What is a Passive Foreign Investment Company?

A passive foreign investment company is one with ownership based outside of the Unites States whose main purpose is to draw investments. Such a company must derive the majority of its assets from passive income, which comes from investment benefits such as dividends, capital gains, or interest. U.S citizens are required to report the income earned from a passive foreign investment company, also known as a PFIC, for tax purposes. These companies are subject to harsh tax laws by the U.S. Internal Revenue Service (IRS) in an effort to dissuade investors from such an investment.

In the case of mutual funds or partnerships within the U.S., the company in question automatically reports any dividends and payments to shareholders to the IRS for tax purposes. A passive foreign investment company is not required to do such reporting, leaving it to the shareholder to do the reporting. Since that is the case, it is incumbent upon investors in a PFIC to keep accurate and detailed records of all transactions having to do with the company to make clear their involvement to the IRS.

For a company to be considered a passive foreign investment company, certain requirements have to be met. First, the company's ownership must be based outside of the United States, but it must contain at least one shareholder from the U.S. It also has to pass one of a pair of tests to be considered an FDIC.

The passive income test requires that a passive foreign investment company derive at least 75 percent of its gross income from passive income. Failing that, a PFIC must pass the passive asset test, which requires that 50 percent of its assets come from investments. These assets may be dividends, capital gains, or interest. Passing either one of these tests would qualify a company as a PFIC.

Strict tax laws, which are detailed in sections 1291 to 1297 of the U.S. Tax Code, are attached to such companies. For example, investors pay income taxes on distributions from a PFIC even though those distributions might not normally be subject to taxes based on capital gains tax rates. The dividends are taxed at the highest possible rate for the year in which they originated, and there is in interest charge levied for deferred distribution of funds from a PFIC. Investors may claim that the PFIC is a qualified electing fund to try and escape some of these taxes, but they then have to pay taxes even on income not distributed to shareholders.