New PFIC regulations clarify reporting requirements.

• Author: Caballero, Michael J.
• Position: Passive foreign investment companies

Introduction

On December 31, 2013, the IRS and the Treasury Department issued temporary and proposed regulations implementing the reporting obligations imposed on U.S. shareholders of passive foreign investment companies ("PFICs") by the 2010 enactment of section 1298(f) as part of the HIRE Act. (1) The regulations are generally targeted at achieving a limited goal--providing guidance on who must file an annual PFIC information report under the expanded reporting requirement. These rules will generally impact individuals more than U.S. companies. However, because the HIRE Act also modified the statute of limitations rules under section 6501(c)(8), which keeps the statute open if a taxpayer fails to file the PFIC annual report, compliance with these rules is critical for all taxpayers.

Background

The PFIC rules were enacted in 1986 and generally limit the ability of U.S. taxpayers to defer the taxation of portfolio investment income by earning this income through a minority investment in a foreign corporation. Accordingly, a U.S. taxpayer that owns any interest in a PFIC, no matter how small, is subject to one of the following three taxation regimes designed to eliminate any deferral.

Section 1291. The default regime under section 1291 imposes an interest charge on any "excess distributions" (regardless of whether the PFIC has actual earnings and profits) from the PFIC. (2) The interest charge only applies when the shareholder receives actual distributions or sells shares in the PFIC and is meant to eliminate the benefit of deferring taxation of the investment income.

QEF Election. Alternatively, taxpayers can make a "qualified electing fund" election or "QEF" election, which effectively treats the PFIC as a passthrough entity for U.S. tax purposes. (3) In this case, the PFIC must supply to the shareholder annual information about its income and gains, which the U.S. shareholder includes on a current basis similar to a subpart F inclusion (except that the PFIC inclusion is with respect to all of the PFIC's income and not just certain types of income).

Mark-to-Market Election. U.S. shareholders also can elect to mark to market their PFIC stock each year if the PFIC stock is "marketable" (e.g., publicly traded) stock. (4)

The determination of whether a foreign corporation is a PFIC is analyzed only at the level of the PFIC itself. In other words, unlike the test for status as a controlled foreign corporation ("CFC") in section 957, which requires a certain level of concentrated U.S. ownership, a foreign corporation can be a PFIC without regard to the level of its ownership by U.S. taxpayers. Therefore, the PFIC rules apply to all U.S. shareholders regardless of how much stock the shareholder owns--there is no minimum threshold. (5)

A foreign corporation is a PFIC if it satisfies one of two tests: (1) the "gross income test" and (2) the "asset test." Under the gross income test, a foreign corporation is a PFIC if 75 percent or more of its gross income is passive income. (6) Under the asset test, a foreign corporation is a PFIC if the average percentage of passive assets held by the corporation during the year is 50 percent or more. Look-through rules apply to 25 percent or greater owned subsidiaries and to dividends, interest, or royalties from a related person that are allocable to nonpassive income. (7) Special exceptions also apply for start-up corporations or corporations that are changing businesses. (8) The only published administrative guidance concerning the definition of a PFIC is in Notice 88-22, (9) which mainly focuses on the asset test.

Because the PFIC rules apply to holders of minority interests, including shareholders owning a small number of shares, serious compliance issues exist for those who may not have access to the necessary information regarding foreign income or assets to determine if the corporation is a PFIC. Although the PFIC rules are intended to prevent U.S. taxpayers from deferring passive income, many foreign corporations that do not appear to present such risk may nevertheless be treated as PFICs. For example, a start-up business, or a corporation changing its business, may be a PFIC due to a temporary lack of sufficient active business income and assets. (10)

In 1997, Congress enacted the so-called "PFIC-CFC overlap rule" in section 1297(d), which reflects a policy decision that the CFC rules adequately address the concerns about deferral and therefore provides that the controlled...