Definition of 'PFIC'
PFIC ownership rules
Federal income taxation of PFIC ownership
Taxation of QEF election
Mark-to-market election
Problems with existing PFIC rules


For many years the United States has taxed certain US shareholders of closely held or controlled foreign corporations (CFCs) deriving principally passive or related-party income on their pro rata share of the corporation's earnings, whether or not distributed. These rules are commonly referred to as 'anti-deferral provisions' and are contained in the Internal Revenue Code. The primary anti-deferral provisions for corporations are the CFC rules and the passive foreign investment company (PFIC) rules.(1)

The principal benefit associated with the use of foreign corporations is the deferral of US taxes on the foreign source income of a foreign corporation until it is repatriated to a US shareholder in the form of a dividend distribution.(2) Given the potentially unlimited duration of the deferral privilege, Congress was concerned that certain kinds of income could escape US taxation because there would never be a need to repatriate the income. Moreover, if US shareholders sold stock in the foreign corporation to raise cash in the United States instead of taking dividends, they could potentially convert the foreign corporation's ordinary income to capital gains subject to preferential tax rates. Congress enacted the CFC rules in 1962 to tax US owners of certain foreign corporations on their pro rata share of certain types of income earned by the foreign corporation – generally speaking, income that could be easily shifted from the United States to an offshore tax haven, thereby obtaining tax deferral.(3)

The CFC rules were designed to apply on the basis of majority US ownership (or at least 10% US ownership on an individual basis), but Congress eventually came to feel that this limitation left a loophole that allowed US taxpayers to enjoy the benefit of deferral by taking minority ownership positions in foreign mutual funds expected to accumulate earnings rather than make annual distributions of income. Congress enacted the PFIC provisions as part of the Tax Reform Act of 1986 in order to restrict the ability of US persons to defer tax in this way, and thereby to equalise the treatment of foreign and US investment vehicles.

Although the PFIC rules originally targeted US persons' investments in offshore mutual funds, the scope of the rules as enacted is broad and can capture a range of investments in offshore companies and investment vehicles. The rules can apply to any US person that owns an interest in an offshore subsidiary with generally passive assets or income. There is no minimum level of stock ownership required by a US person to be subject to the PFIC rules; therefore, even foreign public companies can be considered PFICs for US tax purposes. Thus, even a small percentage of ownership can result in severe tax and reporting consequences. Both the CFC and PFIC rules look not only to direct ownership, where shares of foreign corporations are owned outright by a US person, but also to indirect ownership through foreign corporations, partnerships, trusts and estates, and take into account certain attributed ownership from certain related persons (although attributed or 'constructive' share ownership does not generally lead to income inclusion).

This update provides a general overview of the substantive rules regarding the taxation of interests in PFICs, including the excess distribution regime, the qualified electing fund regime and the mark-to-market regime. In addition to the substantive rules, significant recordkeeping and reporting burdens are placed on US shareholders of a foreign corporation that is a CFC or PFIC. Although the recordkeeping and reporting obligations are not discussed here, with regard to PFICs, each US shareholder of a PFIC must file Form 8621 "Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund" to report distributions from or sales of interests in a PFIC, or to make certain elections. There may be additional filing requirements depending on transactions occurring between the US shareholder and the foreign company (eg, Form 926 "Return of a US Transferor of Property to a Foreign Corporation" to report transfers of property to the foreign corporation).

Following a general discussion of the substantive rules, this update identifies certain challenging areas in the current rules and proposes some preliminary thoughts on ways to improve them.

Definition of 'PFIC'

A foreign corporation is treated as a PFIC for a tax year if:

  • at least 75% of the corporation's gross income for the year is passive or investment-type income (the 'income test'); or
  • at least 50% of the average fair market value of its assets during the year are assets that produce, or are held for the production of, passive income (the 'asset test').(4)

For the purposes of these tests, 'passive income' generally includes any income item that meets the definition of 'foreign personal holding company income' as defined in Section 954(c), which generally includes, among other things, dividends, interest and net gains from the sale of stock or interests in a trust, partnership or real estate mortgage investment conduit.(5) A 'look-through' rule treats the assets and income of a second-tier subsidiary as being directly owned by the foreign corporation being evaluated for PFIC status, but applies only to corporations of which 25% or more is directly or indirectly owned by the corporation being evaluated.(6) Thus, all the income earned by a holding or investment company is most likely to be passive income, and the company will qualify as a PFIC.

A PFIC can be organised as a corporation or a unit trust, but is generally taxed the same in either event. PFICs are generally marketed by large foreign financial institutions, including banks and money managers. PFICs are usually operated as open-ended investment funds and do not generally distribute current income by way of dividends or other distributions. An investor usually realises his or her gains and losses by having shares or 'units' redeemed by the fund.

There is no US shareholder control requirement under the PFIC regime; if a US person holds even a de minimis amount of PFIC shares, it may be subject to tax under the PFIC rules. In addition, while the test for determining PFIC status is based on the income or assets in a given tax year, once a shareholder's investment in a foreign corporation has been characterised as a PFIC, it will generally be treated as a PFIC with respect to that shareholder in future years. This is known as the 'PFIC taint' or the 'once a PFIC, always a PFIC' rule. Coordination rules determine how to tax income subject to both the PFIC and CFC rules. Generally, where a foreign corporation qualifies both as a CFC and PFIC with respect to the same US shareholder after 1997, such foreign corporation is treated solely as a CFC and subject to tax under the Subpart F income rules. However, for this rule to apply the US shareholder must generally make an election to 'purge' the PFIC taint.

PFIC ownership rules

The PFIC regime applies to US taxpayers that directly or indirectly own shares of a PFIC. Indirect ownership rules apply when a foreign trust owns the shares. Shares in a PFIC owned by a trust will be considered as owned proportionately by the beneficiaries of the trust. The Treasury Department has issued regulations that, although in proposed form, still apply.(7) The regulations provide that indirect ownership depends on the facts and circumstances in each case, with the substance rather than the form of ownership controlling. However, the proposed regulations do not address the question of how to apply the proportionate ownership rules to trusts and their beneficiaries.

PFIC shares directly owned by foreign entities are further attributed to US persons who beneficially own the stock.(8) They apply only when their effect is to treat a US person as the owner of PFIC stock.(9) However, the attribution rules do not apply to treat stock owned by a US person as owned by another person, except as provided in regulations.(10) If a single person owns, directly or indirectly, 50% or more in value of the stock of a corporation, such person is treated as owning the stock owned directly or indirectly by or for the corporation, in proportion to the value of the stock owned in such corporation.(11) On the other hand, if a person is a minority interest holder in a foreign corporation, the stock owned by the foreign corporation is not treated as owned by him or her unless the intervening corporation is itself a PFIC. In that case, the person is treated as owning his or her proportionate share of the stock held by the intervening PFIC.(12)

Options to purchase stock of a PFIC are covered under special rules.(13) These rules provide that an option to acquire stock may be treated as ownership of stock for the purposes of the PFIC rules. Proposed regulations provide that for the purposes of the Section 1291 excess distribution regime, an option is considered to be stock.(14) Proposed regulations further provide that the holding period of stock acquired upon exercise of an option includes the period for which the option was held.(15) Thus, it can be concluded that the option to purchase PFIC stock should be treated as actual ownership of stock for the purposes of PFIC analysis.

Federal income taxation of PFIC ownership

If a foreign company meets the requirements of the PFIC income or asset test, the company will be considered a PFIC with respect to each US shareholder in the company. The PFIC regime is essentially a penalty provision. No favourable outcomes or planning opportunities arise once a shareholder falls within these rules.

The general penalty imposed for owning PFIC stock is that certain "excess distributions" from a PFIC, including gains from the sale of PFIC stock, are thrown back rateably over the shareholder's holding period for the stock and subject to tax at the shareholder's highest ordinary income tax rate in each throwback year, rather than the 15% preferential tax rate on qualified dividends and long-term capital gains.(16) In general, the excess distribution rules are designed to prevent the accumulation of passive income in a foreign corporation in a manner that defers current US taxation on the US investor's portion of such income.

All gain recognised on the disposition of PFIC stock is treated as an excess distribution. By contrast, some, all or none of an actual distribution from a PFIC may be treated as an excess distribution. An actual distribution is an excess distribution only to the extent that the total of actual distributions during a tax year received by the investor exceeds 125% of the average of actual distributions received in the three preceding tax years.(17) Once the total amount of the excess distribution has been determined, it is allocated rateably to all days in the investor's holding period for the stock.(18) Amounts allocated to the pre-PFIC period and the current-year period are totalled and included in the US investor's income as ordinary income.(19) The amounts allocated to the prior-year PFIC period are subject to the highest rate of tax for the year to which they are allocated, and each of the resulting amounts of tax draws an interest charge as if it were an underpayment of taxes for the year in question. Importantly, amounts allocated to the prior-year PFIC period are never included in the investor's income. Rather, the tax and interest determined under these rules (the 'deferred tax amount') are added to the investor's tax liability without regard to other tax characteristics of the investor. Thus, the deferred tax amount is a payable tax liability, even though the investor otherwise had a current-year loss, or had net operating loss carryovers.(20)

The tax on excess distributions may be avoided if the US shareholder makes certain elections to purge the prior PFIC taint. The two principal purging elections are the qualified electing fund (QEF) election and the mark-to-market election.(21)

Taxation of QEF election

Under the QEF election, the US person effectively elects to include in each year's income its pro rata share of the PFIC's ordinary earnings and net capital gains.

For each tax year in which the QEF election applies and the PFIC is treated as a QEF, the shareholder must complete Part II of Form 8621 and attach the form to its timely filed tax return. To facilitate this, the PFIC is required to supply each shareholder with a PFIC Annual Information Statement. This statement must contain certain information, including the shareholder's pro rata share of the PFIC's ordinary earnings and profits and net capital gain for that tax year or sufficient information for those calculations to be made.

Where a PFIC is a closely held private entity, it may be possible for the US shareholders to cause the PFIC to comply with the annual statement requirements. However, in the annual statement the company must state that:

"it will permit the taxpayer to inspect and copy the permanent books and accounts, records, and such other documents as may be maintained by the PFIC that are necessary to establish that the PFIC ordinary earnings and net capital gain, as provided in section 1293(e) of the Internal Revenue Code, are computed in accordance with U.S. tax principles."

In the real world, it may be unrealistic or impractical to expect the PFIC to make adequate disclosures to support a QEF election since a foreign public company with no US ties will have no incentive to grant the Internal Revenue Service (IRS) such access or convert their financial statements to US tax principles.

To maximise the benefit, the QEF election should be filed by the due date of the shareholder's return for the year (including extensions) for the first tax year in which the election will apply.(22) If a purging election is not made applicable from the first year in which a US shareholder holds stock in the PFIC, the shareholder may be subject to tax under both the excess distribution regime and current taxation. In certain limited situations, a shareholder may make a retroactive QEF election (making the election for a tax year after the election due date), but only if:

  • the shareholder has preserved its right to make such an election under the protective statement regime; or
  • the shareholder obtains the permission of the IRS under the consent regime.(23)

Mark-to-market election

A US shareholder of a PFIC who is unable to use the QEF rules may nonetheless avoid taxation for excess distributions by accepting current taxation under the mark-to-market election.(24) A US shareholder of a PFIC can make a mark-to-market election with respect to the stock of the PFIC if the stock is "marketable". For stock to qualify as marketable, it must regularly be traded on:

  • a national securities exchange that is registered with the Securities and Exchange Commission;
  • a national market system established under Section 11A of the Securities and Exchange Act of 1934; or
  • a foreign securities exchange that is regulated or supervised by a governmental authority of the country in which the market is located.

Under the mark-to-market election, the US shareholder includes in income each year an amount equal to the excess, if any, of the fair market value of the PFIC stock as of the close of the tax year over the shareholder's adjusted basis in the stock. However, losses are restricted to the amount of current year or accumulated gains.

Amounts included in income under this election, as well as gain on the actual sale or other disposition of the PFIC stock, are treated as ordinary income.(25) If a shareholder makes the mark-to-market election with respect to a PFIC that is a non-qualified fund (ie, a fund for which a QEF election has not been made) after the beginning of the taxpayer's holding period with respect to that stock, a coordination rule applies to ensure that the shareholder does not avoid the interest charge with respect to amounts attributable to periods before the mark-to-market election. Except for this coordination rule, the rules of Section 1291 do not apply to the shareholder of the PFIC if a mark-to-market election is in effect for the shareholder's tax year.

In 2010 the IRS offered an alternative tax computation initiative for taxpayers participating in the offshore voluntary disclosure programme in order to address problems faced by many participants in the programme due to lack of records necessary to determine their tax liability for the unreported years 2003-2008. Under the initiative, PFIC valuation can be done on a basis consistent with the mark-to-market method but without reconstruction of the historical data, and some special rates and limitations apply.(26)

Problems with existing PFIC rules

The current rules regarding taxation of PFICs are highly problematic, starting with the absence of guidance in many aspects of the rules (ie, most portions of the PFIC regulations have remained in proposed form since the late 1990s). Moreover, the current rules are excessively punitive, requiring significant reporting requirements and costs and, as such, may not be economically feasible or practical. Instead of levelling the playing field between domestic and foreign passive investments, the current PFIC rules penalise the latter significantly.

While its purpose was only to eliminate tax advantages, the PFIC tax treatment serves as a punitive tax on PFIC holders. Under the interest charge regime, the deferred tax amount is taxed as ordinary income, and the dividend or capital gain component is not taxed at the dividend/capital gain rates. Under the QEF regime, the pro rata share of the PFIC's net capital gain is taxed as capital gain, while the pro rata share in the PFIC's ordinary income is taxed as ordinary income. Under the mark-to-market regime, all of the PFIC appreciation is included in the taxpayer's ordinary income. In addition, other deductions and carryover losses, other than foreign tax credits, are not taken into consideration when the deferred tax amount is added to the taxpayer's tax liability.

The discrepancy between the tax treatment of US passive investments (under reduced capital gain and qualified dividend tax rates) and non-US passive investments contradicts the intention of Congress, which was to level the playing field between US and foreign investments. Congress enacted the PFIC rules in 1986 due to a concern that:

"U.S. persons who invest in passive assets through a foreign investment company obtain a substantial tax advantage vis-à-vis U.S. investors in domestic investment companies because they avoid current taxation and are able to convert income that would be ordinary income if received directly or received from a domestic investment company into capital gain income."(27)

Since the tax rates on qualified dividends and long-term capital gains are identical, there is no tax disparity between distributions taxed as qualified dividends and long-term capital gains. Thus, the PFIC rules no longer serve to level the playing field, but instead unduly limit a US person's choices in investments.

The adverse side effect of the current rules is further emphasised by the fact that the current definition of a PFIC is overly broad and can capture businesses intended to be engaged in an active trade or business. More specifically, the application of the asset or the income test in determining when a foreign corporation should be treated as a PFIC will often result in the classification of an active business as a PFIC. Thus, for example, an active foreign corporation that has a bad year with low income or losses from the active enterprise may nonetheless generate enough passive income (eg, from a dividend from a portfolio investment) that will cause it to be a PFIC. In addition, sales and services companies and start-up companies are prone to meet the asset test, since they typically do not have significant assets other than working capital, which is passive. The 'once a PFIC, always a PFIC' rule aggravates the adverse side effect of the current rules.

Thus, there appears to be a need to define PFICs more squarely in order to be consistent with the intended purpose of preventing tax deferral and leveling the playing field. One option might be to require that both the income and the asset test be met before a corporation can be classified as a PFIC (ie, requiring a certain threshold of passive income and passive assets). Another option might be to expand the exceptions to the definition of a PFIC to create safe harbours for active businesses and start-up companies that might get caught under the current PFIC definitions.

The existing safe harbours are also problematic. In general, the QEF regime is not appropriate to the situation of many US taxpayers. It requires both that a taxpayer make a timely affirmative election to have the regime apply to a particular investment and that the PFIC itself provide a taxpayer with certain financial information. Moreover, in the case of many US taxpayers with accounts in offshore jurisdictions, the decisions to invest in PFIC stock are generally made not by the taxpayers themselves but rather by foreign investment managers, who often do not understand the consequences of the PFIC regime for their customers and do not advise the taxpayers of the possibility of making a QEF election. Further, because generally shares of foreign investment companies are not intended to be offered to US persons, such PFICs generally do not keep the financial information required by US taxpayers making a QEF election and certainly did not provide it to such shareholders (foreign investment funds are loath to become enmeshed in possible violations of US securities laws).

Difficulties in obtaining information and reconstructing historical data might be relevant not only for the very small investments in PFICs discussed above, but also to various investors in different settings. The potential difficulties of obtaining information have been recognised by Congress. The Senate report provides that:

"[t]he committee recognizes, however, that the extension of current taxation treatment to U.S. investors in passive foreign investment companies (PFICs) could create difficulties for such investors in cases where the U.S. investors do not have ongoing access to the PFICs' records relating to their earnings and profits... for these reasons, the committee considered it appropriate to adopt a taxing mechanism which allows U.S. investors... to compute their income from the PFIC based upon certain reasonable assumptions."(28)

However, the only viable alternative to the QEF regime is the mark-to-market regime, which has limited application (ie, the mark-to-market election is conditioned on the PFIC's stock being marketable). Thus, taxpayers with minority interests in non-marketable securities do not have the option of electing current taxation on the investment's earnings on an annual basis.

Finally, the absence of a de minimis rule for minority holdings of a PFIC is also problematic. The PFIC regime applies from the first dollar and with no percentage interest requirement. The problem is that many US taxpayers do not choose to acquire interests in PFICs; rather, the decision to enter into such investments is often made by the taxpayer's foreign adviser, who may be unaware of the potential adverse US tax consequences to the investor. Nevertheless, even a US taxpayer with a 0.1% interest in a PFIC is exposed to the full compliance costs associated with PFICs. The application of the complicated PFIC rules, which is beyond the expertise and knowledge of many tax professionals, may not be suitable and justifiable for small investments. Thus, small investors often end up being penalised for their inadvertent investments in PFICs.

For further information on this topic please contact Lucy S Lee or Stafford Smiley at Caplin & Drysdale by telephone (+1 202 862 5000), fax (+1 202 429 3301) or email ([email protected] or [email protected]).


(1) Before January 1 2006 there was a third set of rules known as the foreign personal holding company (FPHC) rules. However, Congress felt that because income that would have been taxable under the FPHC rules may also have been taxable under the CFC or PFIC rules, there was unnecessary and confusing overlap. Accordingly, Congress eliminated the FPHC rules in 2004.

(2) See S Rep't No 1881, at 87-88 (1962), reprinted in 1962-3 CB 707, 794; H Rep't No 1447 (1962), reprinted in 1962-3 CB 405, 462.

(3) HR Report No 1447 (2 out of 5), 87th Cong, 2nd Sess, 1962-3 CB 405 (3/16/62).

(4) Section 1297(a).

(5) Section 1297(b)(1).

(6) Section 1297(c).

(7) Prop Reg 1.1291-1(b)(8)(iii)(C).

(8) Section 1298(a).

(9) Section 1298(a)(1)(A).

(10) Section 1298(a)(1)(B).

(11) Section 1298(a)(2).

(12) Section 1298(1)(2)(B).

(13) Section 1298(a)(4).

(14) Prop Reg 1.1291-1(d).

(15) Prop. Reg 1.1291-1(h)(3).

(16) Section 1291(a)(2).

(17) Section 1291(b). Deemed distributions or dispositions with respect to indirectly held PFIC stock may also be subject to the excess distribution rules.

(18) This can potentially result in an allocation to three distinct periods:

  • the pre-PFIC period – that is, days in the investor's holding period before the first day of the first tax year of the foreign corporation in which it was a PFIC;
  • the current-year period – that is, days in the investor's tax year in which the excess distribution occurs; and
  • the prior-year PFIC period – that is, days in the investor's prior tax years during which the foreign corporation was a PFIC.

(19) Section 1291(a)(1)(B).

(20) The only credit permitted against the deferred tax amount is the special foreign tax credit granted under Section 1291(g).

(21) A PFIC that is not subject to the QEF election or is an unpedigreed QEF is known as a Section 1291 fund. Reg 1.1291-2(j)(2)(iii).

(22) A PFIC for which the election is made for the first year of a US owner's holding period is considered a pedigreed QEF. See Prop Reg 1.1291-1.

(23) Reg 1.1297-3T.

(24) Section 1296.

(25) Section 1296(a).

(26) See the Offshore Voluntary Disclosure Initiative: Passive Foreign Income Company Investment Computations, September 2010, available at:,,id..=228621,00.html.

(27) S Rep N 313, 99th Cong, 2d Sess 393-394 (1986).

(28) See id at 394.

An earlier version of this update was published in the November/December issue of Corporate Taxation, © 2011 Thomson Reuters/WG&L.