Foreign Income & Taxpayers
Before investing in foreign equities, U.S. taxpayers should consider the tax consequences that may apply to them. Foreign investments by U.S. taxpayers can be subject to the punitive tax consequences of investments in passive foreign investment companies (PFICs). Under the default Sec. 1291 PFIC taxation regime, excess distributions received from PFICs are allocated pro rata to each day in the investor’s holding period and are subject to interest charges on taxes deemed to be owed in preceding tax years (Sec. 1291(a)(1)). In order to avoid Sec. 1291, U.S. taxpayers can make timely qualifying electing fund or mark-to-market elections. Other various planning alternatives are also available to help U.S. taxpayers avoid the punitive aspects of the PFIC regime.
Determining PFIC Status and Identifying Unexpected PFIC Traps
The IRS implemented regulations on PFICs in 1986 to prevent U.S. taxpayers from deferring tax on passive income earned by entities organized in low-tax jurisdictions. PFICs are foreign corporations that generate 75% or more of their gross income from passive sources or that own assets that are primarily held for the production of passive income (i.e., more than 50% of the entity’s asset value is represented by assets that generate passive income) (Sec. 1297(a)). For purposes of PFIC determination, passive income is foreign personal holding company income (FPHCI) as defined in Sec. 954(c). Principal forms of FPHCI are interest, rents, royalties, capital gains, currency gains, and dividends (Sec. 954(c)). Active banking and insurance income, as defined by Secs. 954(h) and (i), is excluded from passive income for purposes of PFIC determination (Sec. 1297(b)(2)).
When using the asset test to determine PFIC status, assets that produce both nonpassive and passive income are classified based on the relative proportion of income produced in each category (Notice 88-22). Despite their mixed character, certain assets such as working capital will always be considered passive assets, according to Sec. 1296(a)(2). It should also be noted that assets must be valued on a quarterly basis and, more importantly, on a gross basis, disregarding any liabilities that can be traced to particular assets (Notice 88-22). For example, a building used in a trade or business with a fair market value (FMV) of $2 million and with an existing mortgage of $1,500,000 will be valued at $2 million under the asset test for PFIC determination. Due to the inherent difficulty of measuring the FMV of assets, the IRS provides substantial guidance for asset valuation for purposes of PFIC determination in Notice 88-22.
Common examples of PFICs are foreign-based mutual funds and start-up companies that unexpectedly fall within the scope of the PFIC trap. Foreign mutual funds typically are considered PFICs because they are foreign corporations that generate more than 75% of their income from passive sources such as capital gains and dividends (Fitzsimmons, “Downturn Begets PFIC Status,” 17 Canadian Tax Highlights 2 (February 2009)). Certain start-up companies are also at risk of being subject to the PFIC rules because they typically have loss-making operations in their beginning years and may have small sources of passive income such as interest income from bank accounts.
Relief from PFIC provisions is granted to start-up foreign corporations that establish that they will not qualify as PFICs for the two years following their start-up year and that the corporation has not been a PFIC in a predecessor form (i.e., spinoff from a PFIC) (Sec. 1298(b)(2)). Foreign corporations with U.S. taxpayers as investors or corporations with a desire to access U.S. capital markets may disclose PFIC status in the notes to their financial statements (Fitzsimmons, p. 3). It is important to note that once a foreign corporation becomes a PFIC, it will generally always be considered a PFIC for U.S. federal tax purposes. U.S. shareholders owning more than 10% of a controlled foreign corporation (CFC) that otherwise would be considered a PFIC are exempt from the PFIC regime for the years they remain U.S. shareholders of a CFC (Sec. 1297(d)).
Sec. 1291: Excess Distribution Regime
A shareholder of a PFIC is by default subject to the Sec. 1291 excess distribution regime in which U.S. taxpayers must allocate excess distributions and gains realized upon the sale of their PFIC shares pro rata to their entire holding period (Sec. 1291(a)(1)(A)). Excess distributions are actual distributions that are in excess of 125% of average distributions received in the preceding three years in which the PFIC shares were owned (Sec. 1291(b)(2)). All gains realized upon the disposition of PFIC shares are also considered excess distributions (Sec. 1291(a)(2)). Interest charges will be assessed on taxes deemed owed on excess distributions allocated to tax years prior to the tax year in which the excess distribution was received. All capital gains from the sale of PFIC shares are treated as ordinary income for federal income tax purposes and thus are not taxed at preferential long-term capital gain rates (Sec. 1291(a)(1)(B)).
As a result of the highly punitive PFIC regime, a U.S. taxpayer will end up deferring taxes but also accruing interest charges on the taxes deemed to be owed in preceding tax years. Further, capital losses upon disposition of PFIC shares cannot be recognized (Prop. Regs. Sec. 1.1291-6(b)(3)). U.S. taxpayers can find themselves paying significantly more tax than they would have paid if they recognized income from the PFIC shares on an annual basis by making a timely mark-to-market election or by choosing qualified electing fund (QEF) status.
Qualifying Electing Fund, Mark-to-Market Elections, and Planning Strategy Options
U.S. taxpayers that desire to be taxed annually on income deemed to be received from their PFIC shares must make a timely QEF election. This election should be made during the first tax year following the year in which the PFIC shares were acquired, although failure to do so does not bar subsequent remedial action (Sec. 1295(b)(2)). The first U.S. taxpayer in the chain of ownership must make a QEF election for its PFIC shares. For example, U.S. partnerships owning PFIC shares should make QEF elections on behalf of their partners (Regs. Sec. 1.1295-1(d)(2)(i)(A)).
A QEF election can be made only if the PFIC provides the U.S. taxpayer with an annual information statement indicating the U.S. taxpayer’s proportionate share of ordinary income, capital gains, and distributions made within the tax year its PFIC shares were owned (Regs. Sec. 1.1295-1(g)(1)). The QEF election is made on Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, and must reflect the information provided in either the PFIC annual information statement, annual intermediary statement, or applicable combined statement for the tax year of the PFIC ending with or within the tax year for which Form 8621 is being filed (Regs. Sec. 1.1295-1(f)(1)(iii)). If the PFIC annual information statement contains a statement (as described in Regs. Sec. 1.1295-1(g)(1)(ii)(C)) indicating that the U.S. taxpayer can inspect the books and records of the foreign corporation, the shareholder must attach a statement to Form 8621 indicating that the shareholder rather than the PFIC calculated the PFIC’s ordinary earnings and net capital gain.
A timely QEF election is the preferred remedy for an owner of PFIC shares because U.S. taxpayers are taxed only on the income attributed to them annually throughout the period in which the PFIC shares are owned. The benefit of the election is the avoidance of accrued interest charges on taxes deemed to be owed in prior years. However, if a QEF election is not made on a timely basis, U.S. taxpayers owning PFIC shares are subject to both QEF income inclusions throughout the holding period of the PFIC shares and the excess distribution regime upon selling the PFIC shares if those shares are sold at a gain (Prop. Regs. Sec. 1.1291-1(c)(2)). Income recognized from annual QEF income inclusions throughout the taxpayer’s holding period increase U.S. taxpayers’ basis in their PFIC shares. Actual distributions received throughout the taxpayers’ holding period decrease their basis in their PFIC shares (Sec. 1293(d)).
U.S. taxpayers that want to avoid the excess distribution regime but that do not qualify for QEF treatment can make a mark-to-market election. To qualify for that treatment, the PFIC stock must be regularly traded on a qualified exchange, and an election must be made beginning in the first tax year of the taxpayer’s holding period for the PFIC stock. Under mark-to-market treatment, the U.S. taxpayer owning the PFIC shares must recognize as ordinary income annual increases in the market value of their PFIC shares (Sec. 1296(a)(1)). Annual losses in the value of PFIC shares are treated as ordinary losses only to the extent of previously recognized gains. However, any losses recognized upon disposition of PFIC shares are considered capital losses (Regs. Sec. 1.1296-1(c)(4)(ii)).
Various options are available to U.S. taxpayers seeking to purge themselves of the PFIC taint. U.S. taxpayers that failed to make a timely QEF election and desire QEF status can use purging elections. U.S. taxpayers holding foreign corporations that are no longer PFICs but are still subject to the “once a PFIC, always a PFIC” rule can also consider a mark-to-market purge election or deemed dividend purge elections to rid themselves of the PFIC taint (Sec. 1298(b)(1)). Rules surrounding these elections are complex and require the expertise of an international tax professional.
Recent Developments in PFIC Reporting Requirements
The Hiring Incentives to Restore Employment Act of 2010, P.L. 111-147 (the HIRE Act), contained previously proposed provisions of the 2009 Foreign Account Tax Compliance Act in its legislation. One of the provisions of the HIRE act increases PFIC reporting by requiring any U.S. taxpayer holding PFIC shares to file an annual information report with the IRS for tax years beginning after March 18, 2010 (Sec. 1298(f)). Under the previous law, annual reporting on Form 8621 was required only when a U.S. taxpayer owning PFIC shares received a distribution, recognized a gain upon disposition of PFIC shares, or made an election reportable on part one of the form. In a recent turn of events, the IRS issued a notice temporarily suspending the new reporting requirements under Sec. 1298(f) until the revised Form 8621 is released (Notice 2011-55).
The IRS has demonstrated heightened scrutiny of international investments made by U.S. taxpayers in its efforts to reduce the international tax gap. Whether practitioners or their clients are using the services of an international financial adviser or simply investing in foreign equities on U.S. exchanges, they should be aware of the tax consequences of owning PFICs. The tax effects of any investment decision should be considered, and investments abroad should be given particular consideration.
Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.
For additional information about these items, contact Mr. Wong at (212) 697-6900, ext. 986, or email@example.com.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.