Applying the indirect ownership rules to PFICs.

• Author: Madden, David
• Position: Passive foreign investment companies

If uncertainty and ambiguity are the bane of commerce, the passive foreign investment company (PFIC) rules are certainly an annoyance. To get a flavor for the uncertainty, taxpayers need only attempt to navigate the rules governing indirect ownership of PFIC stock.

Background

The PFIC provisions were enacted as part of the Tax Reform Act of 1986. A PFIC is a foreign corporation primarily used as a passive investment vehicle. Characterization of a foreign corporation as a PFIC turns on satisfaction of either an income or asset test under Sec. 1297. The income test requires that 75% or more of a foreign corporation's gross income consist of passive income, which generally means "foreign personal holding company income" as defined in Sec. 954(c). The asset test requires that at least 50% of the foreign corporation's assets (based on either value or, in certain circumstances, adjusted tax basis) held during the tax year be passive assets. Passive assets are assets that produce (or are reasonably expected to produce) passive income; see Sec. 1297(a)(2) and Notice 88-22.

In general, U.S. persons owning stock--even one share--of a PFIC may be subject to tax at top marginal rates, plus an interest charge, on certain distributions on, and dispositions of, PFIC stock. Both the gain from a disposition and a targeted distribution are taxed generally at 35% for corporations, without regard to the tax attributes of the PFIC stockholder (for example, ignoring its net operating losses); see Sec. 1291(a). An interest charge also may be imposed based on the shareholder's holding period for the PFIC stock; see Sec. 1291(c). As discussed below, even an indirect owner of PFIC stock may be subject to the regime.

A taxpayer may avoid the Sec. 1291 regime by means of two alternative elections:(1) the qualified electing fund (QEF) or (2) the mark-to-market election; see Secs. 1291,1293 and 1296. If a QEF election under Sec. 1293 is made, a taxpayer generally includes in income each year its pro-rata share of the PFIC's ordinary earnings and its pro-rata share of the PFIC's net capital gain. Taxpayers holding marketable PFIC stock may make the mark-to-market election under Sec. 1296 to include annually in gross income the excess of the fair market value (FMV) over the PFIC stock's adjusted basis (or, in certain circumstances, take a deduction if adjusted basis is greater than FMV).

Indirect Distributions and Dispositions

In addition to directly owning PFIC stock, a...