The CFC PFIC Overlap Rule for U.S. Investors

U.S. international tax law can be complex when a foreign entity is both a Controlled Foreign Corporation (CFC) and a Passive Foreign Investment Company (PFIC). These two regimes have distinct tax consequences. The Internal Revenue Code (IRC) provides an ordering rule to resolve this conflict. This CFC/PFIC overlap rule determines which classification takes precedence for a U.S. investor, preventing the application of both tax systems simultaneously.

Foundational Concepts of CFC and PFIC Regimes

A foreign corporation is classified as a CFC if “U.S. shareholders” collectively own more than 50% of the total combined voting power or the total value of the corporation’s stock. A “U.S. shareholder” is a U.S. person, such as a citizen, resident, or domestic entity, who owns 10% or more of the foreign corporation’s vote or value.

The primary tax consequence for these U.S. shareholders is the current taxation of certain corporate earnings, regardless of whether cash distributions are made. These shareholders must include their pro-rata share of the CFC’s “Subpart F income” and “Global Intangible Low-Taxed Income” (GILTI) on their personal income tax returns annually. Subpart F income includes passive income like dividends and interest, as well as certain related-party sales and services income.

A foreign corporation qualifies as a PFIC if it meets either an income test or an asset test. The income test is met if 75% or more of the corporation’s gross income is passive income. The asset test is met if at least 50% of the average value of the corporation’s assets produce, or are held to produce, passive income.

Unlike the CFC rules, the PFIC rules apply to any U.S. person who is a shareholder, regardless of their ownership percentage. Under the default “excess distribution” regime of Section 1291, large distributions or gains from selling stock are subject to a high tax rate and an interest charge. To avoid this, investors can sometimes make a Qualified Electing Fund (QEF) or Mark-to-Market (MTM) election, which results in annual income inclusion but avoids the interest charge.

The General CFC Overlap Rule Explained

IRC Section 1297 contains the overlap rule to resolve conflicts when a foreign corporation is both a CFC and a PFIC. The rule states that for a U.S. shareholder, a foreign corporation that is a CFC will not be treated as a PFIC. This prevents a U.S. shareholder from being subject to both the CFC regime’s income inclusions and the PFIC regime’s tax and reporting obligations.

This relief applies only during the “qualified portion” of the shareholder’s holding period. The qualified portion is the time during which the foreign corporation is a CFC and the investor is a “U.S. shareholder” (a 10% or greater owner). If the corporation ceases to be a CFC or the investor’s ownership drops below 10%, the overlap rule may no longer apply for that period.

The rule’s application is determined for each U.S. investor individually. In a single foreign corporation that is both a CFC and a PFIC, an investor owning 15% is a U.S. shareholder and follows the CFC rules, ignoring the PFIC rules. In contrast, an investor owning 2% of the same corporation does not qualify for the overlap rule’s relief and must treat the investment as a PFIC.

The “PFIC Taint” and Its Interaction with the Overlap Rule

The “once a PFIC, always a PFIC” rule complicates this analysis. Known as the “PFIC taint,” this principle dictates that if a U.S. person holds stock in a corporation that qualifies as a PFIC at any point during their holding period, the stock remains treated as PFIC stock for that shareholder for their entire investment horizon. This taint persists even in years when the corporation no longer meets the PFIC income or asset tests.

The interaction between the PFIC taint and the overlap rule is apparent when a corporation’s status changes. Consider a U.S. shareholder of a corporation that is initially both a CFC and a PFIC, where the overlap rule applies. If the corporation ceases to be a CFC, the overlap rule’s protection for the remaining U.S. shareholder terminates.

Because the corporation was a PFIC during the shareholder’s holding period, the PFIC rules apply once CFC status is lost. The shareholder is now holding stock in what the tax code considers a PFIC and must begin complying with that regime.

To manage this transition, the shareholder may need to make a “purging election.” These elections cleanse the PFIC taint by having the shareholder recognize any untaxed appreciation. Common purging elections include a deemed sale or a deemed dividend. A timely purging election allows the shareholder to then make a QEF or MTM election, transitioning to a more favorable tax treatment.

Application to Different Types of U.S. Investors

The practical consequences of the CFC/PFIC overlap rule depend on an investor’s ownership percentage.

For U.S. shareholders owning 10% or more, the overlap rule provides simplification. During the qualified portion, they are subject only to the CFC tax regime and its income inclusions. They are not required to file Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, for that period.

For U.S. investors who own less than 10% of the foreign corporation, the overlap rule does not apply. Even if the entity is a CFC, these smaller investors must treat the corporation as a PFIC. They must file Form 8621 annually and face the default excess distribution tax regime unless they can make a QEF or MTM election.