For US tax purposes, under section 1297 of the Internal Revenue Code, Passive Foreign Investment Company (a "PFIC") is defined as any foreign corporation where either:
At least 75% of its gross income in the taxable year is “passive income” (the “Income Test”), or
On average (generally on a quarterly basis), 50% or more of its assets during the taxable year generate passive income or are held for the purpose of generating passive income (the “Asset Test”).
While the two tests above sound relatively simple, the application of such tests in real life is way more complicated. For example, complexity will arise when a foreign corporation owns other non-US or US subsidiaries. Such complexities, like how to treat intercompany dividends or interest under the Income Test or how to categorize stock of a non-US subsidiary vs a US subsidiary under the Asset Test, are beyond the scope of this post.
Common examples of passive income under the Income Test:
Interest;
Capital gains;
Dividends;
Rents;
Royalties; and
Annuities.
There are certain exceptions to the passive income above and other types of passive income that we won’t discuss here because it is too technical such as certain income from notional principal contracts, excluding income from notional principal contracts entered into to hedge an item in another foreign personal holding company income category.
For example, if a pre-revenue SaaS startup puts the cash from its financing into an interest-bearing bank account for the first two years, it would be a PFIC because 100% of its income for the first two years would be interest income.
Common examples of assets that generate passive income under the Asset Test:
Cash because it potentially generates interest (there is a very narrow exception for “net working capital” under the proposed PFIC regulations); and
Stock because it potentially generates dividends and/or capital gains (assuming the stock ownership is less than 25% of the underlying company).
Publicly traded companies and non-publicly traded companies that are not Controlled Foreign Corporations (“CFC”) would value their assets using fair market value unless the CFC elects to use the adjusted basis of the assets. A CFC must use the adjusted basis of the assets, but the CFC is allowed to increase the adjusted basis of their total assets by the research or experimental expenditures (within the meaning of section 174 of the Internal Revenue Code) paid or incurred by the CFC during the taxable year and the preceding 2 taxable years.
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