Most of the tax rules on foreign stocks cost you a few percent here and there. The Passive Foreign Investment Company rules are different. If you own a PFIC and do nothing about it, a profitable sale can be taxed at the top ordinary rate plus an interest charge, and you'll owe an extra IRS form every year. Congress wrote the rules to stop Americans from deferring tax through offshore funds. They also land on many ordinary investors who never meant to own an offshore fund.
What makes a company a PFIC
A foreign corporation is a PFIC for a year if it meets either of two tests, as described in the Form 8621 instructions:
- Income test: 75% or more of its gross income is passive income, such as interest, dividends, rents, royalties, and capital gains on investments.
- Asset test: on average, 50% or more of its assets produce passive income or are held to produce it. Cash counts as a passive asset.
Status is tested every year. A company can be a PFIC one year and not the next. And under the general "once a PFIC, always a PFIC" principle, shares you held while the company was a PFIC can keep that taint for you even after the company stops qualifying, unless you make a specific election to purge it. That last point is technical, and it's one of several reasons to involve a tax professional.
Who gets caught
Foreign mutual funds and ETFs
A fund that holds a portfolio of stocks and bonds earns almost entirely passive income. A non-U.S. fund, such as a European-domiciled UCITS ETF or a Canadian mutual fund, is almost always a PFIC. U.S.-listed ETFs that invest overseas are U.S. corporations and are not PFICs. That distinction is why many advisors steer Americans toward U.S.-domiciled funds for international exposure; see ADRs vs. international ETFs.
Pre-revenue exploration companies
A junior miner that has raised $10 million and hasn't produced an ounce of metal has one main asset on its balance sheet: cash. Its only income may be interest on that cash. That combination can fail both tests. Exploration spending and mineral property can shift the asset mix, but many juniors conclude they are or may be PFICs in a given year. See how junior mining stocks work.
The tax code has a narrow start-up exception for a company's first year with gross income, but it rarely protects an exploration company that spends years before generating revenue.
The default: the excess distribution regime
If you own a PFIC and make no election, you fall into the default rules of section 1291. They apply to two events:
- Excess distributions: the part of this year's distributions that exceeds 125% of the average you received over the prior three years (or your shorter holding period).
- Any gain on sale. The entire gain is treated as an excess distribution.
The excess is spread evenly over every day you held the shares. The part allocated to the current year, and to years before the company became a PFIC, is taxed as ordinary income. The part allocated to each earlier PFIC year is taxed at the highest ordinary rate in effect for that year (37% for 2018 through 2025, per the Form 8621 instructions), plus an interest charge as if you had underpaid tax in that year. No capital gains rate applies. Losses get no special benefit.
Worked example (simplified)
You buy a Canadian junior for $10,000 and sell it four years later for $30,000. The company was a PFIC every year, and you made no election. The $20,000 gain is spread over four years, about $5,000 per year. The current year's $5,000 is ordinary income at your normal rate. Each of the three earlier years' $5,000 is taxed at that year's top rate, 37%, or $1,850 per year, plus interest running from each year's due date. In a normal account you'd have owed long-term capital gains tax, perhaps 15%, or $3,000 in total. Here the tax is several times higher.
The two elections that fix it
QEF election
A qualified electing fund election makes you include your share of the PFIC's ordinary earnings (as ordinary income) and net capital gain (as long-term capital gain) each year, whether or not anything is distributed. In exchange, a later sale gets normal capital gains treatment.
The catch: you can only make a QEF election if the company gives you a PFIC Annual Information Statement with the numbers you need. You generally make it on Form 8621 with your return for the first year you hold the shares. Making it late is possible but complicated.
For a pre-revenue explorer, the QEF election is often attractive because the company's ordinary earnings and net capital gain are frequently nil, so there's nothing to include, and your eventual gain is a capital gain.
Mark-to-market election
If the PFIC stock is "marketable," meaning regularly traded on a qualifying exchange, you can elect to mark it to market. Each year you report the increase in value as ordinary income. Decreases are deductible only to the extent of earlier inclusions. It avoids the interest charge but converts every gain into ordinary income. Shares that trade only over the counter may not meet the marketable-stock definition.
Form 8621 and filing
A U.S. shareholder generally files a separate Form 8621 for each PFIC for each year in which they receive certain distributions, sell shares, report a QEF or mark-to-market election, or are required to file an annual report. The instructions include a limited exception from Part I if the total value of all your PFIC stock is $25,000 or less at year-end ($50,000 on a joint return) and you had no excess distribution or gain on sale.
Shares held in an IRA, a 403(b) or 457(b) plan, or a 529 plan are generally outside these rules, because the account owner isn't treated as the shareholder. That is a real point in favor of holding speculative juniors in retirement accounts, though it has to be weighed against other placement issues covered in foreign stocks in IRAs. PFIC dividends also aren't qualified dividends; see qualified dividends on foreign stocks.
Why Canadian juniors publish PFIC statements
Look at the investor page of almost any TSX Venture exploration company with American shareholders and you'll find an annual "PFIC status" notice and a PFIC Annual Information Statement. The company is telling U.S. holders that it may be a PFIC and giving them what they need for a QEF election. A typical statement reports ordinary earnings and net capital gain (often nil), shares outstanding, and any distributions. Publishing it costs the company little and keeps the stock accessible to U.S. investors.
If you own juniors in a taxable account, check each company's site for these notices every year, and keep copies. More on the sector at our Canadian juniors hub.
Get professional help
PFIC rules are among the most complex in the individual tax code, and mistakes are expensive to unwind. If you hold or plan to hold foreign funds or exploration stocks in a taxable account, work with a tax professional who has prepared Form 8621 before, ideally before your first year-end. Also see reporting foreign investments.
Common questions
Is every foreign stock a PFIC?
No. Most operating companies, such as large foreign manufacturers, banks, and miners in production, are not PFICs. The rules target foreign corporations whose income is at least 75% passive or whose assets are at least 50% passive, which catches most foreign mutual funds and ETFs and many pre-revenue companies.
Do PFIC rules apply to shares in my IRA?
Generally not. The Form 8621 instructions say that people who hold PFIC stock through an IRA and certain other tax-exempt accounts are not treated as PFIC shareholders for these rules.
What is a PFIC Annual Information Statement?
It's a statement a foreign company publishes so U.S. shareholders can make and maintain a qualified electing fund (QEF) election. It reports the shareholder's share of the company's ordinary earnings and net capital gain, which the shareholder includes in income each year.
Sources
Educational content only, not investment, tax or legal advice. The Stateside Report does not recommend buying or selling any security. Tax rules depend on your situation; confirm with a qualified tax professional. Full disclosures.