What Are the FIF Tax Rules and How Do I Comply?
Understand New Zealand's FIF tax rules for your offshore investments. This guide covers assessing your liability and the steps for accurate tax calculation and reporting.
The United States implements specific tax rules for certain foreign investments to address potential tax deferral on income earned offshore. These regulations, known as the Passive Foreign Investment Company (PFIC) rules, were established by the Tax Reform Act of 1986. Their primary purpose is to prevent U.S. taxpayers from using foreign corporations to delay recognizing taxable income. The PFIC regime targets U.S. persons who own shares in foreign entities that primarily generate passive income or hold assets that produce passive income. Failure to properly identify and report these investments can lead to significant tax liabilities and penalties.
Determining if the FIF Rules Apply
The PFIC rules apply broadly to U.S. persons, which includes U.S. citizens, resident aliens, domestic corporations, trusts, and estates. If you fall into one of these categories and hold an interest in a foreign corporation, you must determine if that corporation qualifies as a PFIC. The Internal Revenue Service (IRS) uses a two-part test, and a foreign corporation only needs to meet one of the two criteria to be considered a PFIC.
A foreign corporation is classified as a PFIC if it meets either the income test or the asset test. The income test is met if 75% or more of the corporation’s gross income for the year is passive income, which includes dividends, interest, rents, royalties, and certain capital gains. The asset test is met if at least 50% of the average percentage of its assets held during the year are assets that produce, or are held to produce, passive income. Common examples of investments that fall under these rules include foreign mutual funds, foreign exchange-traded funds (ETFs), and foreign pension funds.
Several exemptions can relieve a U.S. investor from the PFIC reporting requirements. An investor is exempt from filing Form 8621 if the total value of all their PFIC stock is $25,000 or less at the end of the tax year, or $50,000 for those married filing a joint return. This exception only applies if the investor did not receive an “excess distribution” during the year.
Another exception relates to foreign corporations that are also classified as Controlled Foreign Corporations (CFCs). If a U.S. shareholder is subject to the CFC rules, which tax certain undistributed income of the foreign corporation, they may be exempt from the overlapping PFIC rules for the same stock. This prevents double taxation on the same income.
Calculation Methods for FIF Income
Once an investment is identified as a PFIC and no exemption applies, the U.S. shareholder must calculate the taxable income. The IRS provides three distinct methods for this calculation. The default method, which applies if no other election is made, is governed by Internal Revenue Code Section 1291 and is known for its punitive nature, using high tax rates and interest charges to offset tax deferral.
The default method treats any gain on the sale of PFIC stock or receipt of an “excess distribution” in a specific way. An excess distribution is the portion of a distribution that exceeds 125% of the average distributions received over the prior three years. The gain or excess distribution is allocated ratably over the investor’s entire holding period. Amounts allocated to prior tax years are taxed at the highest ordinary income tax rate for those years, plus an interest charge, while the amount for the current year is taxed as ordinary income.
A more favorable alternative for marketable stock is the Mark-to-Market (MTM) election. Under this method, the investor includes in their gross income each year the difference between the fair market value of the PFIC stock at year-end and their adjusted basis in the stock. This gain is treated as ordinary income. If the stock’s value decreases, the investor can claim an ordinary loss, but only to the extent of previously recognized MTM gains. This election must be made in the first year to avoid the default Section 1291 treatment.
The third option is the Qualified Electing Fund (QEF) election, which aligns the tax treatment more closely with that of a U.S. mutual fund. To make this election, the PFIC must provide the shareholder with a “PFIC Annual Information Statement,” which details the shareholder’s pro-rata share of the fund’s ordinary earnings and net capital gains. The shareholder then reports these amounts on their personal tax return annually. This method is contingent on the foreign fund’s willingness to comply with IRS reporting requirements.
Reporting and Paying FIF Tax
After calculating PFIC-related income, the next step is to report this information to the IRS and pay any associated tax. The primary document for this is Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.” A U.S. person is required to file a separate Form 8621 for each PFIC they own.
This form is not a standalone filing; it must be attached to the shareholder’s annual income tax return, such as Form 1040 for individuals. The calculated income from Form 8621 is then carried over and included in the total income on the main tax return.
Investors may be able to claim a credit for foreign taxes paid on PFIC income, but the ability to do so often depends on the taxation method being used. Credits are available for shareholders using the QEF or MTM methods but are often restricted under the default rules. When a credit can be claimed, it is done by filing Form 1116, “Foreign Tax Credit,” with the tax return. The credit is limited to the amount of U.S. tax attributable to the foreign-source income.
The deadline for filing Form 8621 and paying any resulting tax coincides with the due date for the individual’s income tax return, which for most U.S. residents is April 15. Taxpayers living abroad receive an automatic extension to June 15. If more time is needed, a further extension can be requested, which pushes the filing deadline for both the income tax return and the attached Form 8621. Any tax owed must still be paid by the original April deadline to avoid interest and penalties.