Passive Foreign Investment Companies
Two of the main legal issues regarding foreign investments are (1) voluntary disclosures, to correct past mistakes or omissions or wrong doing, and (2) Passive Foreign Investment Companies (“PFIC”) and their tax treatment. In the past, the IRS did not have access to most foreign banking information and therefore could not monitor income produced, earned or stored overseas. The US government has become aware of the problem, has instituted targeted programs for compliance enforcement, and is utilizing technology to do so.
Individuals and companies in the U.S. are required to account for income and pay appropriate taxes on foreign investments. One way the IRS has encouraged the disclosure of overseas money is by instituting a voluntary disclosure program. Just this year the IRS instituted the 2011 Offshore Voluntary Disclosure Initiative. See OVDI. Similar programs were instituted in 2009 and 2003. Voluntary disclosure programs may be very helpful for taxpayers who want to avoid penalties and criminal prosecution, but they are complicated in procedure and result and are not for everyone.
The IRS has defined certain foreign corporations as Passive Foreign Investment Companies, also known as PFICs. It then established an intricate set of laws and rules for their tax treatment. Many of these rules hinge on which elections (if any) are made by U.S. shareholders Knowing the when, how, and which, of elections is complicated for most foreign investors. Subsequently providing the appropriate tax treatment for any income received or lost through the PFIC is also a complex matter. The Federal income tax rules regarding those who have interest in any Passive Foreign Investment Company (“PFIC”) are complicated, to say the least. However, it is important to have a basic understanding of PFIC treatment for income tax purposes so that a holder will be able to have an adequate dialogue with his or her tax and legal professional. Full detail of the treatment of PFICs can be found in the United States Tax Code §§1291-1298; below are some very basic notes to summarize the law.
A foreign corporation is categorized as a Passive Foreign Investment Company when it passes either the “asset test” or the “income test,” both of which relate to passive income. Passive income is different from the standard income produced by the operation of a business and generally includes (but is not limited to) dividends, interest, royalties, rents, annuities, and certain gains from property transactions, commodities trading, and foreign currency, with exceptions. The asset test is passed when at least 50 percent of the assets produce or are intended to produce passive income. The income test is passed when at least 75 percent of the gross income is passive income. Shareholders of a PFIC must file a form 8621 with the Internal Revenue Service every year during which the person recognizes certain gains or distributions, or makes a certain “election” (discussed below).