978 / What is the passive income test that applies when determining PFIC status?

A foreign corporation is a PFIC if 75 percent or more of its gross income for a taxable year is passive income.¹ Passive income generally includes any income of a kind that would constitute Foreign Personal Holding Company Income (“FPHCI”).²

For this purpose, passive income includes dividends, interest, royalties, rents, and gains from the disposition of assets that generate any one of those types of income or do not generate income at all. Passive income also includes income from commodities transactions, foreign currency gains, income from notional principal contracts, and income or payments which are the equivalent of interest or dividends.³

However, note that for FPHCI purposes, there are several exceptions to what is included in passive income that are not carried over for PFIC determination purposes. For example, FPHCI does not include dividends and interest received from a related person that is a corporation created or organized under the laws of the same foreign country under the laws of which the controlled foreign corporation (CFC) is organized if a substantial part of its trade or business assets are located in the same country.⁴ Rents and royalties received from a corporation which is a related person for the use of property within the CFC’s situs country are also excluded for FPHCI purposes, but not PFIC purposes.⁵

The passive income test considers all income of the foreign corporation, without regard to reductions or exclusions that might apply for U.S. federal tax purposes. For example, passive income includes interest income that would be tax-exempt for U.S. tax purposes.⁶

The income test is calculated based on a tested foreign corporation’s gross income. However, certain types of income are FPHCI only to the extent that gains exceed losses with respect to a certain category of income.⁷ For example, only the excess of gains over losses from the sale or exchange of certain property is treated as FPHCI.⁸

Similar netting rules apply to income from commodities transactions,⁹ foreign currency gains,¹⁰ and income from notional principal contracts.¹¹ For purposes of the income test, income that is determined by netting gains against losses is accounted for on that net basis, so that only net gains in a particular category of FPHCI may be counted.¹²

However, the net amount of income in each category of FPHCI is determined separately for each relevant corporation, so that net gains or losses of a corporation, at least 25 percent of the value of stock of which is owned, directly or indirectly, by a tested foreign corporation (also called a “look-through subsidiary”) may not be netted against net losses or gains of another look-through subsidiary or of a tested foreign corporation.