In our last post we introduced the complex international tax issues of passive foreign investment companies (PFICs) and gave a brief background on the regulations. In this blog post we’ll briefly discuss the various methods of taxation and how to make certain elections related to PFICs. There are three taxation methods that U.S. taxpayers can select from; however, each method has certain rules and limitations that are imposed by the IRS.
The first method is the default method of taxing U.S. owners of PFICs. Internal Revenue Code Section 1291 is the default method if the taxpayer does not make an election. Under this method, the funds’ prior year’s excess distributions (defined below) are taxed in the year the excess distribution occurs at the highest rate possible for those prior years, including an underpayment interest calculation. In contrast, the current year’s excess distributions are included as other income on the taxpayer’s U.S. tax return and taxed in the regular manner.
Under Section 1291, excess distributions are defined as either the part of the current year distribution that is greater than 125% of the average distributions received during the three preceding tax years or any capital gains resulting from the sale of PFIC shares. The excess distribution rules are designed to prevent the deferral of tax on a U.S. shareholder’s allocable share of PFIC income by creating harsh consequences.
The second method for taxation of PFICs is the Qualifying Electing Fund (QEF) election. Under this election the PFIC is treated like a U.S. mutual fund in that the ordinary income and capital gains of the PFIC separately flow through to the shareholder according to percentage of ownership. While this method seems like the simplest and easiest method, a QEF election may be made only if the fund agrees to comply with IRS reporting requirements. These requirements involve annual reporting to the shareholder their share of the fund’s ordinary income and net capital gains, based on Earnings and Profits (E&P) as determined for U.S. tax purposes. The QEF must also provide an annual information statement containing additional information, which as a foreign entity may be difficult and time consuming to do in order to comply with the IRS regulations. Another limitation of the QEF election is that it must be made on or before the due date of the shareholder’s tax return.
The third and final method is the Mark-to-Market Election. Under this method, the shareholder reports the annual gain in market value as ordinary income on his or her tax return. The taxpayer may also report unrealized losses on the return but only to the extent that gains have been previously reported. The PFIC basis is then adjusted for all gains and losses previously reported as ordinary income. Upon the sale of PFIC shares, all gains are reported as ordinary income; losses may be ordinary or capital depending on the circumstances. This election may only be made for the PFIC for current and future years, so it is best to make it during the first year of ownership of the PFIC.
The methods of taxation of PFICs are complex. We recommend that you consult with a tax professional in order to determine the most appropriate method for your situation.