A Passive Foreign Investment Company, or PFIC, is a foreign corporation where passive income constitutes 75% or more of gross income during a year. A corporation is also considered to be a PFIC if 50% or more of corporate assets are held for production of passive income.
The PFIC rules deter taxpayers from seeking unlimited income tax deferral inside foreign corporations. They also seek to limit the ability of investors to convert ordinary income into capital gains through the same foreign entities. The PFIC rules impose a hefty interest charge on any deferred payments within a PFIC, and they treat all PFIC distributions as ordinary income regardless of its capital gains status.
In trying to determine if a foreign corporation might be classified as a PFIC, it is important for this discussion to know that income that is derived from “active banking” is excluded from the definition of “passive income.” In other words, banks are allowed to engage in banking activities without the threat of income from those activities being classified as passive, and without the banks being deemed PFICs. For investors, that means you can invest in foreign banks without the risk of hefty charges and the loss of capital gains status under the PFIC tax laws. This exception exists as a policy matter, so that investors in the US won’t fear investing in foreign bank shares.
In recent years, economies have been shaky and foreign banks have invested quite heavily in US government securities (bond investments produce passive, non-banking income), rather than putting those funds to work in “active banking” (lending, etc.). The question this forces is, whether the increased degree of passive income in the foreign banks push them over the limit and trigger the harsh application of the PFIC rules? Will foreign banks be deemed PFICs, and will US taxpayers be punished with harsh charges on those investments?
To address this question, the IRS issued a notice in late June of 2012. The notice stated that for tax years 2011 thru 2013, income from certain government bonds held by “active banks” will be treated as if it was earned from active banking. Thus, foreign banks can invest in US government securities, US taxpayers can invest in foreign banks, and otherwise passive income from the banks’ US securities investments will be ignored for PFIC determination.
It is important to understand that this does not avoid investor income tax obligations, but rather the imposition of the burdensome PFIC tax penalties. Essentially the IRS is recognizing that in the current global economic environment (low interest rates, soft economies, etc.) banks are going to need to invest more in government securities. Foreign banks investing in US government bonds are not having that income interest counted as passive income, and US investors are being allowed to avoid PFIC penalties on investments in these foreign banks.