Foreign Income & Taxpayers
In enacting Secs. 1291 through 1298 in 1986, Congress created a complex and punitive tax regime for certain passive foreign investments that continues—nearly three decades later—to plague U.S. taxpayers and their tax advisers.
U.S. taxpayers who invest in offshore mutual funds or certain other passive foreign investments without understanding the tax consequences may learn only years later that those investments are subject to the onerous tax rules for investments in passive foreign investment companies (PFICs).
The PFIC rules were enacted to eliminate beneficial tax treatment for certain offshore investments. Under prior law, U.S. taxpayers could accumulate tax-deferred income from offshore investments and, upon sale of the investment, recognize gain at the long-term capital gains tax rate.
Under the PFIC rules, absent a beneficial election, PFIC investments are generally subject to tax on distributions at the highest ordinary income rates in effect for the tax year, rather than the currently more beneficial dividend and capital gains rates. Sec. 6621 interest charges accrue on deferred taxes until the due date of the return (without regard for extensions) for the last PFIC year; losses are disallowed.
Typically, these PFICs are passive investments in offshore mutual funds, hedge funds, stocks, annuities, or income-producing property.
Under Sec. 1297, a PFIC is defined as a foreign corporation that meets at least one of the following tests:
- 75% or more of its income is derived from passive sources (the income test), or
- 50% or more of the average fair market value of the assets it held during the year are passive income-producing assets (the asset test).
If a U.S. taxpayer’s investment is characterized as a PFIC in one year, it is generally also treated as a PFIC in future years—commonly referred to as the once-a-PFIC-always-a-PFIC rule or the PFIC taint.
The U.S. taxpayer-investor in a PFIC is taxed according to an onerous excess-distribution regime under Sec. 1291 unless the taxpayer cleanses the PFIC taint with either of two elections: the mark-to-market election under Sec. 1296 (available for assets that are regularly traded on qualified exchanges or other markets) or the election to be treated as a qualified electing fund (QEF) under Sec. 1295. The latter is the focus of this item. If either election is made for a tax year other than the year the asset was purchased, the taxpayer must first cleanse the PFIC taint—with a deemed-sale election in the case of the QEF election.
A QEF Election in a Year After the Year of Purchase
Under the QEF tax regime, a U.S. taxpayer’s investment in a PFIC is generally subject to the same tax rules and rates as a domestic investment—except that dividends are not considered qualified dividends. The taxpayer elects to include in each year’s taxable income a pro rata share of the PFIC’s ordinary earnings and net capital gains.
Generally, unless the taxpayer files the QEF election in the tax year the PFIC investment was made, the excess-distribution regime applies until the PFIC taint is cleansed with a deemed sale under Sec. 1291(d)(2)(A). Under very limited circumstances—and only when the taxpayer fails to file the election based on a reasonable belief that the investment was not a PFIC—the taxpayer may file a retroactive QEF election as described in Regs. Sec. 1.1295-3.
Deemed-sale election: To cleanse the asset’s PFIC taint, the taxpayer must recognize any gain on the investment; losses are disallowed. The amount of the recognized gain is equal to the asset’s fair market value as of the first day of the PFIC’s first tax year, less its adjusted basis. The gain is taxed at ordinary income tax rates, according to the excess-distribution regime, and is subject to Sec. 6621 interest charges. The gain is reported on Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, filed with the taxpayer’s federal income tax return. The holding period of a U.S. shareholder for purposes of applying the PFIC rules—but not for other tax purposes—begins on the date of the deemed sale.
QEF election: The QEF election must be made by the extended due date of the taxpayer’s federal income tax return. To make the initial QEF election for an asset, the taxpayer must file Form 8621 with his or her tax return and check the “Election to Treat the PFIC as a QEF” box. If this tax year is not the year in which the investment was first purchased, the taxpayer must also check the “Deemed Sale Election” box on Form 8621. The QEF election is revocable only with the IRS’s consent.
In every subsequent year, the taxpayer must file a separate copy of Form 8621 for each QEF asset.
To facilitate calculations and reporting under the QEF rules, PFICs are required each year to provide each investor with a “PFIC Annual Information Statement.” The statement must contain essential information for the Form 8621 filing, such as the investor’s pro rata share of the PFIC’s ordinary earnings and any net capital gain for the tax year—or provide the information on which to base those calculations. Taxpayers who do not have access to this information cannot elect the QEF tax regime.
The excess-distribution regime—the default tax rules for a PFIC—is generally less favorable for taxpayers with PFIC investments than the mark-to-market and QEF methods. Because of restrictions on the use of the mark-to-market method, the QEF election is the more favorable approach for the majority of U.S. taxpayers—preferably elected in the year the investment is made or as soon as possible thereafter to begin the running of the holding period for a subsequent sale.
An example illustrating the results of the excess-distribution rules vs. the QEF tax regime is available here.
Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York City.
For additional information about these items, contact Mr. Wong at 212-697-6900, ext. 986 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.