Friday, August 6, 2010

The Passive Foreign Investment Company (“PFIC”) Provisions – A Quick Q&A



(or “Just when you thought you were safe because your foreign corporation isn’t a CFC…”)
Background – There seems (understandably) to be a fair amount of confusion on how to treat PFICs, whether directly owned by US taxpayers or by entities (e.g., partnerships) in which they have an ownership interest.  The purpose of this Q&A is to clarify some of the questions and provide guidance for further research if needed.  This is not meant to be an exhaustive discussion of the PFIC rules, but simply a starting point.  If you have further questions, please ask someone with experience in this area (e.g., me!).
1.            What is a PFIC and why is that classification relevant?
A PFIC (short for Passive Foreign Investment Company) is a foreign corporation that meets either an asset test (at least 50% of the foreign corporation’s assets either actually produce, or are held to produce, passive income) or an income test (at least 75% of the foreign corporation’s gross income is passive income).  PFICs are subject to special rules meant to limit a US taxpayer’s benefit from deferring income earned by the PFIC (e.g., section 1291, which imposes an interest charge on “excess distributions”).
Passive income in this context is any income treated as “foreign personal holding company income” under section 954(c).  This generally (but with exceptions) includes dividends, interest, royalties, rents, annuities, net gains on property that give rise to the aforementioned items, certain net commodity transaction gains, certain net foreign currency gains, income equivalent to interest and dividends, certain net derivative gains, and certain personal service contracts that can be fulfilled by others.
While there are a number of exceptions to these general rules, they are beyond the scope of this Q&A.  For further information, please start with sections 1291 through 1298.
2.            What is a QEF and why is it relevant?
A QEF (short for Qualified Electing Fund) is a PFIC for which the US shareholders (whether direct or indirect) have elected under section 1295 to recognize their proportionate share of the PFIC’s current earnings and profits (as ordinary earnings and net long-term capital gain, as the case may be).  Please see below for further information.
In addition, a QEF election (if made for the year in which the electing US shareholder first held the PFIC’s stock) will generally prevent the application of the otherwise-required anti-deferral rules (e.g., section 1291).
3.            How is a PFIC’s US shareholder taxed if the PFIC does not have a QEF election in place?
If no QEF election was made, the US shareholder will generally be taxed as follows:
·         Income/gains earned by the PFIC – No impact.
·         Deductions/losses incurred by the PFIC – No impact.
·         Distributions by the PFIC:
o    Distributions by the PFIC will be treated as dividends to the extent of the US shareholder’s share of the PFIC’s E&P (short for “Earnings & Profits”), with any excess applied first against stock basis (until zero) and then to capital gain.
o    In addition, “excess distributions” are subjected to the interest charge rules of section 1291 (as well as a historical lookback/grossup re the taxes that would have been paid, using the highest applicable ordinary income rates for those years).  This requires the US shareholder to track taxable distributions for the preceding 3 years and if the current year distributions exceed 125% of that 3-year average, the excess is considered an “excess distribution.”
Note:  If the US shareholder held the stock for less than 3 years, they use the average for that shorter preceding period.  In addition, there can be no excess distributions in the 1st year in which the US shareholder held the PFIC’s stock.
Note: All distributions “in respect of stock” of the PFIC are included for purposes of determining excess distributions, even if those amounts would otherwise have been nontaxable to the US shareholder (e.g., distributions in excess of the PFIC’s E&P which would otherwise have been treated as returns of capital).
·         Gain on disposition of the PFIC stock by the US shareholder – Treated as an excess distribution in its entirety, which includes taxation at ordinary income rates.
·         Loss on disposition of the PFIC stock by the US shareholder – Treated as a capital loss.
4.            How is a PFIC’s US shareholder taxed if the PFIC has a QEF election in place?
If a QEF election was made, the US shareholder will generally be taxed as follows (but see also the comment below regarding situations in which the US shareholder doesn’t make the QEF election with respect to a particular PFIC in the 1st year of stockholding):
·         Income/gains earned by the PFIC – Included in income and an increase to basis in PFIC stock.
o    Ordinary income – As ordinary income, the US shareholder's pro rata share of the ordinary earnings of the QEF for such year.
o    Capital gain – As long-term capital gain, the US shareholder's pro rata share of the net capital gain of the QEF for such year.
·         Deductions/losses incurred by the PFIC – No impact.
·         Distributions by the PFIC:
o    Distributions of previously recognized/taxed income – Excluded from income, but reduces basis in PFIC stock.
o    Distributions of current-year recognized/taxed income – Excluded from income, but reduces basis in PFIC stock.
o    Distributions in excess of cumulatively recognized/taxed income – Reduces basis in PFIC stock as a return of capital; amounts in excess of basis are capital gains.
·         Gain on disposition of the PFIC stock by the US shareholder – Treated as a capital gain (long or short as the facts dictate).
·         Loss on disposition of the PFIC stock by the US shareholder – Treated as a capital loss.
5.            What if the PFIC is also a CFC (a Controlled Foreign Corporation)?
A CFC is defined under section 957(a) and is a foreign corporation controlled (more than 50%) by US shareholders that each own at least 10% of the foreign corporation.
If a PFIC is also a CFC, section 1297(d)(1) generally treats the foreign corporation as not being a PFIC during the “qualified portion” of such shareholder’s holding period with respect to stock in that corporation.  The “qualified portion” means the portion of the shareholder’s holding period which is after 12/31/97, and during which the shareholder is a “United States shareholder” (i.e., owns at least 10% of the foreign corporation) and the foreign corporation is a CFC.
Caveat:  Just because a CFC isn’t generally subject to the PFIC rules doesn’t mean there aren’t issues to deal with.  There are, but they are beyond the scope of this Q&A.
6.            Who makes the QEF election, and when/how is it made?
The QEF election may only be made by the first US person (including a domestic partnership, S corporation, or estate) that is a direct or indirect shareholder of the PFIC.  For example, if a US individual (“USI”) is a partner in a US partnership (“USP”), which is a partner in a foreign partnership (“FP”), which is a shareholder in a PFIC, the QEF election could only be made by the US partnership (“USP”).
A US shareholder generally must make a QEF election by the due date (including extensions) for filing the US shareholder’s federal income tax return for the first year to which the election is desired to apply.  The election will then apply to that (and all subsequent) years of that foreign corporation.  The election is made by completing the applicable parts of Form 8621 (instructions here) and attaching it to the US shareholder’s timely-filed federal income tax return.
7.            Is the QEF election required to be made in the first year the US shareholder owns the PFIC stock?
No.  However, if the US shareholder does not make the election in the 1st year of holding the stock, it will be subject to both the section 1291 rules and the QEF rules.
8.            If the US shareholder doesn’t make the QEF election with respect to a particular PFIC in the 1st year of stockholding, how can they avoid the section 1291 rules?
There are several ways to do so, including (but not limited to) the following:
·         Deemed sale election – The US shareholder may prospectively treat the PFIC as if it had been a QEF from the 1st year in which they held stock (i.e., a “pedigreed PFIC”) by electing under section 1291(d)(2)(A) to recognize gain on the sale of that PFIC’s stock on the first day of the year for its fair market value (with the gain, if any, treated as an excess distribution for section 1291 purposes).  Caveat:  The US shareholder must meet 3 tests to qualify for this election:
o    The PFIC becomes a QEF with respect to the US shareholder for a taxable year which begins after December 31, 1986,
o    The US shareholder holds stock in that PFIC on the first day of such taxable year, and
o    The US shareholder establishes to the IRS’s satisfaction the fair market value of such stock on such first day.
·         Deemed dividend election – The US shareholder may prospectively treat the PFIC as if it had been a QEF from the 1st year in which they held stock (i.e., a “pedigreed PFIC”) by electing under section 1291(d)(2)(B) to include in gross income as a dividend an amount equal to the portion of the post-1986 earnings and profits of such company attributable to the stock in the PFIC. This amount will be treated as an excess distributionNote/Caveat:  The US shareholder must meet 3 tests to qualify for this election, but this election is generally relevant to less-than-10% US shareholders due to the elimination of the CFC/PFIC overlap (as noted above) in 1997.
o    The PFIC becomes a QEF with respect to the US shareholder for a taxable year which begins after December 31, 1986,
o    The US shareholder holds stock in that PFIC on the first day of such taxable year, and
o    The PFIC is a CFC.
·         Retroactive election – The US shareholder may retroactively treat the PFIC as if it had been a QEF from the 1st year in which they held stock (i.e., a “pedigreed PFIC”) by electing under Treas. Reg. section 1.1295-3(b) if they:
o    Reasonably believed that as of the election due date the foreign corporation was not a PFIC for its taxable year that ended during the retroactive election year;
o    Filed a Protective Statement with respect to the PFIC, applicable to the retroactive election year, in which the shareholder described the basis for their reasonable belief and extended the periods of limitations on the assessment of PFIC-related taxes for all taxable years of the shareholder to which the Protective Statement applies; and
o    Complied with any other terms and conditions of the Protective Statement.
9.            Do dividends from a PFIC qualify for the federal 15% capital gains tax rate (whether or not a QEF election has been made)?
No.  Section 1(h)(11)(C)(iii) specifically excludes dividends from a PFIC from the special beneficial rate.
10.         Does California conform to these rules?
No.  As a result, you will often see differences in both income recognized (as well as differences in stock basis) between federal and California.  California taxes distributions from a PFIC when made to the US shareholder.

10 comments:

  1. I had a question regarding CFC's. I have been told that U.S owners of foreign corporations are only taxed the long term capital gains rate ( 15% ) upon sale of their stock or dissolution of the corporation if they have held that stock for more than one year.

    Is this true ?

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  2. It depends on several factors.

    Some of these factors are: (1) whether the CFC had previously untaxed earnings and profits ("E&P") in which case section 1248 generally applies [see http://www.law.cornell.edu/uscode/26/usc_sec_26_00001248----000-.html], (2) the ownership percentages of the US owners of the CFC, (3) and where the CFC is located (i.e., the country).

    For example, let's say a US individual has a $100 long-term capital gain in 2011 on the sale of their 100%-owned Canadian CFC, which had $40 of E&P. In that case, the seller would recognize $40 of qualified dividend income (because the US has an income tax treaty with Canada) taxed at a 15% federal rate. The remaining $60 would be taxed at the 15% long-term capital gains rate.

    Note that this simple example ignores state taxes (and other possible complications). Please post if you need additional clarification.

    -Andrew

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  3. I bought some PFIC stocks in 2008 and forgot to make the QED election. Sold some of them at the end of 2010 and I believe the gains are now subjected to Sec. 1291 rules, that is, the ED rules. There was a $85 distribution from the PFIC stocks for 2009 and I have reported the amount as dividend income for both Federal & State. Should I include the $85 dividend reported as part of my Federal and State stock basis? In my case, would the ED rules apply to both Federal and State? I am on extension for the 2010 tax return, I have also received a $85 distribution in 2010 before I sold the stocks. How should I treat the $85? Thanks!

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  4. Without additional information, I can't give you a complete answer, but I can tell you this much:
    - Since you didn't make a QEF ("qualified electing fund") election, the 2009 distribution appears to be an excess distribution.
    - The 2010 gains may also represent an excess distribution (but it depends on the amount of the gain).
    - California doesn't adopt the PFIC rules. I don't know which state you're in, so I can't tell if your state is similar.
    - In the absence of any elections, the distribution should not give rise to any basis increases.
    - If you have access to BNA Portfolio (Portfolio 923-2nd - PFICs), it provides excellent guidance in this area. If your accountant or attorney doesn't have it, I suspect your local University law library does.

    Good Luck!
    -Andrew

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  5. I bought PSLV stocks in October 2010 (when the stocks were first offered) but was not aware of reporting requirements at the time. So according to what I read here, if I still own the stocks, I can make a QEF election for 2011 when my 2011 taxes are due (including extensions). The gain that I will pay tax on will be the difference between what I paid for the stocks in 2010 and their fair market value on the first business day of January 2011. This gain will be reported on my 2011 taxes under the excess distribution rule and I will have to pay interest on the tax due. But I don't need to amend my 2010 tax return. Did I get that right?
    Thank you very much.

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  6. I wish it were that simple. First, are you a US person (either a US citizen or permanent resident)? If not, then it's impossible to say without further details.

    Assuming you are a US person, then (as noted in point #6) it's too late to make the QEF election for the 1st year (i.e., 2010) in which you held the stock since the filing deadline for that year has already passed.

    You should be able to make the QEF election for 2011 (which would then also be applicable for future years), but you'll then need to consider the issues in point #8. And how to proceed on that point will depend on your own particular facts and circumstances.

    I hope that helps. Please let me know if it's still unclear.

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  7. For no QEF election made, you state that a loss on disposition of the PFIC stock is treated as a capital loss.

    Regs. 1.1291-6(b)(3) seems to point to nonrecognition of loss. Do you know where you cite the capital loss?

    Thanks for your help!


    3. How is a PFIC’s US shareholder taxed if the PFIC does not have a QEF election in place?
    If no QEF election was made, the US shareholder will generally be taxed as follows:
    · Loss on disposition of the PFIC stock by the US shareholder – Treated as a capital loss.

    ReplyDelete
    Replies
    1. Thanks for the question! The regulation section you cite only denies the loss if "such loss would not otherwise be recognized under another section of the Code or regulations." Since a loss on an actual disposition is generally recognized, the regulation (in my view) shouldn't apply. Please let me know if you need additional clarification.

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  8. Thanks for this blog. Very helpful! Just to confirm if I understand correctly. I had some shares in a foreign-domiciled fund that I sold for a loss in 2010. The fund wouldn't qualify as QEF, and I did not make a QEF election either. I had not selected mark-to-market for prior years. I'm trying to go back to correct things and if I were to do an amendment to 2010 can I declare the capital losses in my Sched D capital gains / capital losses schedule? I do have some capital gains that year I could potentially offset the losses against. Thanks again,
    JW

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    Replies
    1. Glad you like it!

      Short answer: If you didn't elect QEF status, then it's not (and was not) a QEF.

      Finally, since it wasn't a QEF, and based on the limited information provided, you should be (have been) entitled to a loss on the QEF stock upon its sale. If you didn't claim that loss, I'd probably file an amended return as long as the amount involved makes it worthwhile.

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