Shedding Some Light on the PFIC Regime

By: Kenneth A. Grossberg

Today, United States investors in foreign corporations often find themselves with an unknown or unexpected problem.  In particular, investors in mutual funds organized outside of the United States have run into problems with the Passive Foreign Investment Company (“PFIC”) rules.  As the application of these rules can result in severe tax consequences to the unwary and unprepared, this article is intended to shed some light on the PFIC regime and to answer some basic questions.

Presently, United States investors (individuals or corporations) in stocks and securities incur tax on investment returns and trading gains, whether they own the stocks and securities directly, or via pass-through entities such as domestic partnerships (i.e. hedge funds), or registered investment companies (i.e. mutual funds, REITs, or UITs).

Prior to the implementation of the PFIC rules in 1986, there were significant advantages afforded to United States investors who invested in stocks and securities through a foreign corporation, rather than a domestic corporation.  Mainly, a foreign corporation’s investment returns and trading gains were generally not subject to tax in the United States until their repatriation.  Additionally, the United States investor would often qualify for long-term capital gains treatment (in lieu of ordinary treatment) upon the disposition of his interest in the foreign corporation.[1]

As a result of Congress’ desire to eliminate the incentive for United States investors to invest in foreign corporations at the expense of domestic corporations, the PFIC rules were added to the Internal Revenue Code (“IRC”).  The goals of the PFIC regime were to end the deferral of tax resulting from investment in foreign entities and to eliminate the ability of United States investors to turn ordinary gain into capital gain by investing in foreign corporations.  The mechanism through which Congress chose to accomplish the goals of the PFIC regime was to tax PFIC stock gains at the maximum ordinary rate applicable for each year of PFIC status, and to apply an interest charge for each such year.  This is a severe penalty, and can result in an amount of tax and interest due that exceeds the amount of gain recognized by the taxpayer.

What exactly is a PFIC?  Section 1297 of the IRC defines a PFIC as any foreign corporation in which at least 75% of gross income is passive income (“income test”), or in which 50% of the assets produce, or are held for the production of, passive income (“asset test”).[2]  Passive income includes dividends, interest, rents, royalties, annuities, and other similar items.  Note that cash and cash equivalents are virtually always considered to be passive.[3]  Keeping in mind that gross income is defined as gross revenue minus cost of goods sold, a simple example is illustrative the applicability of the income test: $150 of dividend income with $1,000 of active gross revenue and at least $950 of cost of goods sold results in treatment as a PFIC, even though there is a small amount ($150) of passive income relative to gross revenue.  This is because $150 of passive income equals 75% of gross income ($150 / $150 + $50 = 75%).  As the example demonstrates, while PFIC status should be avoided if at all possible, it is rather easy to fall in to – a relatively small amount of passive income, coupled with small margins, can create a very problematic situation.

Is there any way to avoid the PFIC regime?  An investor cannot avoid PFIC status once the income or asset test has been satisfied, but can mitigate harm caused by PFIC status by making a qualified electing fund (“QEF”) election under section 1295(b) of the IRC.[4]  If the QEF election is in place for the investor’s entire holding period of the PFIC stock, the PFIC is considered a pedigreed QEF.  The pedigreed QEF is treated like a pass-through entity, with the investor including his pro rata share of ordinary earnings and net capital gain in income for each year the PFIC stock is held. [5]  In this situation, there is no penalty to the shareholder.

If the QEF election is not put in place until after the beginning of the investor’s holding period of the PFIC stock and the shareholder does not make an election to purge any prior PFIC years from his holding period[6] (i.e. recognize gain and pay tax in accordance with section 1291 of the IRC for the period prior to the QEF election – a new holding period would then begin from which the PFIC is treated as a pedigreed QEF), the PFIC is considered to be an unpedigreed QEF.  If no QEF election is made at all, the PFIC is considered a nonqualified fund.  Both unpedigreed QEFs and nonqualified funds are considered section 1291 funds.

Distributions from section 1291 funds carry with them the potential for disaster.  If a distribution from a section 1291 fund exceeds 125% of the average distribution made by the fund over the previous three years (“an excess distribution”), the amount of the distribution will be allocated ratably over the taxpayer’s entire holding period of the PFIC stock.[7]  The amounts allocated will be taxed at the highest ordinary tax rate for each year in which the PFIC stock was held, and the amounts allocated will also be subject to underpayment interest.  For example, assume that Jack owns 1 share of PFIC, which he purchased for $1,000.  Jack has owned the share for 10 years, but has not made a QEF election.  There have been no distributions to Jack over the past 3 years.  In year 10, Jack sells his share for $11,000, leaving him with a $10,000 gain.  This gain must now be allocated over his entire holding period, or $1,000 each year.  If the highest ordinary tax rate for each year of Jack’s holding period is 50%, Jack owes $5,000 in tax, plus underpayment interest for each year.[8]  At an interest rate of 5.00% compounded annually, Jack will owe more in tax and interest than his amount gained, leaving him in a worse position than if he had never made the investment.

While foreign mutual funds have been the most common vehicle by which the PFIC regime has reached shareholders in recent years, taxpayers should also be wary of investments in foreign corporations that hold a significant amount of assets in cash or cash equivalents, that hold real property for rent without performing significant “active” management functions, that purchase and/or hold intellectual property for lease or license without “adding value” to the property[9], and any foreign corporation that is earning some amount passive income while maintaining relatively small margins in their active business.  Also, be aware that meeting either the income test or the asset test for one day is enough to turn any foreign corporation into a PFIC, and, as the saying goes, once a PFIC, always a PFIC.  While PFIC status is not ideal, if the situation does arise it is always better to be aware and be proactive in making a QEF election than to find yourself receiving distributions from a section 1291 fund.


[1] See, Steines, John P., International Aspects of U.S. Income Taxation, Ch. VII, Fourth Ed., 2009.[2] I.R.C. § 1297

[3] See IRS Notice 88-22, 1988

[4] I.R.C. § 1295(b); Please note there are certain situations – beyond the scope of this article – in which PFIC status overlaps with controlled foreign corporation (“CFC”) status.  In some of these situations, the foreign corporation is not treated as a PFIC.  For more information on PFIC/CFC overlap, see I.R.C. § 1297(d), and Ocasal, Christopher, and Tello, Carol, New PFIC Guidance Provided: But More to Be Done, Tax Management International Journal, Dec. 11, 2009. 

[5] I.R.C. § 1293(a), (b)

[6] TD 9231 and 9232, Dec. 8, 2005; See also Miller, Michael, J., Cleansing the PFIC Taint Just Got Easier: New Regulations Permit Cleansing Elections for Closed Years, Tax Management, 2006.

[7] I.R.C. § 1291(a), (b)

[8] See I.R.C. § 1291(c)(3)

[9] For more about the active rental and licensing exceptions, see I.R.C. § 954(c)(2)(a).

Disclaimer

This communication is for general informational purposes only which may or may not reflect the most current developments. It is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decision of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult an independent licensed attorney before making any decision or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between Andreozzi Bluestein LLP and the recipient.

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