When a CFC is Also a PFIC: The Overlap Rule

The United States tax code has anti-deferral regimes to prevent U.S. taxpayers from postponing tax obligations by holding investments in foreign corporations. By keeping earnings offshore, a U.S. person could defer paying U.S. tax until those profits are brought back as dividends. To counter this, Congress enacted rules to accelerate U.S. taxation in certain situations.

Two of the most significant sets of rules are for Controlled Foreign Corporations (CFCs) and Passive Foreign Investment Companies (PFICs). These regulations identify foreign corporations that are either controlled by U.S. persons or primarily generate passive, investment-type income. The rules ensure that U.S. persons cannot use foreign corporations to shield certain income from immediate U.S. taxation.

Controlled Foreign Corporation (CFC) Framework

A foreign corporation is classified as a Controlled Foreign Corporation (CFC) if “U.S. Shareholders” collectively own more than 50% of its stock on any day during its taxable year. This 50% threshold is measured by either the total combined voting power or the total value of the corporation’s stock. This dual test ensures that arrangements designed to shift formal voting power while retaining economic value do not circumvent the rules.

A “U.S. Shareholder” is a U.S. person who owns 10% or more of the foreign corporation’s stock, measured by vote or value. Only the ownership of these 10% U.S. Shareholders is aggregated to determine if the greater-than-50% control test is met. For instance, if a foreign corporation is owned by eleven unrelated U.S. persons, each holding a 9.09% share, it would not be a CFC because no single shareholder meets the 10% threshold.

To prevent avoidance of these ownership thresholds, the IRS uses stock attribution rules that treat a person as owning stock that is not held directly. Direct ownership is stock titled in the U.S. person’s name, while indirect ownership attributes stock held through foreign entities like corporations, partnerships, or trusts.

Constructive ownership rules are the broadest, attributing stock ownership between related parties. Stock owned by a family member, such as a spouse, child, or parent, can be attributed to the U.S. person. Similarly, stock owned by a partner or a related corporation can be attributed, making it necessary to analyze an entity’s entire ownership structure to determine its CFC status.

Passive Foreign Investment Company (PFIC) Framework

A foreign corporation may qualify as a Passive Foreign Investment Company (PFIC) even if it does not meet the control requirements of a CFC. Unlike the CFC rules, the PFIC rules are based on the corporation’s income and assets, not shareholder control. There is no minimum ownership threshold for a U.S. person to be subject to the PFIC rules; owning a single share can trigger reporting and tax consequences. A foreign corporation is a PFIC if it satisfies either an income test or an asset test.

The income test is met if 75% or more of the foreign corporation’s gross income for the year is passive income. This includes income from investments rather than active business operations, such as:

• Dividends
• Interest
• Royalties
• Rents
• Annuities

It also captures net gains from the sale of property that produces this type of income, as well as certain foreign currency gains.

Alternatively, a corporation is a PFIC under the asset test if at least 50% of the average value of its assets during the year produce passive income or are held to produce it. For this test, assets are measured by their fair market value. Cash is a classic example of a passive asset, while factory machinery and inventory used in an active business are active assets. This determination requires a quarterly analysis of the corporation’s balance sheet, as the asset composition can change.

Resolving the PFIC and CFC Overlap

A single foreign corporation can meet the definitions of both a CFC and a PFIC. For example, a foreign corporation wholly owned by a U.S. person that holds only investment assets would be a CFC by ownership and a PFIC by its assets. To prevent applying two separate anti-deferral regimes to the same income, the tax code provides an ordering provision known as the overlap rule.

This rule, found in Internal Revenue Code Section 1297, provides that a foreign corporation will not be treated as a PFIC for a shareholder during the period the corporation is a CFC and the shareholder is a U.S. Shareholder (a 10% or more owner). For that specific shareholder, the CFC rules for income inclusion and reporting take precedence, and the PFIC rules are turned off.

The overlap rule’s protection is specific to each shareholder’s ownership level. A U.S. person who owns less than 10% of the same CFC is not a U.S. Shareholder and cannot benefit from the rule. For this smaller investor, the corporation is still treated as a PFIC, and they must follow the PFIC tax and reporting regime.

For example, consider a foreign corporation 60% owned by a U.S. parent company and 40% owned by various U.S. investors, each holding a 2% stake. The corporation is a CFC. For the parent company, the CFC rules apply exclusively. For the 2% investors, the overlap rule does not apply, and they must treat their investment as a PFIC if it meets the income or asset test. If a company ceases to be a CFC but remains a PFIC, the overlap rule’s protection ends, and the PFIC rules would then apply to all U.S. investors.

Taxation and Reporting Consequences

For a U.S. Shareholder of a CFC, the main consequence is potential current-year income inclusion under the Subpart F and Global Intangible Low-Taxed Income (GILTI) regimes. These rules require the U.S. Shareholder to include their pro-rata share of the CFC’s specified earnings in their U.S. taxable income annually, regardless of whether they receive cash distributions. The reporting instrument for this is Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. Subpart F income includes passive income and certain related-party income, while the GILTI regime subjects most of a CFC’s active business earnings to a minimum U.S. tax.

The tax treatment for a PFIC shareholder is different and depends on which of three regimes applies. The default regime under Section 1291 applies to gains on sale or “excess distributions,” which are taxed at the highest ordinary income rates plus a non-deductible interest charge for the tax deferral. To avoid this, a shareholder can make a Qualified Electing Fund (QEF) election to be taxed annually on their share of the PFIC’s earnings and capital gains. If the PFIC stock is marketable, a Mark-to-Market (MTM) election can be made, requiring the shareholder to include the annual change in the stock’s fair market value in their income. The primary reporting form for PFICs is Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.