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PFICs Explained Thumbnail

PFICs Explained

Ethan Kent

US citizens are faced with a variety of complex tax rules, regardless of where they live. To optimize your portfolio, it is important to understand which investment vehicles incur different tax liabilities. This is particularly true when considering non-US funds, which fall under the punitive Passive Foreign Investment Company (PFIC) regime.

PFICs are investment vehicles subject to strict reporting requirements and complicated tax rules, generating passive income through dividends, interest, capital gains, or holding assets that produce income. They aim to avert US taxpayers from deferring taxes by investing in foreign entities not subject to the same rules as US-based companies. PFICs come in many different forms, including certain hedge funds, startups with significant cash reserves, and pooled investment vehicles like foreign mutual funds and exchange-traded funds (ETFs). The latter vehicles more commonly cause issues as they are typically more popular investment choices. 

There are two ways that an entity qualifies as a PFIC:

  1. Income test—75% or more of the foreign corporation’s income is generated passively through means like dividends, interest, royalties, rents, or capital gains. Annual evaluations are made, meaning PFIC status can change on a yearly basis. 
  2. Asset test—50% of the pooled investment vehicle’s assets generate passive income through means like dividends, interest, royalties, rents, or capital gains.
  3. To determine if a foreign corporation itself is a PFIC, “passive income” is defined very broadly in Section 1297 of the US Internal Revenue Code to include all investment income including interest, dividends, rents and royalties, and capital gains. 

Mutuals funds and ETFs based in the US are almost always not PFICs because they are regulated and registered under US law. Conversely, foreign investment funds are not subject to US law and will be classified as PFICs assuming they meet the income or asset test. If a US citizen’s investment falls under the PFIC classification, a set of complex reporting requirements will follow (filing Form 8621), imposing punitive tax rates. 

Taxation Methods

There are three main ways to tax PFIC investments:

1. Excess Distribution Method—This is the default method of taxing PFICs. The portion of the year of sale’s distribution exceeding 125% of the previous three years’ average distribution is considered “excess distribution.” The portion not exceeding this threshold is taxed at that year’s ordinary income tax rate. The excess distributions are evenly allocated across all previous year’s distributions (every year’s distribution except the year at which the sale occurred) and taxed at the highest ordinary income rate for each respective year and charged interest. The total capital gain from the sale is divided evenly across every holding year. The year of sale’s portion is taxed at the ordinary income tax rate for that year, and all previous year’s portions are taxed at the highest income tax rate for their respective year and charged interest. 

2. Mark-to-Market Election—This is an alternative to the punitive default method, only available for marketable stock (those regularly traded on recognized exchanges). Taxes are paid annually, and in exchange, the IRS waives the interest charges and the highest income tax rate implication. Each year, any capital gain is taxed at that year’s ordinary income rate. If a capital loss occurs, you can deduct this amount to the extent that it offsets all previous years’ gains from other ordinary income, like a salary. Finally, each year’s distribution is taxed at that year’s ordinary income tax rate. 

  •  For example: 
    • Beginning Year 1 PFIC Investment Value: $10,000
    • End Year 1 PFIC Investment Value: $13,000
    • Year 1 PFIC Taxable Income: $3,000
    • Beginning Year 2 PFIC Investment Value: $13,000
    • End Year 2 PFIC Investment Value: $11,000
    • Year 2 PFIC Taxable Income: $0 ($2,000 loss deducted due to previous gains)
    • Beginning Year 3 PFIC Investment Value: $11,000
    • End Year 3 PFIC Investment Value: $16,000
    • Year 3 PFIC Taxable Income: $5,000
    • Total Taxable Income: $6,000

Because losses were deducted in year 2, you are able to report this as an ordinary loss on Form 8621, which can reduce other taxable income, like a salary, thereby reducing your total taxable income.

3. Qualified Electing Fund Election—This is considered the most favorable but least common method of PFIC taxation. It is the only method that treats a foreign fund like a US fund, allowing you to pay capital gains rates rather than income rates. However, this method can only be used if the fund agrees to provide you with their PFIC Annual Information Sheet. Essentially, the investor is taxed annually on their pro-rata share of the PFIC’s earnings at a blended ordinary income and capital gains rate. Their share of the fund’s ordinary earnings will be charged at that year’s ordinary income rate, and their share of the fund’s capital gains will be charged at the capital gains rate. The total amount of their earnings over each year is added to their cost basis, and capital gains from the sale of PFIC shares are subject to capital gains tax. 

 Exceptions to PFIC filing

There are three main ways in which you can be exempt from filing Form 8621.

  1. Low-Value Exemption: When filing single, you are exempt if the total amount of your PFIC holding’s value is less than USD$25,000. When filing jointly, the value is USD$50,000. 
  2. Foreign Pension Plans: PFICs that are included in certain foreign pension plans are sometimes exempt from filing requirements. 
  3. Controlled Foreign Corporation (CFC) Status: You will not need to file Form 8621 if the PFIC qualifies as a CFC. However, there will be other lengthy tax forms to complete like Form 5471. 
    • To qualify as a CFC, more than 50% of the total combined voting power or the total value of all stock in a foreign corporation must be owned by US shareholders. In this context, a US shareholder is defined as an individual citizen or resident, a domestic corporation, a partnership, or trust/estate. 

Final Words

If you are a US citizen interested in increasing your exposure to foreign markets, you may consider buying shares in US-domiciled international ETFs and mutual funds, US-domiciled global funds, and individual foreign stocks. Such investment vehicles can expose you to growing foreign markets without introducing punitive tax regimes. Please speak to one of our wealth managers for more information on how to properly position your portfolio so that it reflects your own personal interests and avoids unnecessary tax liabilities. 


This material is intended for educational and informational purposes only. It is not intended to provide specific advice or recommendations for any individual. Additionally, you should consult with your Financial Advisor, Tax Advisor, or Attorney on your specific situation. The views expressed in the material are that of the author and do not necessarily reflect those of any market, regulatory body, State or Federal Agency, or Association. All efforts have been made to report or share true and accurate information. However, the information may become materially outdated or otherwise rendered incorrect due to subsequent new research or other changes, without notice. The author nor the firm are able to always verify the content from third-party sources. For additional information about the firm, please visit the MAS Website at https://www.mas.gov.sg/  and the SEC Website at www.adviserinfo.sec.gov. For a copy of the firm's ADV Part 2 Brochure, please contact us at info@avriowealth.com.