How PFIC/CFC Overlap Can Impact Tax & Reporting

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PFIC/CFC Overlap

PFIC/CFC Overlap

PFIC/CFC Overlap

How PFIC/CFC Overlap Can Impact Tax & Reporting: A PFIC is a Passive Foreign Investment Company (PFIC) and a CFC is a Controlled Foreign Corporation (CFC). Each of these types of entities are IRS legal constructs that result in additional tax and reporting requirements involving: Subpart F, GILTI and excess distributions. The resulting tax and reporting can be very comprehensive and complicated. When the same foreign company falls into both CFC and PFIC territory — and overlaps — there are some limitations in place to prevent unnecessary duplicative reporting and tax. Let’s review the basics of PFIC/CFC overlap.

General PFIC Rules

When it comes to PFIC/CFC overlap, the natural starting point is understanding the basics of the PFIC tax rules. A PFIC is a Passive Foreign Investment Company. If you own or have interest in a PFIC, you may be subject  to very burdensome and onerous tax and reporting rules; it depends.

PFIC Test

As defined by the IRS:

A foreign corporation is a PFIC if it meets either the income or asset test described below.

Income Test

        • 75% or more of the corporation’s gross income for its taxable year is passive income (as defined in section 1297(b)).

Asset Test

      • At least 50% of the average percentage of assets (determined under section 1297(e)) held by the foreign corporation during the taxable year are assets that produce passive income or that are held for the production of passive income.

PFIC Example 1: Not So Bad

      • You are Married Filing Jointly

      • Your PFIC is due to ownership in foreign mutual funds

      • -Total value of PFIC is under $50,000

      • No Income Distribution

  • Result: In this scenario, since you are below the $50,000 exemption for married couples who have no income distributions from a PFIC, your tax and reporting is not that bad.

PFIC Example 2:  Bad

      • You are Married Filing Jointly

      • Your PFIC is mix of Investment Funds and ownership of a Foreign Company (possibly a BVI that holds a Hong Kong Ltd.) that you use to aggregate all your passive investments under one roof.

      • Total value of the PFIC is $1,300,000

      • The PFIC generates all different types of income. Some is distributed in some years, and not in other years.

  • Result: In the second scenario, you are above the $25,000/$50,000 exclusion and income is being distributed. Therefore, for each bucket of income, for each year, you have to perform an Excess Distribution calculation – which is a very complicated and detailed analysis.

General CFC Rules

In order to be considered a controlled foreign corporation, the Foreign Corporation must be:

  • Owned more than 50% by U.S. Person(s), and
  • Each U.S. shareholder owns at least 10% ownership (Attribution Rules Apply).

PFIC/CFC Reporting

The reporting rules for CFC and PFICs are different.

PFIC Reporting (Form 8621)

Presuming that the taxpayer has a PFIC and the value exceeds the $25K/$50K exclusion amount, he/she has to file a Form 8621 each year with the IRS. If the form is not filed, then the tax return is not considered complete. That means that because the return is not considered complete, it extends the time for the IRS to audit the return (which is bad).

*Even if the Taxpayer has less than $25K/$50K, they may still have to (or may still want to) file the Form 8621 as to Part I.

CFC Reporting (Form 5471)

A U.S. person does not have to report a CFC, “just to report it.” For example, with the PFIC, even if the U.S. person has no income, if he/she exceeds the $25K/$50K exclusion amount – it has to be reported. With a CFC, generally, a U.S. Shareholder files a Form 5471, but only if the shareholder meets one of the definitions of being a “Category of Filer” who is required to file the form.  And, sometimes a person may not even be a shareholder but still have to file a Form 5471, and sometimes Form 5471 has to be filed by a U.S. shareholder even if the foreign corporation is not considered a CFC. In other words, Form 5471 is not limited to just CFC, and even if a person is not a shareholder in a CFC, he or she may still have to file a Form 5471 is they meet the threshold requirement for filing.

What Happens when PFIC/CFC Overlap

The general rules involving the CFC and PFIC overlap are complicated, and can generally be found in section 1297 (Passive Foreign Investment Company) If a U.S. Shareholder is considered a direct owner of a PFIC and CFC, then usually the CFC rules will trump, so that the PFIC will not become subject to the CFC rules. In other words, when a person is held to be the owner of a foreign company, and that company meets the definition of being a CFC, then it will not also have to comply with the PFIC rules.

IRS Section 1297 (d): Exception for U.S. Shareholders of CFCs

      • (1) In general For purposes of this part, a corporation shall not be treated with respect to a shareholder as a passive foreign investment company during the qualified portion of such shareholder’s holding period with respect to stock in such corporation.

      • (2) Qualified portion: For purposes of this subsection, the term “qualified portion” means the portion of the shareholder’s holding period— (A) which is after December 31, 1997, and (B) during which the shareholder is a United States shareholder (as defined in section 951(b)) of the corporation and the corporation is a controlled foreign corporation.

Only the relevant portions have been reproduced from the code – exceptions apply.

PFIC/CFC Overlap is Summarized in the Legislative History

The legislative history involving code section 1297 (d) provides that

      • “[A] shareholder that is subject to current inclusion under the subpart F rules with respect to stock of a PFIC that is also a CFC generally is not subject also to the PFIC provisions with respect to the same stock.”

What is Subpart F?

Subpart is a very complex area of tax law. It involves several ant-deferral of foreign income rules, and requires the immediate taxation of certain foreign income, in years a CFC has Earnings & Profits, involving income which may have not even been distributed to the shareholder.

What Forms for PFIC and CFC Do I Report to the IRS?

While a shareholder of both a PFIC and CFC may not have to deal with the tax issues per se of computing both PFIC and CFC analyses – the reporting is a bit different. When a person owns a PFIC and is not exempt from reporting, then we recommend filing the Form 8621. That is because if Form 8621 is required to be filed, but is not filed, then the tax return remains open for potential audit – and that can be very dangerous. If the PFIC also qualifies as a CFC and meets one of the categories of filers for Form 5471 then the general recommendation by experienced tax practitioners is to file the 5471 as well. While it can be a bit daunting, the penalties for not filing form 5471 are very high (starting at $10,000).  And, the Form 5471 is a common penalty the IRS issues.

What if You Have Unreported Income or Assets?

If you are out of compliance on issues involving PFIC/CFC overlap and related noncompliance, the penalties can be severe. Therefore, you may consider entering IRS offshore voluntary disclosure/tax amnesty, before it is too late.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure and PFIC/CFC Overlap.

Contact our firm today for assistance with getting compliant.