A Guide to PFIC

At a Glance

• A Passive Foreign Investment Company (PFIC) is a non-U.S. corporation that meets specific income or asset tests tied to passive income (such as interest, dividends, certain rents and royalties, capital gains, or currency gains).

• U.S. investors in PFICs face complex reporting requirements and potentially unfavorable tax treatment, typically reported on IRS Form 8621.

• PFIC rules can affect venture and SPV investors, especially when non-U.S. startups are pre-revenue and holding large cash balances or when SPVs invest into foreign funds.

• PFIC exposure can be direct (owning PFIC shares outright) or indirect (owning PFIC shares through a fund or SPV), and tax outcomes depend on elections such as the default excess distribution regime, QEF, or mark-to-market.

• Sydecar does not support SPV investments into PFICs, a policy designed to protect investors from PFIC-related reporting and tax complexity.

• Because PFIC analysis is highly fact-specific, managers and LPs should work closely with qualified tax advisors when evaluating foreign companies or funds that could implicate PFIC rules.

What Is a PFIC?

The U.S. tax code created the Passive Foreign Investment Company (PFIC) rules in the 1980s to prevent U.S. taxpayers from using offshore vehicles to defer or convert U.S. tax on passive income.

A PFIC is generally a non-U.S. corporation that meets either of the following tests in a given tax year:

1. Income Test:

   • At least 75% of its gross income is “passive income” (for example, interest, dividends, certain rents and royalties, capital gains, or currency gains).

2. Asset Test:

   • At least 50% of its assets (by value) produce, or are held to produce, passive income.

If a foreign corporation meets either test, U.S. investors who hold shares in that corporation may be treated as PFIC shareholders for U.S. tax purposes. In many cases, PFIC income can be taxed at higher ordinary income rates, and specialized reporting applies (typically on IRS Form 8621).

Because of this, most U.S. investors and fund managers try to avoid PFIC exposure unless they have deliberate, specialized tax support in place.

How PFIC Rules Intersect With Venture Investing

PFIC rules are not limited to traditional “passive” investments like foreign mutual funds. They can also intersect with venture investing, especially when:

• The portfolio company is organized outside the United States, and

• The company is pre-revenue, early in R&D, or holding large cash balances from a financing round.

Consider a scenario:

• A non-U.S. startup raises several million dollars in seed funding.

• The company has not yet generated operating revenue.

• Most of its balance sheet consists of cash and short-term, interest-bearing instruments.

In that situation, the company’s only income may be bank interest on its cash, which the PFIC rules treat as passive income. If a large portion of its assets are dedicated to producing that passive income, it may meet both the income and asset tests, even though the business is high-growth and operationally active.

The U.S. tax rules now include certain exceptions aimed at limiting unintended PFIC classification for operating companies. Even so, PFIC analysis remains highly fact-specific and often requires specialized tax guidance. For venture investors and SPV managers, this makes it important to identify potential PFIC risk early in the process.

Direct vs. Indirect PFIC Exposure

For venture investors, PFIC exposure can arise in different ways:

• Direct PFIC investment: A U.S. investor owns shares directly in a foreign corporation that qualifies as a PFIC.

• Indirect PFIC investment: A U.S. investor holds their interest through another entity (for example, a fund or SPV) that, in turn, owns PFIC shares.

SPVs are typically treated as “look-through” vehicles for U.S. tax purposes. The tax analysis focuses on the SPV's underlying assets. If an SPV invests in a non-U.S. company or fund that is a PFIC, the SPV’s investors may have indirect PFIC exposure and related reporting obligations.

Key implications for SPV investors:

• Investors on Sydecar’s platform generally hold interests in SPVs, not directly in portfolio companies.

• However, the tax characterization still depends on the nature of the underlying investment.

• Whether an investor is treated as a direct or indirect PFIC shareholder (and what elections are available) requires a case-specific tax analysis of the target company or fund.

Because of this complexity, investors should work with their tax advisors to understand whether a particular foreign investment could trigger PFIC rules and what reporting might be required.

High-Level Overview of PFIC Tax Treatment

If an investment is classified as a PFIC, U.S. taxpayers may be able to choose among several tax regimes, each with different consequences. At a high level, the three primary approaches are:

1. Excess Distribution Regime (Default)

   • This is the default PFIC treatment if no special election is made.

   • “Excess distributions” (including certain gains on sale) are allocated over the holding period and taxed at ordinary income rates, with an interest charge applied to prior-year amounts.

   • This regime often results in a higher effective tax burden and added complexity.

2. Qualified Electing Fund (QEF) Election

   • A U.S. investor may elect to treat the PFIC as a Qualified Electing Fund if the PFIC provides the necessary information.

   • Under a QEF election, the investor generally includes their pro rata share of the PFIC’s income each year (both ordinary income and net capital gains), regardless of actual distributions.

   • This approach can preserve long-term capital gain treatment on certain income, but it depends on cooperation and reporting from the PFIC itself.

3. Mark-to-Market Election (for Marketable Stock)

   • If PFIC stock is “marketable” (for example, regularly traded on certain exchanges), an investor may elect to mark it to market annually.

   • Each year, the investor recognizes gain (or, in some cases, loss) based on the change in fair market value, with gains generally taxed at ordinary income rates.

   • Losses are limited and can only offset prior mark-to-market gains.

Each approach has tradeoffs, eligibility requirements, and detailed rules. Choosing among them is a tax planning question that requires professional advice, which is why PFIC exposure is considered high-friction and undesirable for many venture investors.

Sydecar’s Approach to PFIC Risk

Given the complexity, potential penalties, and reporting burden associated with PFICs, Sydecar has adopted a conservative approach for SPVs:

• Sydecar does not support SPV investments into PFICs.

• This policy is designed to protect SPV investors from unexpected PFIC reporting obligations and unfavorable tax treatment.

• When a target company or fund could potentially fall under PFIC rules, managers and investors are encouraged to speak with the issuer and their own tax advisors to clarify the PFIC status.

If you are investing in or evaluating a foreign company and PFIC risk is on the table, understanding the relevant IRS reporting, typically on Form 8621 (Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund), is critical. Your tax advisor can help determine whether the form is required and which elections, if any, make sense for your situation.

Where to Learn More

Because PFIC rules are technical and situation-dependent, primary and expert sources are essential. Helpful starting points include:

• Cornell Law School: Passive foreign investment company: A plain-language summary of the PFIC provisions in the Internal Revenue Code.

• IRS – Instructions for Form 8621: Official IRS instructions for PFIC and QEF reporting.

• Specialized PFIC Guides and Practitioner Resources: Many cross-border tax practitioners publish explanations and examples of common PFIC scenarios, which can help investors understand typical patterns and pitfalls:

  • PFICs: How do I know if I have it?

  • Golding Lawyers: Common Examples of PFIC Investments

The Bottom Line for Venture and SPV Investors

PFIC rules were not written with early-stage venture investors in mind, but they still apply when U.S. investors own shares—directly or indirectly—in certain foreign companies or funds. For SPV managers and LPs, the key actions are:

• Recognize when PFIC risk might arise, especially with non-U.S., pre-revenue, cash-heavy companies or foreign funds.

• Involve qualified tax advisors early when structuring or evaluating cross-border investments.

• Use platforms and structures (like Sydecar’s SPVs) that are designed to avoid PFIC exposure and the associated reporting burden.

By combining good process, the right advisors, and infrastructure that avoids PFIC pitfalls, emerging managers and their LPs can stay focused on what they do best: finding and backing exceptional companies.