Income of foreign companies that are owned by U.S. taxpayers is not taxable in the U.S. until it is distributed in the form of dividends. However, this principle of taxation is subject to certain exceptions, which are aimed at discouraging U.S. taxpayers from paying taxes in the USA. by doing business through companies in low-tax jurisdictions. These exemptions include the Controlled Foreign Corporation (CFC) rules as well as the foreign passive investment company (PFIC) rules.
Passive Foreign Investment Companies
The rules for passive foreign investment companies (PFICs) are generally similar to the rules applicable to Controlled Foreign Corporations (CFCs). A foreign company is a PFIC if its income is 75% or more of passive sources such as dividends, interest, rentals, royalties, or 50% or more of its assets that generate such income.
The difference between PFIC and CFC is that there are no ownership rules for PFIC, i.e. no matter what the U.S. shareholder’s share in the foreign company is. If the foreign company meets the above conditions, it will be subject to PFIC taxation. However, if the ownership interest of the U.S. shareholders meets the conditions specified in the CFC rules, then the CFC rules will be applied.
Tax consequences for U.S. PFIC shareholders
U.S. shareholders must include in their income an appropriate proportionate share (in proportion to their ownership interest) of PFIC retained earnings by either method:
- include in its income an appropriate share of PFIC’s retained earnings, regardless of whether it has actually been distributed to the U.S. shareholder;
- do not include the appropriate share of PFIC retained earnings in its income, which may result in taxation under a “surplus” distribution rules that do not include the share of PFIC retained earnings in its income until the PFIC actually distributes the earnings.
Excess distribution is the distribution of PFIC retained earnings to shareholders that exceeds 125% of the average distribution actually received by a shareholder in the preceding three years (or less if the shareholder holds less than three years’ shares). Excess distributions are allocated to all prior periods, taxed at the highest rate in the period and include penalties for unpaid amounts for each period. PFIC shareholders are also required to file the relevant tax returns on Form 8621 with the tax authorities.
How to simplify tax preparation
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