Avoiding the PFIC web when liquidating a non-QEF.

• Author: Jones, Horace A.
• Position: Passive foreign investment company; qualified electing fund

Within the context of the passive foreign investment company (PFIC) provisions, Secs. 1291-1298 may provide a surprise for the unsuspecting U.S. shareholder. Specifically, when a U.S. shareholder intends to liquidate a PFIC (primarily under Sec. 331), this intention should be clearly demonstrated by having the PFIC's board of directors pass a resolution to liquidate and filing a Form 966, Corporate Dissolution or Liquidation, within 30 days after the resolution. This is important; if the Service does not recognize the liquidation, the U.S. shareholder's return of capital could be taxed as ordinary income.

Mechanics of the PFIC Provisions

The purpose of the PFIC regime was to deal with what Congress perceived as abuses by U.S. investors in foreign mutual funds. These rules, however, apply to any foreign corporation that meets either the PFIC income or the asset test, regardless of the ownership percentage owned by such U.S. shareholder. In general, under the income test (Sec. 1297(a)(1)), a foreign corporation is a PFIC if 75% or more of its gross income for the tax year is passive income. Under the assets test, a foreign corporation is a PFIC if the average market value of its passive assets (i.e., assets used to generate passive income) during the tax year is 50% or more of the corporation's total assets. (A foreign corporation that is a controlled foreign corporation (CFC), as well as any other foreign corporation that so elects, measures the adjusted basis of its assets for the assets test, rather than their fair market value.)

Taxation of PFICs can become somewhat harsh, to say the least. The undistributed earnings of a PFIC whose shares are not marketable are subject to U.S. tax under one of two methods, each of which is directed at eliminating tax deferral benefits. First, if a U.S. shareholder obtains the necessary information, he may elect to be taxed currently on his pro rata share of the PFIC's earnings and profits (E&P); this is the qualified electing fund (QEF) method. A U.S. shareholder who fails to make a QEF election is taxed under special excess distribution provisions. Here, a U.S. shareholder is permitted to defer tax on the PFIC's undistributed income until he either disposes of the stock or the PFIC makes an excess distribution. If a shareholder disposes of the stock, the gain on the disposition will be taxed under the Sec. 1291(a)(1) excess distribution rules. If, on the other hand, a shareholder receives an excess...