Penalties and Passive Foreign Investment Companies

The Internal Revenue Service does not impose penalties for failing to identify a PFIC per se.

But if the taxpayer’s failure results in an underreporting of income and a failure to pay tax, the IRS will demand payment plus interest and penalties.

Higher tax rates …

The biggest problem with failing to identify a PFIC is that one likely will have to pay a higher rate of tax.  For example, a capital gain taxed at the long-term capital gains tax rate could be taxed instead at the much tax rate for ordinary income.

Let us walk through a hypothetical scenario.  A person invests $50,000 in a passive foreign investment company at the beginning of Year 1.  The person does not know that he has invested in a passive foreign investment company.

Over the next three years, the value of the passive foreign investment company increases to $125,000.  The investor sells for a profit of $75,000.  On his tax return, he reports the $75,000 as a long-term capital gain.  With an income of $190,000 the taxpayer’s long-term capital gains tax rate is 15%.

Tax on the capital gain = $75,000 x 15% = $11,250

Three years later the IRS has determined that the investment was a passive foreign investment company.  Under the default method of PFIC taxation, the IRS taxes the gain at the taxpayer’s ordinary income tax rate, in this case 28%.

Revised tax on the capital gain = $75,000 x 28% = $21,000

Underpayment of tax = $21,000 – $11,250 = $9,750

Penalties and interest …

The calculation of interest and penalties can be complex.  Let’s come up with a simple analysis.

Let’s assume that the penalty is 0.5% per month.

Penalty = 36 months x 0.5% x $9,750 = $1,755

Let’s assume an interest rate of 3%.

Interest = 3 years x 3% x $9,750 = $877.50

Total cost = $23,632.50 of which $11,250 has been paid.

The total cost, as a percentage of the capital gain = $23,632.50 ÷ $75,000 = 31.5%

Fortunately, interest rates today are low and thus the interest charges do not amount to much.  In the past, we have seen much higher rates of interest.  If the interest rate had been 8%, the math would have been different:

Interest = 3 years x 8% x $9,750 = $2,340

Total cost = $25,095 of which $11,250 has been paid.

The total cost, as a percentage of the capital gain = $25,095 ÷ $75,000 = 33.5%

None of this legal advice.  See the Terms of Service.

Asset Test: Another Definition of a PFIC

PFIC (“passive foreign investment company”) includes a foreign company that meets the asset test:  At least 50% of its assets generate passive income.

Technically, the assets do not have to produce passive income.  Merely holding the assets for the production of passive income meets the requirements of the asset test.

What kinds of assets?

Passive income generating assets create or can create the following types of income:

  • rents
  • royalties
  • annuities
  • dividends
  • interest

Stocks, bonds, bank deposits and similar financial instruments can generate passive income.  These types of assets would be counted towards the PFIC asset test.  Annuities, too, count as passive income assets for the purposes of the passive foreign investment company asset test.

Royalties and rents …

Royalties can come from a variety of assets.  Mineral rights are an obvious royalty-producing asset. Thus, a foreign company that earns royalty income on its own mineral deposits (e.g., oil, natural gas, coal, etc) would have passive income assets.  In this case, the foreign company owns the land and permits other businesses to develop and produce the mineral deposits.  The foreign company receives a payment solely by virtue of its ownership.

The passive foreign investment company law may provide an exemption for royalty income from an active business.  Thus, developing and producing one’s own oil reserves may not be a passive income generating activity.

Rents typically come from real estate.  If the rents are part of an active business, then the rents are not passive income.

For both rents and royalties, the active business exemption from the passive income rules is not available if the rents or royalties come from a related party.

Subsidiaries and the asset test:

Passive income assets owned by a subsidiary may be included in the PFIC asset test calculations.  If a parent company owns at least 25% of another company, one must consolidate into the parent a pro rata share of the other company’s income and assets for the purposes of the PFIC definition.

None of this legal advice.  See the Terms of Service.

Income Test: One Definition of a PFIC

PFIC (“passive foreign investment company”) is defined in the tax code using an income test and an asset test.

PFICs have passive income.

Passive foreign investment companies generate at least 75% of income from “passive income.”  Passive income means income from:

  • Dividends
  • Interest
  • Royalties
  • Rents
  • Annuities

The law provides an exception for royalties and rents derived in an active trade or business.  For this exception to apply, someone unrelated  must pay the royalties and rents.

Certain capital gains, too.

Passive income includes capital gains from assets that generate passive income (as defined above).  Gains on commodities transactions may be considered passive income, but the rules provide exceptions for certain types of commodity hedging transactions.

Mutual funds typically have income only from dividends and interest.  Mutual funds also have capital gains on assets that generate passive income.  Therefore, foreign mutual funds almost certainly fall under the definition of a PFIC.  In this sense, Congress’ passive foreign investment company definition correctly captures an intended target:  foreign mutual funds.

Income Test surprises …

Like Congressmen attempting to stamp out tax abuse, deep sea commercial fisherman cast their nets far and wide.  Occasionally, the nets pull up an unwanted creature.

 

 

Similarly, in its zeal to close the passive foreign investment company loophole, Congress’ prules sometimes gather up surprising catches.  For example, a newly public biotechnology company could be a passive foreign investment company if:

  • it has no product revenue, because all of its products are under development, and
  • it is earnings too much interest income on its cash balances.

The investor must keep an eye out for companies that generate too much passive income.  Most companies generate at least a little.  One may have to dig into the financial statements and the footnotes to the financial statements in order to discover exactly how much passive income is being generated.

The income test is one of two PFIC tests.  If a company meets either test, it is a passive foreign investment company.  The other is the asset test …

None of this legal advice.  See the Terms of Service.

Passive Foreign Investment Company

One should avoid investing in a passive foreign investment company (PFIC).  The U.S. tax laws are written to make a PFIC very unattractive from a tax perspective.  By and large, the tax laws have succeeded.

It’s all about taxes …

Some corporate structures suffer from double taxation.  The corporation pays income tax.  When the corporation makes a dividend payment to its shareholders, the shareholders pay a second tax on the dividends received.  If the shareholders owned the business in their own name (rather than through a corporation) they would not have to pay tax twice.  Corporations do not have to pay dividends.  If they keep the money inside the corporation, it can grow over time.  Keeping the money in the corporation is a tax deferral strategy.

Mutual funds are corporations, too, but they don’t have to pay tax at the corporate level if they follow certain rules.  Subchapter M of the Internal Revenue Code sets forth the requirements.  The rules include paying out as dividends at least 90% of the fund’s annual income.  This requirement forces income on the shareholders, which the government attempts to tax.  Congress created a trade-off:  eliminate the double taxation, but force recognition of income immediately (no tax deferrals).

The loophole …

Some foreign governments have written their tax laws differently.  For example, they may not tax corporate income at all, but impose taxes only on dividends paid to shareholders.  In this case, a foreign mutual fund could defer taxes for the benefit of shareholders by not paying dividends.  The fund reinvests the money so the shareholders become wealthier.

Some savvy U.S. investors decided to get in on the game by investing in foreign mutual funds.  Assuming no difference in investment performance, the foreign mutual fund offered a much better tax outcome than the equivalent U.S. mutual fund.  Congress could not shut down this “abuse” because it had no power to tax the foreign mutual fund’s income.  Congress could only tax whatever the foreign mutual fund paid to U.S. residents – in this case, nothing!

Plugging the loophole …

The Tax Reform Act of 1986 put an end to this tax deferral opportunity.  The effect of the tax reform depends on the specifics of the situation.  At best, the 1986 Act put foreign mutual funds on an equal tax footing with U.S. mutual funds.  At worst, foreign mutual funds are tax pigs — truly unattractive.

Basically, if one wants the best tax treatment, one should invest only in foreign mutual funds that pay out all income.  Otherwise, one must pay income tax on whatever income the foreign mutual fund chose to keep for itself.  For the investor to declare the correct amount of income, the mutual fund must provide information on retained income.  The investor must come up with the money to pay the tax because the fund did not pay a dividend.  For the investor to declare the correct amount of income, the mutual fund must provide information on retained income.

If the mutual fund does not provide information about retained income, then the U.S. government imposes a different tax regime.  Depending on the specifics, one may have to pay taxes as if one had sold the investment at the end of the year.   This means not being able to take advantage of lower long-term capital gains tax rates.

Thus, the tax rules make it hard to own a passive foreign investment company.  One can own a PFIC, but one will face heavy taxes.

The “passive foreign investment company” definition problem …

In writing the tax legislation, Congress had to define a “passive foreign investment company.”  Wary of creating new loopholes, Congress created a very broad definition.  This definition has the potential to spring tax surprises on investors in a range of foreign assets – not just mutual funds.

See our next post on how the law defines a passive foreign investment company.