PFIC/CFC overlap: not out of the woods yet.

• Author: Madden, David
• Position: Passive foreign investment company/controlled foreign corporation taxation

In 1997, taxpayers breathed a collective sigh of relief when Congress eliminated a significant headache by enacting the "PFIC/CFC overlap rule" in Sec. 1297(e), which coordinates the passive foreign investment company (PFIC) and the controlled foreign corporation (CFC) anti-deferral regimes. A U.S. person directly, indirectly or constructively owning 10% or more of the voting power of a CFC's stock (U.S. shareholder) may (depending on its direct and indirect stock holdings) be' required to currently recognize certain subpart F income (generally, passive and mobile income) earned by the CFC, thus negating the opportunity for deferral. Under Sec. 957, a CFC is generally any foreign corporation if U.S. shareholders (as defined above) own (directly, indirectly or constructively) more than 50% of the corporation's stock (measured by vote or value).

Under Sec. 1297, a PFIC, by contrast, is any foreign corporation meeting either an income test (i.e., 75% or more of its income is passive) or an asset test (i.e., 50% or more of its assets produce passive income). 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. Taxpayers may generally avoid the interest charge regime via either a qualified electing fund (QEF) or a mark-to-market election, which generally requires the taxpayer to currently include in income its share of the PFIC's earnings or the appreciation in value of the PFIC stock, respectively.

A foreign corporation may be a PFIC and a CFC in any one tax year. Before 1997, it was likely that a shareholder of a foreign corporation could be subject to both the PFIC and CFC regimes on the same investment. Recognizing that applying CFC and PFIC rules to the same investment created unnecessary complexity for taxpayers, the Taxpayer Relief Act of 1997 (TRA '97) enacted Sec. 1297(e) to eliminate the application of the PFIC rules to U.S. shareholders of CFCs. Sec. 1297(e) operates by treating the CFC as not a PFIC with respect to a U.S. shareholder, thus eliminating the prior overlap between the two taxing regimes.

Recently the Joint Committee on Taxation (JCT) drew attention to the seemingly imperfect coordination of the PFIC and CFC regimes under Sec. 1297(e) and recommended certain changes; see JCT, Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and Compensation...