US Citizens/Residents Exercising Stock Options May be Exempt from Korean Income Taxation

Not long ago, I came across a situation in which a US citizen/resident (“Client”) exercised stock options to acquire stock in a South Korean corporation (“KoreaCo”).  KoreaCo granted the options to Client as compensation for services that Client performed in the US during a prior year.  Client has never been an employee of KoreaCo and performed no services in Korea.

Around the time of the option exercise, the Korean professionals involved insisted that Client was subject to Korean taxation on the excess of the stock’s fair market value (“FMV”) over the cost of exercising the option.  (i.e., treating the “bargain purchase price” as income)

For the sake of discussion, assume that the excess was equal to $1 million, which would have given rise to an approximate Korean tax of $200,000.

Issue:                  

Is Client liable for the $200,000 of Korean income tax noted above?

Brief answer:   

No.  The United States - Republic Of Korea Income Tax Convention (the “Treaty”) prohibits Korea from taxing Client on the $1 million.

Discussion:

Tax treaties are bilateral (i.e., applying to both parties) agreements between countries that can override one or both countries’ domestic tax rules to the extent that taxpayers qualify for their benefits.  These benefits often allow applicable taxpayers to be subject to lower rates of tax on income associated with one or both countries.  This could involve reduced withholding rates on things like dividends paid by a domestic corporation to a non-domestic shareholder (e.g., withholding 10% instead of 30%), or even full exemption or certain types of income.

According to the Korean professionals involved in the matter, Korean tax law states that if an individual in Korea exercises stock options for a payment of 100x when the stock has a FMV of 300x, such transaction gives rise to a taxable “gain” of 200x, and a corresponding tax of 40x (20% rate x 200x).

However, the Treaty overrides this otherwise-applicable Korean tax rule as follows.  The text of the Treaty and the Technical Explanation are available at https://www.irs.gov/businesses/international-businesses/korea-tax-treaty-documents.

• Treaty Article 1 (Taxes Covered), paragraph (1)(b) provides that the Treaty covers Korean Income Tax.  Per the Korean tax professionals, the tax on the “gain” is a tax covered by the Treaty.

• Treaty Article 6 (Source of Income), paragraph (6) provides in relevant part that

• Income received by an individual for his performance of labor or personal services, whether as an employee or in an independent capacity, or for furnishing the personal services of another person and income received by a corporation for furnishing the personal services of its employees or others, shall be treated as income from sources within one of the Contracting States only to the extent that such services are performed in that Contracting State.

 ·       The Treaty’s Technical Explanation, Article 6 (Source of Income), paragraph 1 elaborates that a Contracting State (e.g., Korea) may tax a resident of the other Contracting State (e.g., United States) only on income from sources within the first-mentioned Contracting State (as long as the resident is not a citizen of the first-mentioned Contracting State).

·        Treaty Article 16 (Capital Gains), paragraph (1) further clarifies that a US resident recognizing gains in Korea that (a) don’t relate to real property and (b) who does not have a Korean Permanent Establishment (i.e., a fixed place of business in Korea, pursuant to Article 9) is exempt from Korean taxation.

·        Treaty Article 18 (Independent Personal Services) also indicates that Client is exempt from Korean taxation on the “gain” because Client was not in Korea for any amount of time even if Client did perform independent services.

Based on the above, it is clear that the Treaty exempts Client’s “gain” on the option exercise and that the otherwise-applicable corresponding 20% Korean tax does not apply.

Caveat:  the above discussion relates solely to Korean income tax imposed on the economic “gain” and not any other taxes (e.g., stamp duties and social insurance contributions).  This article is meant solely for general awareness purposes and should not be relied upon as professional advice.  Proper treatment of each situation will depend on the specific facts and circumstances and the reader should seek out their own professional advice.

Interesting aside:  Would payment of the $200,000 Korean tax would be eligible for a foreign tax credit?  Unfortunately, the answer is no because that Korean tax is not truly a tax imposed on Client since the Treaty prohibits Korea from imposing it in this example.  To qualify for the foreign tax credit, payment must be compulsory for it to be considered a “tax.”

Withholding on prizes and awards to US nonresidents

Prizes and awards to US nonresidents may be subject to US income tax withholding!

The long arm of the US tax law can reach unexpected places. 

Did you know that awarding prizes (cash or otherwise) to non-US persons might require you to withhold US federal income taxes and pay them over to the US Treasury?  Moreover, failure to do so may result in the person who should have withheld those taxes being responsible for the unpaid tax!

If that weren’t enough, that requirement can also apply to those who simply administer the prize/award program for someone else (even if they aren’t the one choosing the winners).

Example

• COMPANY (based in the US) runs an entertainment website.
• The website has visitors from around the world.
• COMPANY periodically runs promotions on its website where visitors can win cash prizes by solving puzzles and being randomly chosen from correct entries. 
• Entrants are not required to make purchases to enter/win, nor are they required to perform any services to receive their prize.
• ALEX (age 15, a nonresident alien individual) wins a $1000 prize.

Issue 

• How much must COMPANY withhold in US income taxes from its $1000 prize payment to ALEX?

Short Answer

• COMPANY must withhold $300 in US taxes from ALEX's prize and send the remaining $700 to ALEX.

Brief Discussion

• Answer above is not intuitive.  ALEX does not have any obvious taxable connection to the US and solved the puzzle in his own home.
• COMPANY must determine the nature of the transaction taking place because it controls the “source” (i.e., US source vs. foreign source) of the income, which often dictates whether US income taxes must be withheld by the payor.
• Quick synopsis of US income tax withholding requirements (to the extent applicable here):
• Section 1441 applies to withholding of tax on nonresident aliens. It requires (among other things) that those having control over most types of income being paid to nonresidents withhold tax from those payments.
• Section 871 sets the tax rate (and thus the section 1441 withholding rate) at 30% on US source income of nonresident alien individuals.
• Source of income is mostly covered by sections 861 - 865. Key authorities relevant here:
• Section 861 – Compensation for services performed in the US are US source.
• Section 862 – Compensation for services performed outside of the US are foreign source.
• Section 863 – Permits Treasury to promulgate regulations as to source for items of income not specified in section 861 and 862.
• Treas. Reg. section 1.863-1(d)(2) provides that the source of income from prizes and awards is determined by the residence of the payor.
• ALEX winning the prize was not a direct result of solving the puzzle, it was a result of being chosen from all correct entries received by COMPANY.  As such, ALEX was not being compensated for services performed by him for COMPANY's benefit.  Thus, sections 861 and 862 do not apply to this issue.
• As a result, Treas. Reg. section 1.863-1(d)(2) treats ALEX’s prize as US source income because COMPANY (the payor) is a US person.
• Section 871 thus requires 30% withholding on the $1000 prize.
• If the person administering prize payments has (per section 1441) control over the payments, that person is a considered a “withholding agent” (defined under section 7701(a)(16)) and may be held responsible for the failure to withhold.

 Full text of Internal Revenue Code available at https://www.law.cornell.edu/uscode/text/26

House passed Senate version of fiscal cliff bill!

On the evening of January 1 2013, the House passed the Senate's version of the fiscal cliff bill.  Now it goes to President Obama.  Text is at http://1.usa.gov/UkNnw7  and runs 154 pages, covering many areas.  I suspect that individual tax rates will be getting most of the attention in the press, but there are many other items (e.g., business incentives being extended that had expired; international tax issues, etc.) that are very important.

Stay tuned for more!

• TITLE I—GENERAL EXTENSIONS
• Sec. 101. Permanent extension and modification of 2001 tax relief.
• Sec. 102. Permanent extension and modification of 2003 tax relief.
• Sec. 103. Extension of 2009 tax relief.
• Sec. 104. Permanent alternative minimum tax relief.
• TITLE II—INDIVIDUAL TAX EXTENDERS
• Sec. 201. Extension of deduction for certain expenses of elementary and secondary school teachers.
• Sec. 202. Extension of exclusion from gross income of discharge of qualified principal residence indebtedness.
• Sec. 203. Extension of parity for exclusion from income for employer-provided mass transit and parking benefits.
• Sec. 204. Extension of mortgage insurance premiums treated as qualified residence interest.
• Sec. 205. Extension of deduction of State and local general sales taxes.
• Sec. 206. Extension of special rule for contributions of capital gain real property made for conservation purposes.
• Sec. 207. Extension of above-the-line deduction for qualified tuition and related expenses.
• Sec. 208. Extension of tax-free distributions from individual retirement plans for charitable purposes.
• Sec. 209. Improve and make permanent the provision authorizing the Internal Revenue Service to disclose certain return and return information to certain prison officials.
• TITLE III—BUSINESS TAX EXTENDERS
• Sec. 301. Extension and modification of research credit.
• Sec. 302. Extension of temporary minimum low-income tax credit rate for nonfederally subsidized new buildings.
• Sec. 303. Extension of housing allowance exclusion for determining area median gross income for qualified residential rental project exempt facility bonds.
• Sec. 304. Extension of Indian employment tax credit.
• Sec. 305. Extension of new markets tax credit.
• Sec. 306. Extension of railroad track maintenance credit.
• Sec. 307. Extension of mine rescue team training credit.
• Sec. 308. Extension of employer wage credit for employees who are active duty members of the uniformed services.
• Sec. 309. Extension of work opportunity tax credit.
• Sec. 310. Extension of qualified zone academy bonds.
• Sec. 311. Extension of 15-year straight-line cost recovery for qualified leasehold improvements, qualified restaurant buildings and improvements, and qualified retail improvements.
• Sec. 312. Extension of 7-year recovery period for motorsports entertainment complexes.
• Sec. 313. Extension of accelerated depreciation for business property on an Indian reservation.
• Sec. 314. Extension of enhanced charitable deduction for contributions of food  inventory.
• Sec. 315. Extension of increased expensing limitations and treatment of certain real property as section 179 property.
• Sec. 316. Extension of election to expense mine safety equipment.
• Sec. 317. Extension of special expensing rules for certain film and television productions.
• Sec. 318. Extension of deduction allowable with respect to income attributable to domestic production activities in Puerto Rico.
• Sec. 319. Extension of modification of tax treatment of certain payments to controlling exempt organizations.
• Sec. 320. Extension of treatment of certain dividends of regulated investment companies.
• Sec. 321. Extension of RIC qualified investment entity treatment under FIRPTA.
• Sec. 322. Extension of subpart F exception for active financing income.
• Sec. 323. Extension of look-thru treatment of payments between related controlled foreign corporations under foreign personal holding company rules.
• Sec. 324. Extension of temporary exclusion of 100 percent of gain on certain small business stock.
• Sec. 325. Extension of basis adjustment to stock of S corporations making charitable contributions of property.
• Sec. 326. Extension of reduction in S-corporation recognition period for built-in gains tax.
• Sec. 327. Extension of empowerment zone tax incentives.
• Sec. 328. Extension of tax-exempt financing for New York Liberty Zone.
• Sec. 329. Extension of temporary increase in limit on cover over of rum excise taxes to Puerto Rico and the Virgin Islands.
• Sec. 330. Modification and extension of American Samoa economic development credit.
• Sec. 331. Extension and modification of bonus depreciation.
• TITLE IV—ENERGY TAX EXTENDERS
• Sec. 401. Extension of credit for energy-efficient existing homes.
• Sec. 402. Extension of credit for alternative fuel vehicle refueling property.
• Sec. 403. Extension of credit for 2- or 3-wheeled plug-in electric vehicles.
• Sec. 404. Extension and modification of cellulosic biofuel producer credit.
• Sec. 405. Extension of incentives for biodiesel and renewable diesel.
• Sec. 406. Extension of production credit for Indian coal facilities placed in service before 2009.
• Sec. 407. Extension and modification of credits with respect to facilities producing energy from certain renewable resources.
• Sec. 408. Extension of credit for energy-efficient new homes.
• Sec. 409. Extension of credit for energy-efficient appliances.
• Sec. 410. Extension and modification of special allowance for cellulosic biofuel plant property.
• Sec. 411. Extension of special rule for sales or dispositions to implement FERC or State electric restructuring policy for qualified electric utilities.
• Sec. 412. Extension of alternative fuels excise tax credits.
• TITLE V—UNEMPLOYMENT
• Sec. 501. Extension of emergency unemployment compensation program.
• Sec. 502. Temporary extension of extended benefit provisions.
• Sec. 503. Extension of funding for reemployment services and reemployment and eligibility assessment activities.
• Sec. 504. Additional extended unemployment benefits under the Railroad  Unemployment Insurance Act.
• TITLE VI—MEDICARE AND OTHER HEALTH EXTENSIONS
• Subtitle A—Medicare Extensions
• Sec. 601. Medicare physician payment update.
• Sec. 602. Work geographic adjustment.
• Sec. 603. Payment for outpatient therapy services.
• Sec. 604. Ambulance add-on payments.
• Sec. 605. Extension of Medicare inpatient hospital payment adjustment for lowvolume hospitals.
• Sec. 606. Extension of the Medicare-dependent hospital (MDH) program.
• Sec. 607. Extension for specialized Medicare Advantage plans for special needs individuals.
• Sec. 608. Extension of Medicare reasonable cost contracts.
• Sec. 609. Performance improvement.
• Sec. 610. Extension of funding outreach and assistance for low-income programs.
• Subtitle B—Other Health Extensions
• Sec. 621. Extension of the qualifying individual (QI) program.
• Sec. 622. Extension of Transitional Medical Assistance (TMA).
• Sec. 623. Extension of Medicaid and CHIP Express Lane option.
• Sec. 624. Extension of family-to-family health information centers.
• Sec. 625. Extension of Special Diabetes Program for Type I diabetes and for Indians.
• Subtitle C—Other Health Provisions
• Sec. 631. IPPS documentation and coding adjustment for implementation of MSDRGs.
• Sec. 632. Revisions to the Medicare ESRD bundled payment system to reflect findings in the GAO report.
• Sec. 633. Treatment of multiple service payment policies for therapy services.
• Sec. 634. Payment for certain radiology services furnished under the Medicare hospital outpatient department prospective payment system.
• Sec. 635. Adjustment of equipment utilization rate for advanced imaging services.
• Sec. 636. Medicare payment of competitive prices for diabetic supplies and elimination of overpayment for diabetic supplies.
• Sec. 637. Medicare payment adjustment for non-emergency ambulance transports for ESRD beneficiaries.
• Sec. 638. Removing obstacles to collection of overpayments.
• Sec. 639. Medicare advantage coding intensity adjustment.
• Sec. 640. Elimination of all funding for the Medicare Improvement Fund.
• Sec. 641. Rebasing of State DSH allotments.
• Sec. 642. Repeal of CLASS program.
• Sec. 643. Commission on Long-Term Care.
• Sec. 644. Consumer Operated and Oriented Plan program contingency fund.
• TITLE VII—EXTENSION OF AGRICULTURAL PROGRAMS
• Sec. 701. 1-year extension of agricultural programs.
• Sec. 702. Supplemental agricultural disaster assistance.
• TITLE VIII—MISCELLANEOUS PROVISIONS
• Sec. 801. Strategic delivery systems.
• Sec. 802. No cost of living adjustment in pay of members of congress.
• TITLE IX—BUDGET PROVISIONS
• Subtitle A—Modifications of Sequestration
• Sec. 901. Treatment of sequester.
• Sec. 902. Amounts in applicable retirement plans may be transferred to designated Roth accounts without distribution.
• Subtitle B—Budgetary Effects
• Sec. 911. Budgetary effects.

HR 1586 signed into law today - Say hello to some revenue raisers re international taxes

Don't let HR 1586's title(s) ("FAA Air Transportation Modernization and Safety Improvement Act," "Education Jobs and Medicaid Assistance Act," and several others) fool you.  It's chock-full of revenue raisers (i.e., tax increases) mostly in the area of international tax.

Further information (and explanations) will follow, but here are the key revenue offsets and corresponding effective dates:

• Rules to Prevent Splitting Foreign Tax Credits from the Income to Which They Relate - Effective with respect to foreign income taxes paid or accrued by U.S. taxpayers and section 902 corporations in taxable years beginning after December 31, 2010.
• Denial of Foreign Tax Credit with Respect to Foreign Income Not Subject to U.S. Taxation by Reason of Covered Asset Acquisitions - Effective for covered asset acquisitions after December 31, 2010.
• Separate Application of Foreign Tax Credit Limitation, etc., to Items Resourced Under Treaties - Effective for taxable years beginning after the date of enactment (i.e., August 10, 2010).
• Limitation on the Amount of Foreign Taxes Deemed Paid with Respect to Section 956 Inclusions - Effective for acquisitions of United States property after December 31, 2010.
• Special Rule with Respect to Certain Redemptions by Foreign Subsidiaries - Effective for acquisitions after the date of enactment.(i.e., August 10, 2010).
• Modification of Affiliation Rules for Purposes of Rules Allocating Interest Expense - Effective for taxable years beginning after the date of enactment (i.e., August 10, 2010).
• Termination of Special Rules for Interest and Dividends Received from Persons Meeting the 80-Percent Foreign Business Requirements - Effective for taxable years beginning after December 31, 2010.
• Limitation on Extension of Statute of Limitations for Failure to Notify Secretary of Certain Foreign Transfers - Effective for returns filed after March 18, 2010.
• Elimination of Advance Refundability of Earned Income Tax Credit - Effective for taxable years beginning after December 31, 2010.

Source data:

• HR 1586 on Thomas (part of the Library of Congress):  http://bit.ly/ciHQse
• Joint Committee on Taxation's writeup:  http://bit.ly/cEZ5MN

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 1^st 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 1^st 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 1^st 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 1^st 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 1^st 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 distribution.  Note/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 1^st 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.