PFICs is a really complex area of international tax law. Special care is needed. For those who are new to this topic? Please scroll down to read my article below.
If however, you are a more sophisticated investor, we discuss PFICs in the context of
1. Australia funds –
2. UK or United Kingdom or Great Britain or England based funds –
3. Angel investor or fund manager or international investor using a foreign company holding company structure
4. Into Bitcoin on foreign exchanges? Crypto trader or crypto investor –
5. We can help you mitigate or at least minimize their impact –
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While many portions of the U.S. tax code possess confusing and sometimes harsh rulings, the tax regime for Passive Foreign Investment Companies (PFIC) is almost unmatched in its complexity and almost draconian features. Countless times, our international clients have come to us to prepare what they thought would be straightforward tax returns- only to later learn that the small investment they had made in a non-US mutual fund was now subjecting them to all the concomitant filing requirements and tax obligations. While it is beyond the scope of this article to cover all the numerous details related to PFIC reporting requirements, my hope is to provide guidance and insight into the world of PFICs.
The PFIC tax regime was created via the Tax Reform Act of 1986 with the intent to level the playing field for US based investment funds (ie mutual funds). Prior to the legislation of 1986, U.S.-based mutual funds were forced to pass-through all investment income earned by the fund to its investors (resulting in taxable income). In contrast, foreign mutual funds were able to shelter the aforementioned taxable income as long as it was not distributed to its U.S. investors. After the passage of the Tax Reform Act of 1986, the main advantage of foreign mutual funds was effectively nullified by a tax regime that made the practice of delaying the distribution of income prohibitively expensive for most investors. To employ this punitive regime, the IRS requires shareholders of PFICs to effectively report undistributed earnings via choosing to be taxed through one of three possible methods- Section 1291 fund, Qualified Election Fund, and Mark to Market election.
Defined in the Internal Revenue Code (section 1297), a Passive Foreign Investment Company is any foreign corporation that has either:
1. 75% or more of its gross income classified as passive income (i.e. interest, dividends, capital gains, etc…),
2. 50% or more of its assets are held for the production of passive income.
While there are a few exceptions to above rules, most foreign mutual funds, pension funds, and money market accounts would be good examples of PFICs. Furthermore, many foreign REITS also get trapped in the PFIC web. Finally, a foreign holding company that possesses passive investments (like rental real estate or government bonds) would be subject to PFIC regulations if the company was set up as a corporation.
PFIC related information is reported on Form 8621 .
Section 1291 Fund
The Section 1291 Fund election (Excess Distribution) is the default taxation regime unless the taxpayer chooses either of the two alternatives. Under the Sect 1291 regime, all “excess distributions” for prior years will be taxed at the highest marginal rate for each particular year an excess occurred and will incur underpayment interest expenses on those unpaid taxes. In contrast, the current year “excess distributions” are added to the “Other income” line of one’s personal tax return. For the purposes of this election an “excess distributions” are either:1. The part of the distribution received from a section 1291 fund in the current tax year that isgreater than 125% of the average distributions received in respect to such stock by the shareholder during the 3 preceding tax years (or, if shorter, the portion of the shareholder’s holding period before the current tax year; or2. Any capital gains that result from the sale of PFIC sharesTo add to the complexity- excess distributions that are taken (in either of the two aforementioned forms) must be allocated ratably over every year since the most recent excess distribution was taken (if any). Furthermore, all dividends are still required to be reported on Schedule B of the income tax return but any capital gains or losses do not get reported on Schedule D.
To provide an illustration:1 share of XYZ Inc. (a foreign mutual fund) that was purchased for $100,000 on January 1, 2008. It distributed $8,000 of dividends on July 4 of each year. On December 31, 2010, the share was sold for $400,000. Since the dividends for each year never exceeded the prior year’s amount, there are no excess distributions relating to the dividends. However, since the sale resulted in a capital gain of 300,000, the gain is an excess distribution and will be allocated ratably of each day the share was held. In particular, the excess distributions would result in $100,000 being allocated to 2008 and 2009 and taxed at the highest marginal tax rate (35% in 2008 and 2009). Also, interest would be charged to both years for the amount owed as of the due date for the particular tax year’s tax return- i.e. interest would accrue from April 15, 2009 for the 2008 excess distribution tax). Finally, the allocation of excess distribution for 2010 would be added to ordinary income line of the income tax return (line 21 for those filing Form 1040). Assuming the taxpayer was in the 33% income tax bracket for 2010, the additional tax caused by the PFIC regime would exceed $120,000. Please note that the transaction will not be recorded on the taxpayer’s Schedule D and that the dividends, though not taxed as part of the excess distribution regime, would still need to be reported on the taxpayer’s schedule B as non-qualified dividends.
To have perspective on the degree of additional taxation that can occur with the Excess Distribution method- if the $300,000 gain listed in the aforementioned scenario would have come from the sale of a non-PFIC, the tax would have been $45,000 (almost a third of the total PFIC tax liability). As you can clearly see- the IRS wants to discourage investing in foreign mutual funds.
QEF Election (Qualifying Electing Fund)
A second, simpler option for shareholders of PFICs is the QEF election. A first glance, it would appear to be a much better option for most investors since effectively results in the PFIC being treated like a US based mutual fund- the ordinary and capital gains income of the PFIC separately flow through to the shareholder according to percentage of ownership. For example, a taxpayer with a 1% stake in a PFIC that earns $100,000 in ordinary income and another $50,000 in capital gains income will report $1,000 as “other income” on the tax return while $500 will be reported on Schedule D.However, there is one huge obstacle to making this election- most PFICs are unable to be classified as a QEF since the IRS demands that a QEF comply with IRS reporting requirements (a large request for a non-US based company). Consequently, the QEF election is not frequently available.
The third option available to PFIC shareholders is to make a mark-to-market election. This method allows the shareholder to report the annual gain in market value (i.e. unrealized gain) of the PFIC shares as ordinary income on the “other income” line of their tax returns. Unrealized losses are only reportable to the extent that gains have been previously reported. The adjusted basis for PFIC stock must include the gains and losses previously reported as ordinary income. Upon the sale of the PFIC shares, all gains are reported as ordinary income whereas losses are reported on Schedule D.To choose this method, the PFIC generally must be traded on a major international stock exchange and can only apply to the current and future tax years.
Also, this election is independent of prior PFIC elections (i.e. QEF or Sect 1291 election). for example: If stock X was purchased in 2007 for $100, has a FMV on 12/31/11 of $120, and no PFIC forms were filed until 2011 (when Sect 1296- Mark-to-market- election was made), no PFIC filings would be needed for the prior years as long distributions were less than 125% and no capital gains occurred. For the current year, 8621 would be filed using Mark to market and the ordinary income would be $20. see Section 1.1296-1 3 b.iii
Every effort has been taken to provide the most accurate and honest analysis of the tax information provided in this blog. Please use your discretion before making any decisions based on the information provided. This blog is not intended to be a substitute for seeking professional tax advice based on your individual needs.
Elections to Purge IRC Section 1291 Taint
Before the 1992 Treasury Department regulations, Boris Bittker and Lawrence Lokken concluded that the multitude of disadvantages associated with the IRC section 1291 interest-on-tax-deferral regime “suggest that the rules are designed to force the QEF election to be made wherever feasible” (Fundamentals of International Taxation, Warren, Gorham & Lamont, 1991). If a shareholder makes a QEF election in the first year of PFIC ownership, there is no section 1291 (interest-on-tax-deferral regime, discussed below) taint associated with the stock; however, a taxpayer or preparer may not be aware of the investment’s PFIC status when the stock is acquired, for the reasons mentioned previously. A QEF election after the first year of ownership protects the election and subsequent years from the section 1291 interest-on-tax deferral regime.
But what about the 1291 taint that attached to the pre-QEF election years? Requests for retroactive QEF elections are possible; however, the IRS is reluctant to grant retroactive relief except in special circumstances, such as those in which the shareholder satisfies the provisions of Treasury Regulations section 1.1295-3. Fortunately, IRC section 1291(d)(2) works in tandem with a QEF election to cleanse the 1291 taint associated with pre-election taxable years. It provides two elections by which the shareholder of a section 1291 fund can purge the PFIC stock of its section 1291 taint. The tax cost to cleanse section 1291 taint is taxation in the year of election.
Deemed-sale election (IRC section 1291(d)(2)(A))
Once a shareholder elects the QEF regime and can establish the fair market value of the fund stock on the first day of the taxable year of the QEF election, the shareholder can elect to recognize the inchoate gain in the stock as if he had sold it at its fair market value on the first day of the QEF election year. This election permits a shareholder of a 1291 fund to convert the investment into a QEF. The tax price of the conversion is current recognition of gain. The election is particularly beneficial when little appreciation exists with respect to the PFIC stock.
Treasury Regulations section 1.1291-10(d) describes the deemed-sale election process. The electing shareholder makes the election by filing Form 8621 with the return of the taxable year, reporting the recognized gain as an excess distribution pursuant to IRC section 1291(a), and paying the tax and interest due on the excess distribution.
Treasury Regulations section 1.1291-10(f) provides that an electing shareholder who owns stock directly increases the adjusted basis of the PFIC stock by the amount of gain recognized on the deemed sale, and section 1.1291-10(g) provides a fresh-start holding period for the PFIC stock, beginning on the date of the deemed sale. An indirect shareholder who makes the deemed-sale election increases the basis of the property owned directly by the shareholder through which ownership of the PFIC is attributed. This is further evidence that knowledge of indirect PFIC ownership is essential to mitigate the impact of any PFIC tax consequences.
Deemed-dividend election (IRC section 1291(d)(2)(B))
If a QEF is also a controlled foreign corporation (CFC) as defined in IRC section 957(a), a shareholder can purge the fund’s section 1291 taint by electing to include in gross income her proportionate share of the post-1986 PFIC earnings as of the first day that the QEF election is effective. This election is particularly beneficial when the shareholder’s proportionate share of post-1986 PFIC earnings is small.
When the interest on deferral regime is in effect, a shareholder who receives an excess distribution or disposes of PFIC stock at a gain is subject to tax on the deferral and an interest charge.
The election process and the consequences of the deemed-dividend election are similar to those of the deemed-sale election, and they are described in Treasury Regulations section 1.1291-9. For example, the deemed dividend is treated as an excess distribution on the day of the deemed dividend, the adjusted basis of the fund stock is increased by the amount of the dividend, and the shareholder’s holding period in the stock is treated as beginning on the day of the deemed dividend.
Interest on Tax Deferral Regime
The interest on tax deferral regime allows a U.S. person to defer taxation on PFIC income until the U.S. person receives an excess distribution from the PFIC or disposes of PFIC stock at a gain. When the interest on deferral regime is in effect, a shareholder who receives an excess distribution or disposes of PFIC stock at a gain is subject to tax on the deferral and an interest charge. The income from an excess distribution and the gain from a disposition of PFIC stock are ordinary income, in accordance with IRC sections 1291(a)(1)(B) and 1291(a)(2), respectively.
IRC section 1291(b)(2)(A) defines an excess distribution as the excess (if any) of—
- the amount of the distribution received by the taxpayer during the taxable year, less
- 125% of the average amount received by the taxpayer during the three preceding taxable years (or, if shorter, the part of the taxpayer’s holding period before the taxable year).
Allocation of excess distributions
The amount of the excess distribution (or gain) is ratably allocated to each day that the shareholder held the stock [IRC sections 1291(a)(1)(A) and (a)(2)]. Amounts allocated to the current year (i.e., the taxable year of the excess distribution or disposition) are subject to regular U.S. taxation. The tax on amounts allocated to PFIC years exclusive of the current year is computed at the highest rate of tax that is applicable to the shareholder for the applicable tax years [IRC section 1291(c)(2)]. Furthermore, IRC section 1291(c)(3) imposes an interest charge on the tax, computed using the rates and method applicable under IRC section 6621 for underpayment of tax.
Implementation of the deferral method also requires taking into account certain adjustments described in IRC section 1291(b)(3). For example:
- Computations are on a share-by-share basis, except that shares with the same holding period can be aggregated.
- Stock splits and stock dividends must be taken into account.
- If the shareholder’s holding period includes periods during which stock was held by another shareholder, distributions to the other shareholder must be treated as if they were received by the subject shareholder.
- If distributions are received in a foreign currency, computations are made in that currency, and the amount of any excess distribution is translated into dollars.
Coordination with mark-to-market regime
Treasury Regulations section 1.1291-1(c)(3) provides that if PFIC stock is marked to market under IRC section 1296 (discussed below) for any taxable year, then IRC section 1291 and the Treasury Regulations thereunder are not applicable to any distribution with respect to section 1296 stock or any disposition of such stock for that taxable year.
Election of Mark to Market for Marketable Stock
IRC section 1296 permits a U.S. shareholder of a PFIC to mark to market the PFIC stock if it is “marketable stock,” as defined by Treasury Regulations section 1.1296-2. The stock must be regularly traded on a qualified exchange or other market, defined by Treasury Regulations section 1.1296-2(c) as—
- a national securities exchange that is registered with the SEC;
- the national market system established under section 11A of the Securities Exchange Act of 1934; or
- a foreign securities exchange that is regulated or supervised by a governmental authority of the country in which the market is located and has the characteristics described in Treasury Regulations section 1.1296-2(c)(1)(2), such as trading volume and disclosure requirements.
In accordance with IRC section 1296(a), the PFIC shareholder tax consequences of the mark-to-market election are either—
- gain recognized to the extent that the fair market value of the stock as of the close of the taxable year exceeds its adjusted basis; or
- loss recognized to the extent that the adjusted basis of the stock exceeds the fair market value of the stock as of the close of the taxable year.
IRC section 1296(c)(1) further provides that the gain included in gross income is ordinary income and the loss, which is also ordinary, is deductible in computing adjusted gross income. The six examples in Treasury Regulations section 1.1296-1(c)(7) illustrate the recognition of gain or loss associated with the mark-to-market election.
In addition, a PFIC shareholder’s stock basis is adjusted to reflect recognized gain or loss. Treasury Regulations section 1.1296-1(d)(1) provides that if the shareholder holds the stock directly, stock basis is increased by the amount included in gross income or decreased by the amount allowed as a deduction. If the stock is held through a foreign entity, held through a regulated investment company, or acquired from a decedent, the basis adjustment is described in Treasury Regulations sections 1.1296-1(d)(2), (d)(3), or (d)(4), respectively.
It has become increasingly possible for U.S. persons to unwittingly become shareholders of PFICs, the results of which are unexpected federal income taxation and an annual requirement to file Form 8621.
PFIC Shareholder Filing Responsibilities
The IRS Instructions for Form 8621 succinctly summarize the filing responsibilities of PFIC shareholders and provide extensive practical guidance about the QEF and the mark-to-market elections. They state that a U.S. person who is a direct or indirect shareholder of a PFIC must file Form 8621 for each taxable year if that person—
- receives certain direct or indirect distributions from a PFIC;
- recognizes gain on a direct or indirect disposition of PFIC stock;
- is reporting information with regard to a QEF or MTM election;
- is making a QEF election; or
- is required to file an annual report pursuant to IRC section 1298(f). Treasury Regulations section 1.1298-1 identifies the IRC section 1298(f) annual reporting requirements for U.S. persons who are shareholders of a passive foreign investment company.
It is significant to note that these criteria are applicable to both direct and indirect shareholders. This once again demonstrates the importance of identifying U.S. persons who are classified by the statute and regulations as indirect PFIC shareholders.
Avoid Being Caught Unawares
It has become increasingly possible for U.S. persons to unwittingly become shareholders of PFICs, the results of which are unexpected federal income taxation and an annual requirement to file Form 8621. Without guidance from their tax advisors, those U.S. persons may not be aware of elections that mitigate the unexpected federal income tax consequences of PFIC ownership. Knowing the ins and outs of what qualifies as a PFIC is crucial for helping taxpayers recognize when an investment has the potential to be classified as a PFIC, understand what the federal income tax consequences of that investment are, and make timely elections to mitigate the negative tax effects of PFIC ownership.