PFIC deferred tax amount: timing is everything.

• Author: Bowers, Christopher P.
• Position: Passive foreign investment company

Taxpayers familiar with the passive foreign investment company (PFIC) provisions are all too aware of just how onerous those rules can be. Shareholders of a foreign corporation that is a PFIC during part, but not all, of the shareholder's holding period should be especially wary of how the PFIC provisions apply to them.

Background

The PFIC provisions were enacted as part of the Tax Reform Act of 1986 (TRA '86) to combat what Congress determined was improper offshore deferral of passive investment earnings. Although PFICs are generally thought of as foreign corporations primarily used as passive investment vehicles, unpleasant PFIC consequences can apply to active companies, too.

Tests: Characterizing a foreign corporation as a PFIC turns on satisfying, under Sec. 1297(a), either a passive income or passive asset test for any tax year. For the Sec. 1297(a)(1) income test, 75% or more of a foreign corporation's gross income for a tax year must consist of passive income, which generally means "foreign personal holding company (FPHC) income," defined in Sec. 954(c). According to the Sec. 1297(a)(2) asset test, at least 50% of the foreign corporation's assets (based on either value or, in certain circumstances, adjusted tax basis) held during the tax year must be passive (i.e., produce (or reasonably expected to produce) passive income); see Notice 88-22. Under the so-called "once a PFIC, always a PFIC" rule of Sec. 1298(b)(1), stock is generally treated as stock in PFIC if, at any time during the taxpayer's holding period, the foreign corporation was a PFIC, even if it no longer satisfies either the income or asset test.

Anti-deferral rules: PFIC shareholders are subject to a near punitive anti-deferral regime under Sec. 1291 for certain events as to their PFIC stock. Unlike other anti-deferral regimes (e.g., controlled foreign corporation (CFC) or FPHC provisions), Sec. 1291 consequences do not depend on a corporation's earnings. In general, under Sec. 1291(a)(1), "excess distributions" (according to Sec. 1291(b), any distribution from a PFIC that exceeds 125% of the average distributions for the last three years and gains from PFIC stock dispositions) in respect of stock in a PFIC are subject to tax at top marginal rates, plus an interest change.

The PFIC penalty works as follows. First, under Sec. 1291(a)(1)(A), an excess distribution in respect of stock in a PFIC is "allocated ratably to each day in the taxpayer's holding period for the...