PFIC - What is it?
A PFIC (Passive Foreign Income Company) is a corporation located abroad and meeting one of the following two conditions:
- Assets test – at least 50% of the company’s assets produce passive income or passive capital gains;
- Income test – at least 75% of the PFIC’s gross income for the tax year is passive.
Passive income includes: interest, dividends, royalties, רווח הון, etc. Among the examples for PFIC: offshore trust funds, REITs, holding companies, etc. note that what matters for the sake of definition is where the company is located, so an American trust fund investing in foreign stock cannot be considered a PFIC because it is not an offshore company itself – for instance, ARK IZRL.
What does that mean?
The law passed in 1986 and was designed to prevent and deter Americans from sheltering taxation by using offshore entities. The law taxes such investments at high rates and is often not on par with the taxation regulations of the country of origin, which distorts the timing and rate of the tax.
In recent years we have been seeing a massive shift from direct investments to passive, more solid investments in the form of קרנות מחקות and ETFs, and so it is important to understand the meaning of a US citizen’s investment in an offshore fund. The citizen can essentially choose whether to acknowledge their income regularly, or postpone the tax to the time of sale/division and pay linear taxes for each year of profit at the highest bracket. Obviously, this makes investing in accumulation trusts impractical, because it requires regular acknowledgement or high taxation without the ability to cover that with a foreign tax.
How are PFICs taxed?
Section 1291 – the default option. Profit is delayed, but at the time of sale/division, the profit is calculated as linear according to the years of holding. The profit attributed to previous years is taxed at the highest bracket plus interest, and the profit associated with the current tax year is calculated according to the regular brackets.
QEF – Qualified Electing Fund – one of the choices available to US citizens who wish to take a different tax policy than the default one. This choice most closely reflects US taxation of trust funds. Recognition of income is fixed and distinguishes between normal taxation and beneficiary taxation on gross income. To make such a choice, the fund must keep its books according to IRS regulations and provide the investor with the proper paperwork, meaning that not all funds can be considered QEFs.
M2M – Market to Market – another option for fixed taxation for the fund’s annual value increase. Can only be selected for publically traded funds.
Reporting is filed via form 8621 and requires individual filing for each fund, creating high preparation costs in addition to aggressive taxation.
The simplest way is to look up pits ISIN number, a 12-digit combination of numbers and letters that starts with the two letters of the country of origin. For example, the ISIN for Invesco S&P 500 UCITS ETF Acc is IE00B3YCGJ38, meaning that it is located in IE – Ireland.
In most cases, a CFC and the relevant taxation trumps PFIC. Therefore, form 5471 shall be filed, and the income will be included in Subpart F.
In most cases, the fund will make this information publically available, so each fund should be examined individually. For instance, in the following link you will find an announcement by Mor Investment regarding their fund that adheres to IRS requirements.
If you did not execute one of the choices, you can forego annual filing if the portfolio does not exceed $25,000. Keep in mind that this only saves the costs of annual filing and not taxation according to section 1291.
As stated before, the default option is section 1291. When a new selection is made, sale or deemed dividend must be performed according to the taxation detailed in section 1291.
The above is in not to be considered in any shape or form as an offer and/or recommendation for performing any action and/or investment consulting and/or investment marketing and/or any other form of consultation pertaining to the acquisition and/or sale and /or possession of shares and/or financial assets depicted in them or other shares and/or financial assets, or a recommendation to invest in any specific channels. The information presented here is for public knowledge and does not replace professional consultation that takes into account specific data and the needs of every individual. Anyone using this information does so of their own accord and bears sole responsibility.
