PFIC Definition: The Income and Asset Tests in Plain English

The PFIC definition is short: a passive foreign investment company is any foreign corporation where 75% or more of its gross income for the year is passive income, or where at least 50% of its assets on average produce passive income or are held to produce it. Meeting either test is enough. There is no minimum shareholding and no exemption for regulated or well-known funds, which is why nearly every UK fund held by an American is a PFIC.

What is the PFIC definition?

A PFIC is a foreign corporation that meets an income test or an asset test in a given tax year. The definition sits in section 1297 of the Internal Revenue Code, and the IRS restates it in the Instructions for Form 8621: a foreign corporation is a PFIC if it meets either test.

	Income test	Asset test
Threshold	75% or more	At least 50%
Of what	The corporation's gross income for the tax year	The average percentage of the corporation's assets during the tax year
What is counted	Passive income	Assets that produce passive income or are held to produce it
Typical way to meet it	An investment fund, or a holding company living on dividends and interest	A fund, or an operating company with a large cash or investment balance

Four features of the definition explain most of the trouble it causes:

• Either test is enough. A company that fails the income test can still be a PFIC on its balance sheet.
• It is tested every year. PFIC status belongs to a corporation for a tax year. It can change.
• It is tested per corporation. Each fund is its own PFIC. A platform account holding six funds holds six PFICs.
• It ignores the size of your holding. The tests look at the corporation. Any US person holding its stock is a PFIC shareholder.

The income test: 75% of gross income

The income test asks what share of the corporation's gross income for the year is passive. If the answer is 75% or more, the corporation is a PFIC for that year.

Two words in that sentence matter. Gross income is income before expenses. A company cannot fail the test by having high running costs. And passive has a defined meaning: income of a kind that would be foreign personal holding company income under section 954(c). The main categories are:

• dividends, interest, royalties, rents and annuities;
• net gains from selling property that produces that kind of income, such as shares and bonds;
• net gains from commodities transactions;
• net foreign currency gains; and
• income equivalent to interest.

What is not passive

Section 1297(b)(2) and section 954(c) take several things out:

• rents and royalties earned in the active conduct of a trade or business and received from unrelated persons, so a property business that actively manages its buildings is treated differently from a company that simply collects rent;
• income from the active conduct of a banking business by a licensed bank;
• income from the active conduct of an insurance business by a qualifying insurance corporation; and
• interest, dividends, rents and royalties received from a related person, to the extent they are paid out of that person's non-passive income.

The asset test: 50% of assets

The asset test asks what share of the corporation's assets produce passive income or are held to produce it. If the average percentage for the year is at least 50%, the corporation is a PFIC. A company with no income at all can meet it.

How the assets are measured depends on the company. The Form 8621 instructions put it this way:

• a publicly traded foreign corporation uses fair market value;
• a foreign corporation that is not publicly traded and is a controlled foreign corporation uses adjusted basis; and
• under section 1297(e), other non-public corporations use value unless they elect adjusted basis.

The choice changes results. Goodwill built up inside a business has value but often little or no tax basis. On a value measure it counts as an active asset and dilutes the cash. On an adjusted basis measure it barely registers, and the same company can tip over 50%.

The test uses an average over the year, not a single balance sheet date, so a large cash balance held for a few weeks does not decide the outcome on its own.

Does a UK fund meet the PFIC definition?

Yes, in almost every case. A fund's income is dividends, interest and gains on its investments, and its assets are those investments. It meets both tests by a wide margin, whether it tracks the FTSE 100 or holds gilts. The definition applies to foreign corporations, and it is US tax classification, not the UK legal form, that decides what counts as one.

UK holding	PFIC?	Why
OEIC or authorised unit trust	Usually yes	Income and assets are almost entirely investments
Investment trust listed in London	Usually yes	A company whose business is holding investments
Exchange-traded fund domiciled in Ireland or Luxembourg	Usually yes	Same reasoning; the listing venue is irrelevant
Money market fund	Usually yes	Its income is interest
Shares in a UK trading company	Usually no	Income comes from selling goods or services; assets are mostly business assets
UK family investment company	Often yes	Income is dividends, interest and rent from a portfolio
Early-stage UK company holding funding in cash	Possible	The asset test can be met before the business has real revenue
US-domiciled mutual fund or ETF	No	Not a foreign corporation

Two points about wrappers. An ISA is an account, not a company, so it is neither a PFIC nor a shield: the funds inside it are tested one by one, as our article on ISAs and PFICs explains. And HMRC reporting fund status is a UK concept with no bearing on the US definition; see HMRC reporting funds for US citizens.

The rules that modify the two tests

The 25% look-through rule

If a foreign corporation owns at least 25% by value of the stock of another corporation, section 1297(c) treats it as owning its proportionate share of that corporation's assets and receiving its share of that corporation's income. A UK holding company whose only asset is shares in a trading subsidiary is therefore tested on the subsidiary's factory, stock and sales, not on the shares and dividends. Without this rule every holding company would be a PFIC.

The start-up exception

Under section 1298(b)(2), a corporation is not treated as a PFIC for the first tax year in which it has gross income if no predecessor was a PFIC, it is established that it will not be a PFIC in either of the next two years, and it is in fact not a PFIC in either of them. The exception covers one year and is only confirmed in hindsight.

The changed-business exception

Section 1298(b)(3) covers a company that sells an active business and sits on the proceeds. It is not a PFIC for that year if it was never one before, substantially all of its passive income for the year comes from the proceeds of disposing of one or more active businesses, and it is not a PFIC in either of the following two years.

Overlap with the controlled foreign corporation rules

Section 1297(d) says a corporation is not treated as a PFIC with respect to a shareholder for the period in which it is a controlled foreign corporation and that shareholder is a US shareholder as defined in section 951(b). In that case the controlled foreign corporation rules take over. A US person who owns their own UK investment company usually falls here, and reports under that regime instead.

Once a PFIC, always a PFIC?

For a shareholder who held the stock during a PFIC year, generally yes. Section 1298(b)(1) treats stock as PFIC stock if the corporation was a PFIC at any time during the shareholder's holding period, unless it was a qualified electing fund for that shareholder. A company that grows out of PFIC status therefore remains a PFIC for the investors who were there at the start.

The way out is an election to recognize gain as if the stock had been sold, which the Form 8621 lists among its Part II elections for former PFICs. The gain is taxed under the excess distribution rules, and the stock is clean from then on. This is the reason early investors in a company that held too much cash in its first years can find a PFIC problem a decade later.

Who is a PFIC shareholder?

Any US person who owns PFIC stock directly or indirectly. There is no ownership floor. Indirect ownership reaches further than people expect. The Form 8621 instructions list as indirect shareholders:

• a 50%-or-more shareholder of a foreign corporation that is not itself a PFIC but owns PFIC stock;
• a shareholder of a PFIC that owns stock in another PFIC, with no percentage threshold; and
• a direct or indirect owner of a pass-through entity, meaning a partnership, S corporation, trust or estate, that holds PFIC stock.

A fund of funds is the common example of the second item: the shareholder is treated as owning a share of each underlying fund as well.

An illustrative example

Illustrative example: three UK companies, each with one American shareholder. Company A is a manufacturer with gross income of £10 million, of which £300,000 is bank interest, and average assets of £20 million, of which £2 million is cash and investments. Passive income is 3% and passive assets are 10%, so it is not a PFIC. Company B is a family investment company with gross income of £400,000, of which £380,000 is dividends and interest. Passive income is 95%, so it meets the income test and is a PFIC unless its American owner is a US shareholder of a controlled foreign corporation. Company C is a two-year-old software company with £50,000 of gross income, £40,000 of it interest on money raised from investors, and that cash makes up most of its assets. It meets both tests at 80% of income, and the start-up exception helps only for its first year with gross income and only if it is not a PFIC in the two years after. This is a simplified illustration, not advice for any specific person.

What people get wrong about the PFIC definition

• "It only applies to tax-haven funds." The definition has no list of countries. A fund authorised by the UK regulator is tested the same way as one in the Cayman Islands.
• "My fund invests in real companies, so its income is active." The test looks at what the fund itself receives, which is dividends and gains. Unless the fund owns 25% of a company, there is no look-through.
• "I only own a little." The size of the holding affects the paperwork in some cases. It never changes whether the stock is PFIC stock.
• "It is in my ISA, so it does not count." The ISA has no status under US tax law.
• "The company is not a PFIC any more." For a shareholder who held it in a PFIC year, it still is, until an election ends that.
• "Only one test applies to operating companies." Both do. Operating companies usually pass the income test easily and are caught, if at all, by the asset test.

What follows once something meets the definition

PFIC status brings two consequences. The first is reporting: a separate Form 8621 for each PFIC, attached to the tax return, under the current December 2025 revision of the form. The second is how distributions and gains are taxed, which depends on whether a qualified electing fund or mark-to-market election is made. Our Form 8621 instructions guide goes through both, line by line. For what to hold in place of UK funds, see investing as an American in the UK.

How we help

US/UK Cross Border Tax is a firm of US CPAs and UK tax advisers working as one team, with offices in London, Manchester, New York and San Francisco. We apply the PFIC definition to each holding in a portfolio, including the close cases such as family investment companies, employer shares and early-stage companies, and then prepare the reporting for the ones that are caught. We work with cross-border investors and with founders whose own companies may meet the asset test. To have your holdings reviewed, contact us.