Passive foreign investment companies (PFICs) are businesses outside the US that attract investment through passive income. US citizens must report income earned from a PFIC for tax purposes, and strict tax laws apply. PFICs must meet certain requirements, and investors must keep accurate records.
A passive foreign investment company is one with ownership based outside of the United States whose primary purpose is to attract investment. Such a business must derive most of its assets from passive income, which comes from investment benefits such as dividends, capital gains, or interest. US citizens must report income earned from a passive foreign investment company, also known as a PFIC, for tax purposes. These companies are subject to the harsh tax laws of the US Internal Revenue Service (IRS) in an effort to discourage investors from such investment.
In the case of mutual funds or partnerships within the US, the company in question automatically reports dividends and payments to shareholders to the IRS for tax purposes. A passive foreign investment company is not required to make such reports, leaving it up to the shareholder. Since that is the case, it is incumbent on investors in a PFIC to keep accurate and detailed records of all transactions involving the company to make clear their involvement with the IRS.
For a company to be considered a passive foreign investment company, certain requirements must be met. First, the ownership of the company must be located outside of the United States, but it must contain at least one US shareholder. You must also pass one of a couple of tests to be considered an FDIC.
The passive income test requires that a passive foreign investment enterprise earns at least 75 percent of its gross income from passive income. Otherwise, a PFIC must pass the passive asset test, which requires 50 percent of its assets to come from investments. These assets can be dividends, capital gains, or interest. Passing any of these tests would qualify a company as a PFIC.
Strict tax laws, which are detailed in sections 1291 to 1297 of the United States Tax Code, are attached to such companies. For example, investors pay income taxes on distributions from a PFIC even though those distributions are not normally subject to tax based on capital gains tax rates. Dividends are taxed at the highest possible rate for the year in which they originated, and an interest charge is applied for the deferred distribution of funds from a PFIC. Investors can claim that the PFIC is a qualified choice fund to try to escape some of these taxes, but then they have to pay taxes even on income not distributed to shareholders.
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