I would not be honest if I didn’t admit that this was a topic that I have procrastinated writing about for the longest time and have avoided like the Bubonic plague. It is such a tortured area of foreign asset reporting that many tax practitioners refer to it as, “a riddle wrapped in a mystery inside an enigma.”

The PFIC regime is exceedingly complex and this section merely attempts to present the big picture. PFIC stands for “Passive Foreign Investment Companies.” A PFIC is any foreign corporation if:

(1)       “75 percent or more of the gross income of such corporation for the taxable year is passive income,[i] or

(2)       “the average percent of assets … held by such corporation during the taxable year which produce passive income or which are held for the production of passive income is at least 50 percent.”[ii]

A far simpler definition of PFIC is “a foreign corporation that receives predominantly passive foreign source income or holds mainly passive investment assets.”[iii] U.S. persons who own shares of PFICs “are generally subject to current U.S. taxation or the equivalent.”[iv] A key feature of PFIC taxation is that “it does not depend on any threshold of ownership or control by U.S. persons.”[v]

The dawn of the PFIC era did not begin until 1986.[vi]  Prior to 1986, U.S. taxation of foreign corporations was inextricably linked “to control of the corporation held by U.S. persons.”[vii]  This allowed not only the foreign mutual fund to avoid U.S. taxation, but also any U.S. persons who invested in the fund.  How so?

The fund itself avoided U.S. taxation because it was a foreign corporation that derived purely foreign-source income.  How was the fund able to avoid the taint of being classified as a controlled foreign corporation, or “CFC”? By the mere fact that it was owned by a large number of U.S. and foreign investors, each of whom owned a relatively small share.

U.S. investors avoided U.S. taxation in two primary ways.  First, the fund paid no dividends.  And second, when U.S. investors eventually realized earnings from the fund through the sale of stock, they were able to convert the fund’s ordinary income – here, dividends and interest – into capital gains.

The enactment in 1986 of the passive foreign investment company (or “PFIC”) made sweeping changes.  At its most primitive level, this enactment gave the U.S. government the power to tax passive investment income earned by U.S. persons through foreign corporations.

The taxation of PFICs rests on the following idea: “denying to United States persons – and [thus] capturing for the U.S. Treasury – the value of deferral of U.S. taxation on all passive investments channeled through foreign entities.”[viii]  The rules accomplish this in one of two ways: first, by directly taxing U.S. persons who have invested in PFICs,[ix] or second, by indirectly “imposing an interest charge on the deferred distributions and gains of those investors.”[x]

The foundation upon which the PFIC regime lies consists of two central elements: (1) “the definition of a PFIC”[xi] and (2) “the tax regime imposed on U.S. owners of shares.”[xii]  A PFIC is defined as an entity that receives mainly passive investment income or holds mainly passive investment assets.

U.S. shareholders of a PFIC “are subject to a special income tax regime,”[xiii] the details of which depend on whether the PFIC’s shareholders have made an election.[xiv] The shareholders of a PFIC may elect to be taxed as shareholders of a “qualified electing fund.”[xv] Absent that election, the “pure” PFIC tax regime of section 1291 applies.[xvi]

Each method is designed to eliminate the benefits of deferral, that forbidden word that forces the U.S. government to wait until the earnings of a foreign corporation have been distributed to U.S. persons, usually in the form of dividends, before they can be taxed.[xvii] However, each differs in the way it accomplishes this objective.

The qualified election fund (or “QEF” for short) is designed to “[ease] the complexities of PFIC taxation for U.S. investors in foreign mutual funds.”[xviii]  It does so by allowing shareholders to elect to be taxed currently on their pro rata share of the PFIC’s earning and profits rather than suffer the wrath of the PFIC tax system.[xix]  In other words, a U.S. person who owns marketable stock in a PFIC can “recognize unrealized gain or loss in the shares annually.”[xx]

How is this accomplished? The taxpayer merely “elects to include as ordinary income the excess of the fair market value of the stock at the close of the taxable year over its adjusted basis or to deduct as an ordinary loss the excess of the adjusted bases over the year-end fair market value.”[xxi] Stated otherwise, the included income is treated “as ordinary income to the extent of the taxpayer’s pro rata share of the QEF’s ordinary income, and capital gains to the extent of the taxpayer’s pro rata share of the QEF’s net capital gain.”[xxii]

To prevent double taxation of the QEF’s earnings, any actual distributions made by a QEF from its after-tax earnings and profits are tax-free to the investor.  “The shareholder’s basis is adjusted up or down to reflect amounts included or deducted pursuant to this election.”[xxiii]  For example, a U.S. investor would increase his basis in the QEF’s stock when including income while reducing his basis in the stock after receiving distributions of previously taxed income.

A taxpayer who does not make a QEF election is taxed under the pure PFIC tax regime of Section 1291.  Under Section 1291, taxpayers may defer taxation of a PFIC’s undistributed income until the PFIC makes an excess distribution.

An excess distribution includes the following:

• A gain realized on the sale of PFIC stock, and

 

• Any actual distribution made by the PFIC, but only to the extent that the total actual distributions received for the year exceed 125% of the average actual distribution received in the preceding three taxable years (or, if shorter, the taxpayer’s holding period before the current taxable year).

Essentially, Section 1291 “negates the tax benefit of deferral.”[xxiv]  Taking a “big picture” view makes it easier to understand how PFIC taxation undoes this advantage.  First, the economic value of deferral of U.S. taxation is the time value of the deferral itself.  And second, PFIC taxation takes back the time value of deferral through the “deferred tax amount.”[xxv]

Critical to understanding how PFIC taxation takes back the time value of deferral is the treatment of excess distributions.  “An excess distribution is treated as if it has been realized pro rata over the holding period for the PFIC’s stock.”[xxvi]

Against this backdrop, the effect of a pro rata realization of an excess distribution becomes painfully obvious: the tax due on such a distribution is “the sum of deferred yearly tax amounts plus interest.”[xxvii]  But the worst is yet to come.  And that is that “the sum of the deferred yearly tax amounts is calculated using the highest tax rate in effect in the years that the income was accumulated.”[xxviii]

The result is nothing short of devastating: by assessing an interest charge on the deferred yearly tax amounts this method unilaterally eviscerates the benefits of deferral.  With a parade of horribles this expansive, taxpayers might sooner look up at the sky and wring their hands in despair. However, all hope is not lost. Taxpayers can take some comfort in the fact that they can claim “a direct foreign tax credit on any withholding taxes imposed on their PFIC distributions.”[xxix]

A common question is what happens in the event that the distributions fall below the 125% threshold?  Such distributions are treated “as dividends (assuming they represent a distribution of earnings and profits), which are taxable in the year of receipt and are not subject to the special interest charge.”[xxx]

Below is an example to help illustrate how Section 1291 operates.  This example comes from the creative genius of Robert J. Misey, in his book, “Practical Guide to U.S. Taxation of International Transactions”:

“Fred is a U.S. citizen who invests in mutual funds.  On the advice of his broker, on January 1, 2006, he buys 1% of FORmut, a mutual fund incorporated in a tax-haven entity.  Because FORmut only earns passive income on passive assets, it is a PFIC.

Not having any knowledge of international tax or the PFIC rules, Fred and his accountant fail to make a QEF election.  During 2006, 2007, and 2008, FORmut accumulates earnings and profits of $ 30 million (USD).  On December 31, 2008, FORmut pays Fred a dividend of $ 300,000 (USD).

Because Fred never made a QEF election and because FORmut never paid a dividend to Fred, Fred must “throw-back” the entire $ 300,000 dividend received over the entire period that he owned the FORmut shares: $ 100,000 to 2006, $ 100,000 to 2007, and $ 100,000 to 2008.  For each of these years, Fred will pay tax on the thrown-back dividend at the highest rate in effect that year with interest.”[xxxi]

When it comes to filing requirements, a U.S. taxpayer must file annually a separate Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, “for each PFIC for which the taxpayer was a shareholder during the taxable year.”[xxxii]

What are the consequences of failing to file Form 8621?  Section 1298(f) and the regulations do not impose a specific penalty for failing to file Form 8621.  However, the regulations meld the Form 8621 filing requirements with the Form 8938, Statement of Specified Foreign Financial Assets, filing requirements.

As Professor Misey explains:

“Under Section 6038D, a U.S. individual must disclose any directly held foreign financial assets on Form 8938 if the aggregate value of the individual’s foreign financial assets exceeds a certain filing threshold.  An exception to this requirement applies to any foreign financial asset the individual reports on another disclosure form, such as Form 8621.

A U.S. individual shareholder who fails to disclose a directly held PFIC investment on either Form 8621 or Form 8938 can be subject to a $ 10,000 penalty under Section 6038D(d).  In addition, failure to file a required Form 8621 can result in suspension of the statute of limitations with respect to the shareholder’s entire tax return until Form 8621 is filed.”[xxxiii]

The takeaway is this: The IRS could potentially have until time immemorial to examine a U.S. shareholder’s tax return and assess tax if the shareholder fails to file Form 8621.[xxxiv]

However, this comes with an important caveat. To the extent that the shareholder has reasonable cause for failing to file Form 8621 – in other words, the taxpayer has a viable defense to the assertion of the penalty – the “statute of limitations is suspended only with respect to unreported PFIC investments.”[xxxv] Thus, the statute of limitations continues to run with respect to any “unrelated portions of the shareholder’s tax return,”[xxxvi] such as Form 1040.

ENDNOTES:

[i] Section 1297(a).

[ii] Id.

[iii] International Taxation, Second Edition, Isenbergh, Joseph, Foundation Press, 2005, at p. 211.

[iv] Id.

[v] Id.

[vi] Id.

[vii] Id.

[viii] Id.

[ix] Id.

[x] Id.

[xi] Id.

[xii] Id.

[xiii] Id. at 212.

[xiv] Id.

[xv] Id.

[xvi] Id.

[xvii] Id. at 15.

[xviii] Id. at 213.

[xix] Id.

[xx] Id.

[xxi] Id. at 213-14.

[xxii] Practical Guide to U.S. Taxation of International Transactions (9th Edition), Misey, Robert, Wolters Kluwer, 2013.

[xxiii] International Taxation, Second Edition, Isenbergh, Joseph, Foundation Press, 2005, at p. 214.

[xxiv] Id. at 212.

[xxv] Id. (citing Section 1291(a)(1)(C).

[xxvi] Practical Guide to U.S. Taxation of International Transactions (9th Edition), Misey, Robert, Wolters Kluwer, 2013.

[xxvii] Id.

[xxviii] Id.

[xxix] Id.

[xxx] Id.

[xxxi] Id.

[xxxii] Id.

[xxxiii] Id.

[xxxiv] Id.

[xxxv] Id.

[xxxvi] Id.