What is A PFIC? A PFIC (short for "Passive Foreign Investment Company") is a foreign corporation that meets either an asset test (at least 50% of the foreign corporation's assets either actually produce, or are held to produce, passive income) or an income test (at least 75% of the foreign corporation's gross income is passive income). PFICs are subject to special rules meant to limit a US taxpayer's benefit from deferring income earned by the PFIC (e.g., section 1291, which imposes an interest charge on "excess distributions").
Passive income in this context is any income treated as "foreign personal holding company income" under section 954(c). This generally (but with exceptions) includes dividends, interest, royalties, rents, annuities, net gains on property that give rise to the aforementioned items, certain net commodity transaction gains, certain net foreign currency gains, income equivalent to interest and dividends, certain net derivative gains, and certain personal service contracts that can be fulfilled by others.
While there are a number of exceptions to these general rules, they are beyond the scope of this QA. For further information, please start with sections 1291 through 1298.
2. What is a QEF and why is it relevant?
A QEF (short for "Qualified Electing Fund") is a PFIC for which the US shareholders (whether direct or indirect) have elected under section 1295 to recognize their proportionate share of the PFIC's current earnings and profits (as ordinary earnings and net long-term capital gain, as the case may be). Please see below for further information.
In addition, a QEF election (if made for the year in which the electing US shareholder first held the PFIC's stock) will generally prevent the application of the otherwise-required anti-deferral rules (e.g., section 1291).
3. How is a PFIC's US shareholder taxed if the PFIC does not have a QEF election in place?
If no QEF election was made, the US shareholder will generally be taxed as follows:
* Income/gains earned by the PFIC - No impact.
* Deductions/losses incurred by the PFIC - No impact.
* Distributions by the PFIC: Distributions by the PFIC will be treated as dividends to the extent of the US shareholder's share of the PFIC's EP (short for "Earnings Profits"), with any excess applied first against stock basis (until zero) and then to capital gain. In addition, "excess distributions" are subjected to the interest charge rules of section 1291 (as well as a historical lookback/grossup re the taxes that would have been paid, using the highest applicable ordinary income rates for those years). This requires the US shareholder to track taxable distributions for the preceding 3 years and if the current year distributions exceed 125% of that 3-year average, the excess is considered an "excess distribution."
Note: If the US shareholder held the stock for less than 3 years, they use the average for that shorter preceding period. In addition, there can be no excess distributions in the 1st year in which the US shareholder held the PFIC's stock.
Note: All distributions "in respect of stock" of the PFIC are included for purposes of determining excess distributions, even if those amounts would otherwise have been nontaxable to the US shareholder (e.g., distributions in excess of the PFIC's EP which would otherwise have been treated as returns of capital).
* Gain on disposition of the PFIC stock by the US shareholder - Treated as an excess distribution in its entirety, which includes taxation at ordinary income rates.
* Loss on disposition of the PFIC stock by the US shareholder - Treated as a capital loss.