Cleansing the PFIC taint: Planning and pitfalls

The rules governing the taxation of U.S. shareholders of passive foreign investment companies (PFICs) have created complexity and myriad pitfalls for the unwary investor and tax professional. While the intent of these rules is to prevent U.S. taxpayers from taking advantage of deferral and/or conversion strategies via a passive investment in a foreign corporation, it is far too easy for a foreign corporation to be classified as a PFIC. To add insult to injury, unless a taxpayer invokes certain affirmative elections, tax inefficiencies will likely ensue, which can unexpectedly increase the cost of owning PFIC shares. Additionally, the “once a PFIC, always a PFIC” rule, more fully described below, creates a “taint” that requires taxpayer-initiated action to cleanse. This article focuses on the mechanics of the “cleansing” process and the associated advantages and potential pitfalls.

Background

Prior to the enactment of the PFIC rules,¹ investments in offshore companies (typically hedge funds and mutual funds) were treated like most other investments (i.e., eligible for preferential tax treatment if sold after being held for more than a year). Since then, under the PFIC rules, gains associated with these investments are potentially subject to tax at the highest ordinary income tax rate.

The PFIC rules apply only to shareholders who are U.S. persons (e.g., individuals who are U.S. citizens or residents and U.S. domestic partnerships and corporations, trusts, and estates). Whether a foreign corporation is classified as a PFIC is determined year by year. Sec. 1297(a) defines a PFIC as a foreign corporation that satisfies at least one of the following requirements:

• 75% or more of its income is classified as passive; or
• 50% or more of the average percentage of its assets (determined under Sec. 1297(e)) held during the year produce, or are held for the production of, passive income.

In contrast to the anti-deferral rules applicable to controlled foreign corporations (CFCs), which apply only where any U.S. person owns 10% or more of the total combined voting power of all classes of voting stock,²the PFIC rules do not include a minimum ownership test. Thus, a U.S. owner can be subject to the PFIC tax rules through owning only a fraction of a percent of an entity’s outstanding shares. Another major pitfall in the PFIC rules is that under Sec. 1298(b)(1), once an offshore investment is classified as a PFIC, it is always classified as a PFIC with respect to a particular shareholder (referred to as the once-a-PFIC, always-a-PFIC taint).³

As more fully described below, absent making certain elections, a U.S. taxpayer-investor holding PFIC stock is subject to the default regime of Sec. 1291. Sec. 1291 and the regulations spell out a complex and burdensome set of excess-distribution rules,⁴ which are generally much less favorable to the U.S. taxpayer and are designed to eliminate any deferral benefit and prevent conversion of ordinary income to preferentially taxed capital gains.⁵ More specifically, an excess distribution or gain on the sale of PFIC stock (which is treated as an excess distribution) must be spread pro rata over the years in which the shareholder held the PFIC stock. A tax (the deferred tax) is imposed on excess distributions allocable to the years before the current year at the highest ordinary income tax rate in effect in each year. Additionally, the shareholder must pay an interest charge computed as if this hypothetical tax were due on the due date of the allocation year and the taxpayer had failed to pay it until the due date of the year the excess distribution or sale took place. The excess distributions allocable to the current year (and if applicable, any pre-PFIC years in the taxpayer’s holding period) are taxed as ordinary income.

Beneficial election options

To avail themselves of a simpler and more tax-efficient structure, taxpayers should consider making a qualified-electing-fund (QEF) election under Sec. 1295 or, if they own “marketable”⁶ PFIC stock, a mark-to-market election under Sec. 1296 for PFIC stock in the year the security is purchased or thereafter. These elections are made on Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, which is due on or before the extended due date of the taxpayer’s federal income tax return. If the taxpayer makes a QEF election, under Sec. 1293, the taxpayer annually includes in gross income a pro rata share of the PFIC’s ordinary earnings (as ordinary income) and net capital gains (as long-term capital gains). Distributions of previously taxed amounts are treated as a return of capital.

If a taxpayer who owns marketable stock in a PFIC makes the mark-to-market election for the stock, the taxpayer must include in gross income the excess of the FMV of the stock as of the close of the tax year over its adjusted basis. If the adjusted basis exceeds the FMV of the stock at the close of the tax year, the taxpayer is allowed a deduction of the lesser of (1) the excess of the adjusted basis over the FMV, or (2) the excess (if any) of the amount included in gross income in previous years due to mark-to-market gain for the stock, over the amount allowed in previous years as a deduction for mark-to-market losses for the stock.

The QEF election is the more popular of the two options, as the tax regime for domestic investments applies to the foreign investment. Also, in a QEF election, the taxpayer includes a pro rata share of the foreign company’s ordinary earnings and capital gains in income each year, which is easier for the taxpayer (and the practitioner) to track.

Purging the PFIC taint

Shareholder of a current PFIC

As mentioned earlier, the taxpayer and/or practitioner may be unaware of an investment’s PFIC status (or may not have had access to all of the required information to make a proper election), which may preclude the timely filing of a mark-to-market or QEF election. A taxpayer can make a retroactive QEF or mark-to-market election, but, in practice, the IRS will only allow such an election in very limited circumstances.⁷If a timely QEF or mark-to-market election is not made for an investment in PFIC stock, because of the Sec. 1298(b)(1) once-a-PFIC, always-a-PFIC rule, absent any other actions by the taxpayer, the punitive Sec. 1291 excess-distribution rules will apply to distributions related to, and dispositions of, the stock in future years.

A taxpayer may remedy this situation by making the QEF election in a year after the year the taxpayer acquires the PFIC stock. However, making the QEF election is not enough; where a shareholder makes a QEF election in a year subsequent to the first PFIC year, the QEF becomes an “unpedigreed” QEF. An unpedigreed QEF is subject to both the Sec. 1296 QEF rules and the Sec. 1291 excess-distribution rules.

To create a “pedigreed” QEF that is subject only to the Sec. 1296 QEF rules, the owner must purge the PFIC taint by making either a deemed-dividend election or a deemed-sale election (a purging election). A deemed-sale election requires a taxpayer to recognize any gain on the investment as if the taxpayer sold the PFIC stock for its FMV as of the qualification date, which is the first day of the PFIC’s first tax year as a QEF. Losses are disallowed. The gain is calculated and reported on Form 8621. A deemed-dividend election, which can only be made for a PFIC that is also a CFC, requires taxpayers to include in taxable income a pro rata share of the PFIC’s post-1986 earnings and profits (E&P) attributable to the stock held on the qualification date (the first day of the PFIC’s first year as a QEF).

The deemed-dividend and deemed-sale elections must be made on an original return by the due date, including extensions, for the original tax return for the tax year that includes the qualification date, or on an amended return within three years from the due date, as extended, of the original return for the tax year that includes the qualification date.

In both instances, any gain/dividend resulting from the election is considered an excess distribution subject to the PFIC tax regime, which basically subjects the income to ordinary tax rates and requires the inclusion of a nondeductible interest charge. These rules can be illustrated as follows:

Example: S, a U.S. citizen, made an investment in a foreign fund, B Inc. At the time of the investment, S was unaware of the fund’s foreign status, which prevented him from making a timely QEF election. He purchased 7,000 shares for a total of $500,000 on Jan. 1, 2012. At the beginning of 2015, the shares had an FMV of $650,000, resulting in an unrealized gain of $150,000. S’s pro rata share of post-1986 E&P attributable to the PFIC stock on Jan. 1, 2015, was $200,000.

Based on the facts and after crunching the numbers, S should make a deemed-sale election for 2015 since the net tax cost including interest ($60,303) will be less than if he were to make a deemed-dividend election ($80,404).⁸ See illustrative calculations in the exhibit, “Comparison of Election Approaches,” below.

Shareholder of a former PFIC

Because of the PFIC taint, a shareholder of a foreign corporation that no longer qualifies as a PFIC under either the income or asset test of Sec. 1297(a) (a former PFIC) is treated as still holding PFIC stock (subject to the Sec. 1291 excess-distribution rules) unless the shareholder makes a purging election. The purging elections available are the same as those for a shareholder of a current PFIC—a deemed-sale or a deemed-dividend election.

A shareholder making the deemed-sale election treats the stock of the former PFIC as sold for its FMV on the last day of the last year it was treated as a PFIC (the termination date). The election is made on Form 8621, which must be filed with the shareholder’s original return for the tax year that includes the termination date, by the due date, including extensions, for the original return, or with an amended return, filed within three years of the due date, as extended, for the original return.⁹ The shareholder reports the gain as an excess distribution in accordance with Sec. 1291(a)(1) and pays the additional tax and interest due on the excess distribution.

Similarly, a former PFIC shareholder who opts for the deemed-dividend election makes the election on Form 8621 and reports the deemed dividend as an excess distribution under Sec. 1291(a)(1). As with the deemed-sale election, the Form 8621 must be filed with an original return for the tax year that includes the termination date by the due date, including extensions, for the original return, or with an amended return, filed within three years of the due date, as extended, for the original return.¹⁰ However, if this time frame is missed, the taxpayer can make a late purging election for a closed tax year by filing Form 8621-A, Return by a Shareholder Making Certain Late Elections to End Treatment as a Passive Foreign Investment Company, with the IRS.

Both elections will “cleanse” the PFIC taint, and the electing shareholder’s stock in the foreign corporation will no longer be treated as stock in a PFIC. For purposes of applying the PFIC rules, a new holding period for the affected shares will start on the day after the termination date.

Potential conflicts when filing amended returns

As noted above, a PFIC shareholder who makes an election to treat a PFIC as a QEF after the corporation’s first year as a PFIC and a shareholder of a former PFIC are allowed to make a purging election on an amended return.

Sec. 7502(a)(1)states:

If any return, claim, statement or other document required to be filed, or any payment required to be made, within a prescribed period or on or before a prescribed date under authority of any provision of the internal revenue laws is, after such period or such date, delivered by the United States mail . . . the date of the United States postmark stamped on the cover in which such return, claim, statement, or other document, or payment, is mailed shall be deemed to be the date of delivery or the date of payment, as the case may be.

Thus, under the timely mailing rule of Sec. 7502,¹¹ a return, claim, statement, or any other document or payment that is required to be made within a prescribed period or by a prescribed date under the internal revenue laws is deemed filed or paid on the date of the postmark stamped on the envelope or on the date of the electronic postmark, even if it is received after the limitation period. Regs. Sec. 301.7502-1 reiterates this rule and provides further clarification on the definition of a document, claim, statement, or payment. The documentation required under Regs. Sec. 1.1298-3 to make a valid purging election falls squarely within these definitions.

There does, however, appear to be some conflict in the rules when a purging election is made on an amended return that reflects additional tax due. In Chief Counsel Advice (CCA) 201052003, the IRS asserts that the postmark rule of Sec. 7502 does not apply to an amended return that is received after the limitation period and reflects additional tax due. The Service bases its conclusion on the following:

• In keeping with Estate of Lewis¹² and Myers,¹³ a timely mailed amended return that shows additional tax is not “required to be filed” under Sec. 7502; and
• Even though the IRS administratively permits the use of amended returns, the filing of amended returns is not a matter of right because there is no statutory provision ­expressly authorizing their filing—see ­Badaracco;¹⁴ but
• Sec. 7502 would apply to an amended return that includes a claim for refund because taxpayers are required to file a claim in such cases under Sec. 6511 and Regs. Sec. 301.6402-3(a)(5).

The holding in CCA 201052003 contradicts Regs. Secs. 1.1298-3(b)(3) and 1.1298-3(c)(4), which state that if the purging election is made on an amended return, “the return must be filed by a date that is within three years of the due date, as extended under [Sec.] 6081, of the original return for the election year.” So, what if a former PFIC investor makes a purging election on an amended return that reflects additional tax and mails the return prior to the expiration of the statute of limitation, but the IRS receives it after the limitation period? Will the return and associated payment be rejected and the purging election be ineffective? There is no obvious answer to this question, so it behooves the practitioner to err on the side of conservatism and make sure that the amended return and payment are received by the IRS before the statute runs.¹⁵

Weighing the cleansing options

The rules governing the taxation of PFICs are fraught with complexities and potential pitfalls for the unwary investor and tax professional. Due to the once-a-PFIC, always-a-PFIC rule, if a taxpayer does not make a QEF or mark-to-market election for PFIC stock in the year of acquisition, the taxpayer is required to make a purging election in a later year to cleanse the stock of the PFIC taint. Therefore, tax professionals should exercise caution when advising clients with an investment in a foreign enterprise, as the investment’s classification may not be obvious. This may be of particular concern when the professional has not been on the scene from the investment’s inception. The practitioner should carefully weigh the cleansing options available to the client and be mindful of the lack of clarity surrounding statute-of-limitation issues, particularly where the cleansing election requires the filing of an amended return that results in additional tax due.  

Footnotes

¹By Section 1235 of the Tax Reform Act of 1986, P.L. 99-514, effective for tax years of foreign corporations beginning after Dec. 31, 1986.

²Sec. 951(b).

³Note that Sec. 1297(d) applies a special overlap rule, which precludes PFIC applicability in periods when the U.S. shareholder is a 10% owner of the CFC. That said, if the first year of a shareholder’s holding period is also a PFIC year, the PFIC taint will continue to apply in subsequent years, even though CFC status now controls.

⁴Sec. 1291(b)(1) defines a shareholder’s excess distribution as any distribution in respect of stock received during any tax year to the extent the distribution does not exceed its ratable portion of the total excess distribution (if any) for the tax year. Sec. 1291(b)(2) generally defines a shareholder’s total excess distribution as the excess of total distributions received by the shareholder for the tax year over 125% of the average amount of distributions received by the shareholder in the three preceding tax years. Excess distributions are set to zero in the year in which the taxpayer’s holding period commences.

⁵An often-overlooked byproduct of these default rules is the failure to obtain a basis step-up on the death of the PFIC shareholder pursuant to Sec. 1291(e).

⁶Marketable stock is stock regularly traded on a national securities exchange registered with the SEC, the national market system established by the Securities and Exchange Act of 1934, or certain foreign securities exchanges that are regulated or supervised by a governmental authority of the country in which the market is located. It also includes stock in certain PFICs described in Regs. Sec. 1.196-2(d).

⁷Special rules under Regs. Sec. 1.1295-3 apply to requests for retroactive QEF elections. The general rules for requests for extensions of regulatory elections in Regs. Sec. 301.9100-3 govern requests for retroactive mark-to-market elections.

⁸Deciding on which approach is more beneficial requires careful analysis. Generally, in earlier years, when the PFIC’s FMV is low, a deemed-sale election may be appropriate. Conversely, the deemed-dividend election may be more beneficial in certain instances since unrealized appreciation and pre-1987 E&P are not considered in the calculation.

⁹Regs. Sec. 1.1298-3(b)(3).

¹⁰Regs. Sec. 1.1298-3(c)(4).

¹¹Sec. 7502(a)(1).

¹²Estate of Lewis, T.C. Memo. 1988-36.

¹³Myers, T.C. Memo. 1988-306.

¹⁴Badaracco, 464 U.S. 386 (1984).

¹⁵The practitioner should consider obtaining a transcript from the IRS to ­confirm the expiration date of the statute of limitation.