Proposed PFIC regulations could complicate elections and reporting

Editor: Howard Wagner, CPA

On Jan. 25, 2022, Treasury and the IRS published proposed regulations (REG-118250-20) regarding passive foreign investment companies (PFICs) as they relate to U.S. partnerships and S corporations. The proposed regulations would extend to PFICs the aggregate treatment of U.S. partnerships and S corporations for Subpart F income. Under the proposed regulations, the filing obligation for Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, would shift away from a partnership or S corporation to its partners or shareholders. The partners and shareholders would also be responsible for making any elections with respect to the foreign corporations. The proposed regulations would also revise the application of the overlap rule outlined in Sec. 1297(d) when a PFIC is also a controlled foreign corporation (CFC).

Background

A foreign corporation is deemed to be a PFIC if either the income test or the asset test is met. Under the income test, a foreign corporation is a PFIC if 75% or more of its gross income is passive (Sec. 1297(a)(1)). Passive income for PFIC purposes is foreign personal holding company income as defined under Sec. 954(c), such as interest, rents, royalties, certain capital gains, currency gains, and dividends. Under the asset test, a foreign corporation is a PFIC if 50% or more of its assets’ average value consists of assets that produce passive income (Sec. 1297(a)(2)). Regardless of whether a foreign corporation is an active trade or business entity, it could be a PFIC under either of these two tests.

Absent an applicable election, a U.S. shareholder of a PFIC is subject to the excess-distribution rules, which impose a deferred tax and interest charge on distributions from the PFIC that exceed a certain threshold. The U.S. shareholder may defer the tax amount attributable to preceding tax years until actual distribution. However, interest on the deferred tax amount accrues based on the U.S. person’s holding period in which the foreign corporation qualified as a PFIC. This interest charge also applies upon the disposition of a PFIC. If the U.S. shareholder makes an applicable election, the excess-distribution rules can be avoided.

Under the current regulations, for purposes of Sec. 1291, neither a U.S. partnership nor an S corporation is treated as a U.S. shareholder except for information reporting requirements and for making elections on behalf of its partners or shareholders. The following elections can thus be made by U.S. partnerships or S corporations on behalf of their shareholders or partners to prevent the default excess-distribution rules from coming into play: the qualified electing fund (QEF), PFIC purging, and mark-to-market (MTM) elections.

Consistent with the treatment for elections, U.S. partnerships and S corporations are required to file Form 8621 under Sec. 1298(f). In other words, for purposes of information reporting, a U.S. partnership or S corporation is effectively treated as an entity and classified as a U.S. shareholder if it owns, directly or indirectly, stock in a PFIC. A U.S. partner or shareholder whose interest in the PFIC is owned through a partnership or S corporation may be subject to a duplicative Form 8621 obligation in certain circumstances. However, they would generally be relieved of this filing obligation under Regs. Sec. 1.1298-1(b)(2)(ii) if the U.S. partnership or S corporation timely files the Form 8621 and a timely QEF election was made.

The current regulations provide additional relief under the CFC/PFIC overlap rule provided in Sec. 1297(d)(1). If a foreign corporation is both a CFC and a PFIC, a U.S. shareholder of the foreign corporation would not be subject to the PFIC rules. Accordingly, PFIC shareholders (including passthrough entities) subject to the Subpart F inclusion rules are not subject to the PFIC rules. Many U.S. partnerships and S corporations have simply relied on the CFC/PFIC overlap rule and often filed only Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. In general, they have not undertaken PFIC testing for partners or for shareholders who did not meet the definition of a U.S. shareholder under Sec. 951(b) (a U.S. person holding a 10% or more interest in the foreign corporation).

2022 proposed regulations

Under the proposed regulations, a U.S. partnership or an S corporation would not be respected as a shareholder for the purposes of filing Form 8621 and making QEF, MTM, or purging elections. Prop. Regs. Sec. 1.1291-1(b)(7) would revise the current definition of “shareholder” to expressly exclude U.S. partnerships and S corporations. As a result, the burden of the Form 8621 filing obligation would shift from U.S. partnerships and S corporations to their partners and shareholders. U.S. partnerships and S corporations would then be required only to compile and provide information about their ownership interest in PFICs for their investors on Schedule K-3, Partner’s [or Shareholder’s] Share of Income, Deductions, Credits, etc. — International, Part VII, Information to Complete Form 8621.

In addition, investors in U.S. partnerships and S corporations would no longer be able to rely on the ownership of the partnership or S corporation when applying the CFC/PFIC overlap rule. The partnership or S corporation would need to conduct PFIC analysis annually for any investors who do not meet the 10% threshold of the U.S. shareholder rule and thereby are not subject to the income inclusions under the CFC regime.

In other words, depending on the ownership structure of investors, a foreign corporation could be considered a CFC to one investor and a PFIC to another under the proposed regulations. In such a case, multiple information return forms would be necessary for the foreign corporation, i.e., Form 5471 and PFIC information on Schedules K-2, Partners’ Distributive [or Shareholders’ Pro Rata] Share Items — International, and K-3.

The proposed regulations would also require QEF and MTM elections to be made by the partners and shareholders because U.S. partnerships and S corporations would no longer be able to make these elections on their investors’ behalf. U.S. partners and shareholders would then be required to notify the U.S. partnerships and S corporations of such elections “in any reasonable manner” within 30 days of filing their return and making the election (Prop. Regs. Secs. 1.1295-1(d)(2)(i)(A) and 1.1296-1(h) (1)(i)(B)).

The proposed regulations provide transition rules that would allow any QEF and MTM elections that are effective for tax years of PFICs ending on or before the date the proposed regulations are finalized to still apply. In that case, if a preexisting election was made by the partnership or S corporation, partners and shareholders would not be required to separately make a new QEF or MTM election. The same treatment would also apply to PFIC purging elections, as they would no longer be made at the level of a U.S. partnership or S corporation but instead by the partners and shareholders.

Implications

The proposed regulations, if finalized in their current form, would make compliance for U.S. partnerships and S corporations owning stock in foreign corporations far more complex. U.S. partnerships and S corporations would have administrative burdens to track whether and which elections are made by their investors, along with potentially assisting the investors in computing their pro rata share of PFIC stock on an annual basis. In some situations, it would be difficult for U.S. partnerships or S corporations to determine whether they could apply QEF or MTM treatment to their ownership in a PFIC because they may not presume that all partners or shareholders would make consistent elections.

For an example, the proposed regulations do not provide rules for determining each partner’s share of QEF stock held by the partnership, while partnerships currently allocate QEF inclusions to their partners under the partnership rules. In the same context, further clarification would be necessary on how the shift from entity-level treatment to partner-level treatment should be reflected in partnership capital accounts under Sec. 704.

Partners and shareholders would also have an increased administrative burden for PFICs under the proposed regulations. Unlike Form 5471 filing requirements, from which investors with less than 10% ownership interests could be exempt, there is no minimum stock ownership threshold for a shareholder of a foreign corporation to be subject to the PFIC rules. Under the proposed regulations, partners and shareholders would be required to themselves file Forms 8621, while the filing requirement could be met under the current rules to the extent that partnerships and S corporations file on behalf of their partners and shareholders. The increased administrative burden would likely result in higher fees associated with partners’ and shareholders’ individual or corporate income tax return filing requirements. In the same context, the IRS would also see an increased administrative burden, as it would need to process more than one Form 8621 for a PFIC.

Timing would be a major concern associated with the administrative burden. Many partnership agreements generally mandate U.S. partnerships to issue Schedules K-1 to their partners early in the year, often in the spring, to allow individual partners to file their Form 1040, U.S. Individual Income Tax Return, without extending its due date, or at a minimum to be able to estimate their taxable income and avoid an underpayment by the original due date of April 15 when filing on extension.

To meet the filing requirements under the proposed regulations, partnerships would need to consider amending their partnership agreements to allow adequate time to gather all the required information related to PFIC reporting. Further, timing would also be an issue when partners and partnerships have different tax year ends. The IRS has indicated this burden would be on the partner to timely obtain relevant information.

If a shareholder or partner files their tax return before the information on their PFIC filing obligation is provided, the partner or shareholder would not be able to timely make applicable elections in relation to their PFIC holdings. For example, QEF and MTM elections are required to be made on a timely filed original return. If a QEF election is not made timely, any subsequent gain on the PFIC stock’s sale would be ineligible for long-term gain treatment, and the excess-distribution rules would apply.

Lastly, if a U.S. shareholder of a PFIC fails to file Form 8621, under Sec. 6501(c)(8), the statute of limitation on the U.S. person’s entire tax return will not start. Since Form 8621 filing obligations have historically been fulfilled by partnerships and S corporations, partners and shareholders might pay too little attention to the information provided on Schedules K-3 and fail to timely file their Forms 8621.

The proposed regulations generally apply for tax years of shareholders beginning on or after the date final regulations adopt the proposed rules. Treasury and the IRS received comments on various aspects of the proposed regulations through April 2022.

Editor Notes

Howard Wagner, CPA, is a partner with Crowe LLP in Louisville, Ky. For additional information about these items, contact Wagner at howard.wagner@crowe.com. Unless otherwise noted, contributors are members of or associated with Crowe LLP.