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…), or
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 is
greater 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; or
2. Any capital gains that result from the sale of PFIC shares
To 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 100,000, 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.