PFICs (Passive Foreign Investment Companies) – A Quick Q and A

February 16, 2012 by  Filed under: Taxes 

(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 QA 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!

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 QA. 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: Distributions by the PFIC will be treated as dividends to the extent of the US shareholder’s share of the PFIC’s EP (short for “Earnings Profits”), with any excess applied first against stock basis (until zero) and then to capital gain. 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 EP 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. If ordinary income, the US shareholder’s pro rata share of the ordinary earnings of the QEF for such year. If 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: (1) Distributions of previously recognized/taxed income – Excluded from income, but reduces basis in PFIC stock. (2) Distributions of current-year recognized/taxed income – Excluded from income, but reduces basis in PFIC stock. (3) 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 QA.

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 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: (1) The PFIC becomes a QEF with respect to the US shareholder for a taxable year which begins after December 31, 1986, (2) The US shareholder holds stock in that PFIC on the first day of such taxable year, and (3) 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 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: (1) The PFIC becomes a QEF with respect to the US shareholder for a taxable year which begins after December 31, 1986, (2) The US shareholder holds stock in that PFIC on the first day of such taxable year, and (3) 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: (1) 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, (2) 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 (3) 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.

Please see some of my other articles at http://tax-fishing-and-other.blogspot.com/ and let me know if you have any questions or comments!

Article Source:
http://EzineArticles.com/?expert=Andrew_L_Gantman

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