PFICs: Classification & Reporting Requirements
Prior to the implementation of the PFIC (passive foreign investment company) rules in 1986, the taxation of foreign corporations was tied solely to ownership. Controlled Foreign Corporation rules were used to determine whether the U.S. shareholders of a foreign corporation should be taxed on their foreign income. Minor U.S. shareholders (less than 10%) were able to invest money abroad and escape U.S. taxation on items that would otherwise be taxable as ordinary income. The PFIC rules interact with the ownership requirements of Controlled Foreign Corporations in such a way that they ensure anti-deferral treatment regardless of the percentage of U.S. ownership.
Every U.S. shareholder of a foreign corporation has to determine whether his foreign corporation investment is classified as a PFIC for U.S. tax purposes. This determination is complex, but it begins with two seemingly basic tests.
In order for the foreign corporation to be considered a PFIC, it has to meet the “passive” threshold either through the income or the asset test. If the foreign corporation derives 75% of its income from passive activities, it is a PFIC. If 50% of the foreign corporation’s assets are passive assets or assets held to produce passive income, then the corporation is a PFIC. Only one of these tests needs to be met. Note that cash is considered a passive asset and income calculation is performed on “gross” and not “net” basis.
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Bob Klueger Speaks on Tax Planning for Foreign Investment in the US
In this videocast, Bob talks about how the United States taxes US business operations and investments of foreigners. Unlike US persons, non US persons are not subject to worldwide taxation (tax on all income earned inside or outside the United States). They are, however, subject to taxes on income effectively connected with a US business or trade.
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