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.
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, 2 the 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 prePFIC 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 qualifiedelecting-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...