PFICs: some new twists to old rules.

• Author: Henderson, Michael E.
• Position: Passive foreign investment company

The passive foreign investment company (PFIC) rules continue to pose significant problems for many U.S. taxpayers. Although Congress intended the PFIC rules to apply only to foreign passive investment funds, the wide scope of the rules permits their application to any foreign corporation, including controlled foreign corporations (CFCS) and foreign personal holding corporations (FPHCS) that otherwise meet the definition of a PFIC. The two examples discussed will illustrate the continuing need to address these rules. Example 1: U.S. parent corporation USP has a wholly owned subsidiary, FS, in a foreign country. FS is in the process of winding down its business All of FS's earnings and profits have been included in USP'S income under the subpart F rules, and thus have been taxed by the United States. In 1990, FS made a $10,000,000 distribution to USP. USP had not made a qualified electing fund (QEF) election under Sec. 1295 with respect to its interest in FS.

Under the general principles of subchapter C, the $1 0 million distribution constitutes a "return of capital." Without the PFIC rules, the distribution would result in n U.S. tax. However, under the PFIC rules, there is no concept of "earnings and profits." In computing an "excess distribution," the entire amount of the distribution (regardless of whether it is a dividend, return of capital or capital gain) is included. In Example 1, the entire $10 million distribution constituted an "excess distribution" under Sec. 1291(b). Such excess distribution is then allocated over USP'S holding period and subject to the deferred tax and interest charge provisions of Sec. 1291(c).

This situation clearly demonstrates the harsh results that arise when a foreign corporation meets the definition of a PFIC. Note that in this situation, a late QEF election is not available. Under Sec. 1295(b), a QEF election must generally be made on or before the due date (determined with regard to extensions) for filing the tax return. Sec. 1295(b) states that regulations may provide for an election to be made later than the due date, but this exception is limited to circumstances in which the taxpayer fails to make a timely election because the taxpayer reasonably believed that the company was not a PFIC. Note also that Sec. 1291(b)(3)(f) exempts previously taxed income under Sec. 959 from the definition of "excess...