What is a PFIC and how does it affect U.S. persons investing in foreign companies?

Under IRC Section 1297, a foreign corporation is a PFIC if it meets either: (1) the income test — 75% or more of its gross income is passive income (dividends, interest, rents, royalties, gains from property sales, etc.); or (2) the asset test — 50% or more of its assets (by average value) produce or are held to produce passive income. Most foreign mutual funds, ETFs, and investment holding companies meet one or both tests. Even some operating companies can inadvertently be PFICs if they hold large cash reserves (which are passive assets) relative to their total asset base.

If you are a U.S. person who owns shares in a PFIC and makes no election, the default tax regime under IRC 1291 applies. It is intentionally punitive: when you receive an "excess distribution" (a distribution exceeding 125% of the average distributions over the prior three years) or sell the PFIC shares at a gain, the income is allocated ratably over your entire holding period. The portion allocated to prior years is taxed at the highest individual rate for each prior year, plus interest is charged as if the tax had been due in each of those prior years. This results in an effective tax rate that can exceed 50% — far above the normal capital gains rate.

The QEF election under IRC 1295 allows you to include your pro rata share of the PFIC's ordinary earnings and net capital gains in your income each year, similar to a pass-through. Ordinary earnings are taxed at ordinary rates; net capital gains are taxed at the preferential long-term capital gains rate. This avoids the punitive Section 1291 regime but requires you to pay tax currently on income you may not have received. The QEF election requires that the PFIC provide you with a "PFIC annual information statement" detailing its ordinary earnings and net capital gains. Many foreign funds do not provide this information, making the QEF election impractical.

The mark-to-market (MTM) election under IRC 1296 allows you to include the increase in the fair market value of your PFIC shares as ordinary income each year (and deduct decreases, limited to prior MTM gains). This is simpler than the QEF election and does not require the PFIC to provide an annual information statement. However, all gains are treated as ordinary income (no capital gains rates), and the election is only available for PFIC stock that is "marketable" — traded on a qualified exchange. For a foreign investment fund that is publicly traded, MTM is often the most practical election.

U.S. persons who own shares in a PFIC must file Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund) for each PFIC they own. Form 8621 is attached to the shareholder's income tax return. Filing is required each year you own PFIC shares, even if there are no distributions or dispositions. Failure to file can extend the statute of limitations on your entire return. The form reports the PFIC's identity, your basis and holding period, any elections made, and the tax computation under the applicable regime.

Foreign investment funds, including foreign mutual funds and ETFs, are almost always PFICs because their income is predominantly passive (investment income) and their assets are passive (securities). If you hold shares in any non-U.S. registered investment fund, it is very likely a PFIC. Some funds will explicitly state their PFIC status in their prospectus or provide annual PFIC statements. If in doubt, assume it is a PFIC and file Form 8621 — the penalties for non-filing are severe, and filing when not required causes no harm.