Adverse consequences to U.S. shareholders of PFICs.

• Author: Melcher, Gary
• Position: Passive foreign investment companies

A passive foreign investment company (PFIC) is any foreign company for which (1) 75% of its annual gross income is passive or (2) 50% of the average value of its assets produces passive income. (Controlled foreign corporations (CFCs) must measure their assets by adjusted basis, rather than by value.) Companies with high-value intangibles, such as high technology companies, and others, such as service or manufacturing companies, with large amounts of cash and other investments compared to active assets, can be PFICs. The adjusted basis measurement of assets imposed on CFCs can have dramatic effects in turning an active company into a PFIC, A PFIC's income is not taxed until distributed, but the tax consequences for a PFIC's U.S. shareholders can be harsh: 1. An excess distribution (defined in relation to past distributions) is taxable, even if it exceeds the PFIC's earnings and profits and would not otherwise be a taxable dividend. 2. Excess distributions are allocated to all years the PFIC stock has been held. Amounts allocated to years before they are actually received are taxed at the highest statutory rate for each year, regardless of the shareholder's actual tax bracket during those years. (However, amounts allocated to pre-1987 years are grouped with the current allocation and are taxed at current year rates.) All capital gain from a disposition of PFIC stock is deemed to be an excess distribution. 3. To the extent an excess distribution is allocated to earlier post-1986 years, the tax imposed on it is deemed to have been "deferred," and interest is charged as if it had been due to those earlier years. Foreign tax credits are extremely limited when attributable to an excess distribution. 4. Tax-free exchanges and reorganizations involving PFIC stock are generally not allowed. Proposed regulations would permit them only if PFIC stock, is exchange for other PFIC stock, or if the PFIC is transferred to another U.S. owner who would be subject to tax in an amount equal to that which the transferor would have had to pay. The PFIC rules treat such transfers as gifts and transfers by death as taxable exchanges. 5. Capital gain benefits are denied on sales or exchanges of PFIC stock. 6. The IRS may tax capital gain in PFIC stock held at death.

An excess distribution is one greater than 125% of the prior three-year average distributions. Gain from selling PFIC stock is spread evenly to all years in...