For the past few weeks we explored the regulations on Passive Foreign Investment Companies (PFICs), discussed how they are taxed, and examined how certain rules determine ownership and affect reporting requirements. In this post we will discuss the tax impact of selling PFICs or removing an investment from the harsh PFIC taxation scheme.
Oftentimes U.S. taxpayers may realize that they own shares in a PFIC too late. For example, they may realize that they have owned it for several years and have not made the appropriate elections. One option is to sell the shares in the PFIC. Although the disposition will be subject to the unfavorable PFIC taxation scheme governed by Code Section 1291 (discussed in a prior blog), it may be the best alternative in that it stops any further escalation of the problem.
If selling the shares of the PFIC is not a viable option and the taxpayer must or wants to continue ownership in the PFIC, there are implications.
Generally, once a foreign company is classified as a PFIC for a U.S. taxpayer, all of the subsequent distributions and dispositions of the investment by the taxpayer are subject to the excess distribution rules we discussed in the second post of this series. This PFIC “taint,” as it is commonly referred to, is in place even if the foreign company ceases to be a PFIC. Generally the only way to remove the PFIC taint is for the U.S. taxpayer to make a purging election at a potentially high cost.
The purging election is typically made after a foreign company has ceased to be a PFIC, or when the foreign company remains a PFIC and the U.S. taxpayer wants to make a QEF election but has passed the period of making a timely election. There are several types of purging elections, and while we won’t get into the gritty details of each type, it is best to know that they fall under categories of deemed sale elections and deemed dividend elections. These elections can only be made by the owner. As with a disposition, the purging election can be costly but does stop any further increase in the PFIC taint.
The world of PFIC taxation is a complex one, and in general the suggested guidance for a U.S. person is to avoid ownership of PFICs. Of course, all investment decisions should consider both the potential investment income or gain and the tax consequences. Please feel free to contact us if you would like to further discuss the classifications and taxation of PFICs.