a U.S. Resident

Individuals interested in or planning to move to the United States should be aware of Passive Foreign Investment Corporations (PFICs) and their implications on taxes before arriving and settling in. PFICs attract very specific and sometimes penal tax consequences as well as reporting obligations absent any specific elections that may be made for that individual. Investments holding a PFIC designation can result in increased taxes, penalties, and interest charges—gains on the disposition of PFIC ownership may be treated as “excess distribution” and taxed as ordinary income rates.

PFICs are foreign corporations subject to specific tests to determine their classification under U.S. tax rules. There are two separate tests to determine if a foreign corporation is a PFIC under U.S. tax rules:

1. Income Test: 75% or more of the company’s gross income is passive in nature; or
2. Asset Test: 50% or more of the quarterly average value of the company’s gross assets consists of assets that produce passive income.

The rules regarding PFICs are complex, but essentially, assets such as non-U.S. unit trusts, foreign mutual funds, and offshore bonds are often considered PFICs for U.S. income tax purposes. This also applies to founders of non-U.S. companies with low revenue who have obtained third-party investment.

Depending on one’s circumstances, there are two considerations to take regarding PFIC testing prior to an individual’s arrival to the US:

1. Portfolio: Analyze the individual’s investment portfolio before arrival to identify potential PFIC investments. One should be looking for foreign mutual funds, offshore bonds, unit trusts, Real Estate Investment Trusts (REITs), and Exchange-Traded Funds (ETCs).
2. Private companies: Understand the individual’s shareholding in private non-U.S. operating or family investment entities that may require PFIC testing.

PFIC Taxation

Without any proactive measures, as discussed below, if one continues to hold onto any PFICs, any excess distributions or sale of assets considered a PFIC will be taxed over the entire holding period. This means a U.S. taxpayer will be subject to taxation for each year the asset was held. If an individual is a U.S. income tax resident during those years, they will also face additional charges for prior year taxes, including interest and penalties. All taxation is at the individual’s highest marginal rate per year over the entire holding period. However, according to the proposed regulations from 1992, a person becoming a U.S. resident is not subject to tax on the built-in gains accrued in those years prior to obtaining U.S. residency under the PFIC regime but under normal taxation principles.

Mark to Market Election

The Mark to Market election is an option for publicly traded PFICs that treats the PFIC as a marketable security, resulting in annual tax payments on the asset’s growth. While this eliminates the penalties and interest charges on holdings from the back years’, the tax rates applicable to the election can be high and are subject to tax regardless of distributions or disposition of the PFIC. The election is done on an individual PFIC basis and is irrevocable once made on that specific investment.

Qualified Electing Fund (QEF) Election

The purpose of QEF treatment is to essentially disregard the opaque nature of the PFIC as a corporation and instead subject the U.S. taxpayer to the underlying income and original source of the investment, similar to the status of being a partner in a partnership. To take advantage of this, a taxpayer must meet certain conditions, including making a QEF election and ensuring the foreign fund/company complies with IRS requirements. The election applies to future years unless the foreign corporation is no longer a PFIC or the shareholder revokes the election with IRS consent. The election is made with one’s federal tax return after which the PFIC will need to provide an annual statement of income and gains to be attached to the tax return, which may be difficult to obtain from management if the U.S. represents only a minority interest.

Planning Ideas to Apply Pre-Arrival to the U.S.

Before moving to the U.S., individuals holding PFICs should discuss both practical and structural planning ideas with their tax advisers. Options may include doing nothing for short-term stays, selling PFICs with gains prior to arrival, selling PFICs with losses in the first year of residency, or potentially using a limited liability partnership. It may also be possible to look at the elections mentioned above to see if any of these are a possibility or relevant for that individual’s circumstances. For more information about PFIC planning before becoming a U.S. resident, please reach out to Kevin Brown, Principal of Anchin’s International Tax and Private Client Groups, Gwayne Lai, Partner of Anchin’s International Tax Group, or your Anchin Relationship Partner.