QEF elections under PFIC rules.

• Author: Usher, Scott F.
• Position: Qualified electing fund, passive foreign investment companies

In enacting Secs. 1291 through 1298 in 1986, Congress created a complex and punitive tax regime for certain passive foreign investments that continues--nearly three decades later--to plague U.S. taxpayers and their tax advisers.

U.S. taxpayers who invest in offshore mutual funds or certain other passive foreign investments without understanding the tax consequences may learn only years later that those investments are subject to the onerous tax rules for investments in passive foreign investment companies (PFICs).

Background

The PFIC rules were enacted to eliminate beneficial tax treatment for certain offshore investments. Under prior law, U.S. taxpayers could accumulate tax-deferred income from offshore investments and, upon sale of the investment, recognize gain at the long-term capital gains tax rate.

Under the PFIC rules, absent a beneficial election, PFIC investments are generally subject to tax on distributions at the highest ordinary income rates in effect for the tax year, rather than the currently more beneficial dividend and capital gains rates. Sec. 6621 interest charges accrue on deferred taxes until the due date of the return (without regard for extensions) for the last PFIC year; losses are disallowed.

Typically, these PFICs are passive investments in offshore mutual funds, hedge funds, stocks, annuities, or income-producing property.

Under Sec. 1297, a PFIC is defined as a foreign corporation that meets at least one of the following tests:

* 75% or more of its income is derived from passive sources (the income test), or

* 50% or more of the average fair market value of the assets it held during the year are passive income-producing assets (the asset test).

If a U.S. taxpayer's investment is characterized as a PFIC in one year, it is generally also treated as a PFIC in future years--commonly referred to as the once-a-PFIC-always-a-PFIC rule or the PFIC taint.

PFIC Taxation

The U.S. taxpayer-investor in a PFIC is taxed according to an onerous excess-distribution regime under Sec. 1291 unless the taxpayer cleanses the PFIC taint with either of two elections: the mark-to-market election under Sec. 1296 (available for assets that are regularly traded on qualified exchanges or other markets) or the election to be treated as a qualified electing fund (QEF) under Sec. 1295. The latter is the focus of this item. If either election is made for a tax year other than the year the asset was purchased, the taxpayer must first cleanse the...