979 / What is the passive asset test that applies when determining PFIC status?

A foreign corporation is a PFIC if at least 50 percent of its assets produce passive income or are held for the production of passive income.¹ The passive asset test is calculated by determining the value of the foreign corporation’s assets each tax year. Asset valuation is based on fair market value unless the corporation is also a controlled foreign corporation (CFC), in which case assets are valued based on their adjusted bases.²

An asset will be treated as though it is held for the production of income if it is held to produce capital gains and/or foreign currency gains.³

The asset test applies on a gross basis. In other words, if the corporation’s liabilities are secured by particular assets, that fact does not reduce the value of those assets for purposes of the 50 percent test.

The 50 percent test is based on the average of the fair market value of the foreign corporation’s assets determined at the end of each quarterly period. Typically, foreign corporations will not be required to obtain an independent appraisal to apply the 50 percent test.⁴

The average percentage of a foreign corporation’s assets is determined using the average of the gross values (or adjusted bases) at the end of each quarter of the foreign corporation’s tax year.⁵ The foreign corporation can also measure asset value more frequently than quarterly. The quarter (or shorter period) used by a tested foreign corporation is referred to as its “measuring period.” Applying the asset test based on a period that is shorter than a quarter can provide a more accurate measurement of average asset value, but the more frequently recurring time period is not required because of the potential administrative burden that it could impose on shareholders.

The same measuring period must generally be used for the tested foreign corporation for the initial tax year (including any short year in which the shareholder elects to use the alternative measuring period) and all subsequent years unless the election to use the more frequently recurring measuring period is revoked.⁶ In the case of a short tax year, the quarterly measuring dates for purposes of the asset test are the same as for a full tax year, except that the final quarterly measuring date will be the last day of the short tax year.⁷

A foreign corporation’s income and assets may also include assets and income of lower-tier corporations if the corporation owns at least 25 percent of the stock.⁸ This look-through rule means that a foreign corporation cannot use subsidiaries to avoid PFIC status. Indirect stock ownership is determined under the general rules used in determining ownership by value.⁹ These rules apply without regard to whether entities are domestic or foreign, meaning that indirect ownership includes corporate ownership through intermediate corporations, partnerships, trusts, and estates, regardless of where the entity is organized. Further, stock treated as owned by application of the indirect ownership rules is generally considered actually owned for purposes of reapplying the indirect ownership rules.¹⁰

The foreign corporation is deemed to own its proportionate share of the lower-tier entity’s assets and income.¹¹ However, when lower-tier entities are operating subsidiaries, the foreign corporation may avoid PFIC treatment because dividends and interest derived from them are not considered passive income. Under the look-through rule, interest and dividends passed from lower-tier entities retain their character as operating income when passed to the parent corporation.¹²

For purposes of the passive asset test, a foreign corporation that directly or indirectly owns an interest in a partnership is treated as if it held its proportionate share of the assets of a partnership, provided the tested foreign corporation owns, directly or indirectly, at least 25 percent, by value, of the interests in the partnership.¹³ A corporation’s proportionate share of a partnership asset is treated as passive to the extent the asset produced, or was held to produce, passive income in the partnership’s hands, taking into account only the partnership’s activities. If a foreign corporation owns less than 25 percent of the value of the partnership, its interest in the partnership is treated as a passive asset.¹⁴

The look-through rule does not always apply to a domestic corporation or any subsidiaries of the domestic corporation. That’s true if the stock of the domestic corporation is treated as a non-passive asset that produces non-passive income.¹⁵

A foreign corporation may attempt to avoid PFIC status regardless of direct and indirect ownership of passive assets by ensuring that a sufficient amount of the assets are held indirectly through two tiers of domestic subsidiaries.¹⁶ For example, a foreign corporation might hold stock in another foreign corporation that is PFIC, but use a two-tiered domestic chain holding passive assets to avoid being treated as a PFIC. In this case, a U.S. person holding stock of the foreign corporation would generally not be treated as a shareholder of the PFIC stock owned by the tested foreign corporation.¹⁷

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Planning Point: An anti-abuse rule provides that look-through exceptions regarding a foreign corporation subject to the accumulated earnings tax will not apply if the tested foreign corporation would be a PFIC if the qualified stock or any income received or accrued with respect to such stock were disregarded.¹⁸ A second anti-abuse rule provides that the exception will not apply if a principal purpose for the foreign corporation’s formation or acquisition of the 25-percent-owned domestic corporation is to avoid PFIC status. The law presumes such a principal purpose exists if the 25-percent-owned domestic corporation is not engaged in an active U.S. trade or business.¹⁹

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An asset is passive for purposes of the asset test if it produces passive income or is held for the production of passive income. However, if the asset produces both passive income and non-passive income during the same tax year, it is treated as two separate assets (one passive and one non-passive).²⁰ The asset is treated as partly a passive asset and partly a non-passive asset in proportion to the proportionate amounts of income generated by the asset during the year.²¹ For purposes of the asset test, the fair market value (or adjusted basis) of the asset is allocated between the passive assets and non-passive assets based on the ratio of passive income produced by the asset during the tax year to non-passive income.