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A Deep Dive into How the PFIC Regime Taxes Foreign Investments

This article discusses how the passive foreign investment company (or “PFIC”) rules impact U.S. investors that invest in foreign mutual funds or foreign stocks. In order to understand why PFIC rules were enacted, it is important to take a step-back and understand the historical background as to why these rules were enacted. U.S. investors in domestic mutual funds have always been taxed on the fund’s investment income because a domestic fund must distribute at least 90% of its income each year in order to avoid U.S. corporation taxation. See IRC Section 851 and 852. On the other hand, at one time the U.S. holders of foreign mutual funds were able to avoid U.S. tax as a result of the funds not paying dividends. Congress believed that U.S. owners of foreign mutual funds had an unfair advantage over U.S. owners of domestic mutual funds. This resulted in the enactment of the PFIC tax regime that significantly expanded the reach of the Internal Revenue Code (“IRS”) with respect to passive investment income earned by U.S. persons through foreign corporations.

The objective of the PFIC provisions of the Internal Revenue Code is to deprive a U.S. taxpayer of the economic benefit of deferral of U.S. tax on a taxpayer’s share of the undistributed income of a foreign investment company that has predominantly passive income. Although the PFIC provisions were aimed at U.S. persons holding stock in foreign investment funds, the PFIC provisions have a much broader impact. The PFIC provisions of the Internal Revenue Code may apply to any U.S. person holding stock in any foreign corporation, even one engaged in an active foreign business such as manufacturing, for any tax year in which the corporation derives enough passive income or owns enough passive assets to meet the definition of a PFIC.

Definition of PFIC

A foreign corporation is a PFIC if it satisfies either an income or asset test. Under the income test, a foreign corporation is a PFIC if 75% or more of the corporation’s gross income for the taxable year is defined as “foreign personal holding company” for purposes of Subpart F provisions of the Internal Revenue Code, with certain adjustments. Internal Revenue Code Section 954(c) defines “foreign personal holding company income” to include most types of passive income, such as interest, dividends, rents, annuities, royalties and gains from the sale of stock, securities or other property that produces interest, dividends, rents, annuities or royalties. See IRC Section 954(c)(1)(A) and (c)(1)(B)(i). The adjustments include exclusions for income derived from the active conduct of a banking, insurance, or securities business, as well as any interest, dividends, rents, and royalties received from a related person to the extent such income is properly allocable to nonpassive income of the related person. A “related person” is defined in Internal Revenue Code Section 954(d)(3). An individual, corporation, partnership, trust or estate that controls or is controlled by a controlled foreign corporation (“CFC”) is a “related person.” Control means, in the case of a corporation, direct or indirect ownership of more than 50 percent of the total voting power or value of the stock of the corporation.

For purposes of the income test, passive income is subject to four exceptions. The first two exceptions relate to income from the active conduct of a banking or insurance business. See IRC Section 1297(b)(2)(A) and (B). The third covers interest, dividend, rent or royalty income received from a related person to the extent that such income is properly allocated to income of such related person that is not passive income. See IRC Section 1297(b)(2)(C). The fourth covers certain foreign trade income subject to special treatment under two preferential tax regimes for export sales.

Under the asset test, a foreign corporation is a PFIC if the average market value of the corporation’s passive assets during the taxable year is 50% or more of the corporation’s total assets. An asset is characterized as passive if it has generated (or is reasonably expected to generate) passive income in the hands of the foreign corporation. See IRC Section 1297. Assets that generate both passive and nonpassive income in a tax year are treated as partly passive and partly nonpassive to the proportion to the relative amounts of the two types of income generated by those assets in that year. See IRC Notice 88-22. Both the Internal Revenue Service (“IRS”) and taxpayers may apply a PFIC test using the adjusted bases of its assets (as determined for earnings and profits purposes) in lieu of their value. However, a publicly traded corporation is required to use the value of its assets in applying the asset test. A PFIC that is also a CFC but is not publicly traded is required to use the adjusted bases of its assets in applying the asset test for PFIC status with no option to use the value of its assets.

Look Through Rule

For purposes of the PFIC income and asset tests, a look-through rule applies to foreign corporations that own, directly or indirectly, at least 25 percent by value of the stock of another corporation. Under this rule, a foreign corporation is treated as owning its proportionate share of the other corporation’s assets and as receiving it directly its proportionate share of the other corporation’s income in determining whether the foreign corporation is a PFIC. In addition, in applying the PFIC tests to the foreign corporation, amounts such as dividends and interest received from the 25-percent-or-more-owned subsidiary are eliminated from the foreign corporation’s income for purposes of the income test, and the foreign corporation’s stock or debt investment in the subsidiary is eliminated from the foreign corporation’s assets for purposes of the asset test. See IRC Section 1297(c).

Special Rules for Start-Up Year and Corporations Changing Businesses

A foreign corporation is not treated as a PFIC during the first year that it has gross income (also known as the “start-up year”) as long as three requirements are satisfied. First, no predecessor of the corporation was a PFIC. Second, the corporation establishes to the satisfaction of the IRS that it will not be a PFIC for either of the first two years after the start-up year. Third, the corporation is not in fact a PFIC for either of the first two years after the start up year. See IRC Section 1298(b)(2). A foreign corporation that is changing businesses is not treated as a PFIC for a tax year if three requirements are satisfied. First, neither the corporation nor any predecessor  was a PFIC. Second, the corporation establishes to the satisfaction of the IRS that i) substantially all of its passive income for the tax year is attributable to the proceeds from disposition of one or more active trades or businesses, and ii) it will not be a PFIC for either of the first two tax years after such tax year. Third, the corporation is not in fact a PFIC for either of these two years. See IRC Section 1298(b)(3).

Taint of PFIC Status

The determination regarding the status of PFIC for a foreign corporation is made on an annual basis. Thus, a corporation may be a PFIC in some years but not others. However, under Section 1298(b)(1), a foreign corporation’s status as a PFIC for even a single tax year may continue to taint the shareholders’ stock even if the corporation does not satisfy the definition of PFIC in any other tax year. Under Section 1298(b)(1), stock held by a taxpayer will be treated as stock in a PFIC if, at any time during the taxpayer’s holding period for such stock, the corporation or any predecessor was a PFIC. There are only two ways that a shareholder can purge the stock of its PFIC taint. First, the shareholder can prevent the application of Section 1298(b)(1) by making a qualified fund election (discussed below). Second, the shareholder can purge the stock of its PFIC taint by electing to recognize gain on the last day of the last year on which the corporation was a PFIC as if the stock had been sold for its fair market value on that day.

Overlap Between CFCs and PFICs

Sometimes a foreign corporation can satisfy the definition of both a CFC under Section 957 and PFIC under Section 1297(a). In these situations, Section 1297(e)(1) provides that a foreign corporation will not be treated as a PFIC with respect to a shareholder during the “qualified portion” of the shareholder’s holding period for the stock in the corporation. The “qualified portion” of the holding period is when the shareholder is a “U.S. Shareholder” as defined in Section 951(b) of the Internal Revenue Code. Thus, a U.S. shareholder that is subject to current inclusions under the Subpart F or GILTI rules with respect to stock in a PFIC is not also subject to the PFIC rules with respect to such stock.However, the PFIC provisions continue to apply to other U.S. persons owning stock in the PFIC who are not U.S. shareholders within the meaning of Section 951(b).

If a shareholder is not subject to the PFIC provisions by reason of Section 1297(e)(1) and then ceases to qualify for such treatment either because the shareholder is no longer a U.S. shareholder under Section 951(b) or because the PFIC is no longer a CFC, the shareholder’s holding period for the stock, for purposes of the PFIC rules, is treated as starting immediately after such cessation. See IRC Section 1297(e)(3)(A).

Taxation of PFICS

A shareholder of a PFIC is subject to the Section 1291 excess distribution rules in which shareholders must allocate excess distributions and gains realized upon the sale of their PFIC shares pro rata to their holding period. See IRC Section 1291(a)(1)(A).

An excess distribution includes the following:

1) A gain realized on the sale of PFIC stock, and

2) Any actual distribution made by the PFIC, but only to the extent the total actual distribution received by the taxpayer for the year exceeds 125 percent of the average actual distribution received by the taxpayer in the preceding three taxable years. The amount of an excess distribution is treated as if it had been realized pro rata over the holding period of the foreign share and, therefore, the tax due on an excess distribution is the sum of the deferred yearly tax amounts. This is computed by using the highest tax rate in effect in the years the income was accumulated, plus interest. Any actual distributions that fall below the 125 percent threshold are treated as dividends. This assumes 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. 

Interest charges are assessed on taxes deemed owed on excess distributions allocated to tax years prior to the tax year in which the excess distribution was received. All capital gains from the sale of PFIC shares are treated as ordinary income for federal tax purposes and thus are not taxed at favorable long-term capital gains rates. See IRC Section 1291(a)(1)(B). In addition, the Proposed Regulations state that shareholders cannot claim capital losses upon the disposition of PFIC shares. See Prop. Regs. Section 1.1291-6(b)(3).

Below, please see Illustration 1. and Illustration 2. which demonstrates a typical sale of PFIC stock.

Illustration 1.

Jim is an engineer and a citizen of Germany. Jim moved to California and became a U.S. green card holder. Jim likes to invest in foreign mutual funds. On the advice of his German broker, on January 1, 2016, Jim buys 1 percent of FORmut, a mutual fund incorporated in a foreign country for $1. FORmut is a PFIC. During the 2016, 2017, and 2018 calendar years, FORmut accumulated earnings and profits. On December 31, 2018, Jim sold his interest in FORmut for $300,001. To determine the PFIC excess distribution, Jim must throw the entire $300,000 gain received over the entire period that he owned the FORmut shares – $100,000 to 2016, $100,000 to 2017, and $100,000 to 2018. For each of those years, Jim will pay tax on the throw-back gain at the highest rate in effect that year with interest.

It is easy to envision significantly more complex scenarios. Such a scenario is described in Illustration 2 which is based on an example in Staff of Joint Comm. On Tax’n, 100 Cong., 1st Sess., General Explanation of Tax Reform of 1986, at 1027-28(1987).

Illustration 2.

On January 1 of year 1, Samatha, a U.S citizen, acquired 1,000 shares in FC, a foreign corporation that is a PFIC. She acquired another 1,000 shares of FC stock on January 1 of year 2. During years 1 through 5, Samatha receives the following dividend distribution from FC:

Date of Distribution Amount of Distribution

Dec. 31 of year 1 $500
Dec. 31 of year 2 $1,000
Dec. 31 of year 3 $1,000
Dec. 31 of year 4 $1,000
Apr. 1 of year 5 $1,500
Oct. 1 of year 5 $500

Under Internal Revenue Code Section 1291, none of the distributions received before year 5, are excess distributions since the amount of each distribution with respect to a share is 50 cents. However, with respect to distributions during year 5, the total distribution to each share is 37.5 cents ($1 minus 62.5 cents (1.25 times 50 cents)).

Accordingly, the total excess distribution for FC’s tax year ending December 31 of year 5 is $750 (37.5 per share times 2,000 shares). This excess distribution must be allocated ratably between the two distributions during year 5. Thus, $562.50 (75 percent of the excess distribution, i.e., $750 times $1,500/$2,000) is allocated to the April 1 distribution and $187.50 (the remaining 25 percent of the excess distribution, i.e. $750 $500/$2,000) is allocated to the October 1 distribution. These amounts are then ratably allocated to each block of stock outstanding on the relevant distribution date. For the distribution on April 1 of year 5, $281.25 of the excess distribution is allocated to the block of stock acquired on January 1 of year 1 and $281.25 is allocated to the block of stock acquired on January 1 of year 2 and $281.25 is allocated to the block of stock acquired on January 1 of year 3. The $187.50 excess distribution on October 1 of year 5 is also allocated evenly between the two blocks of stock outstanding on the date of the distribution. Finally, the excess distribution for each block of stock is in accordance with Internal Revenue Code Section 1291(a)(1).

The federal tax due in the year of disposition (or year of receipt of an excess distribution) is the sum of 1) U.S. tax computed using the highest rate of U.S. tax for the shareholder (without regard to other income or expenses the shareholder may have) on income attributed to prior years (called “the aggregate increase in taxes” in Section 1291(c)(1)), plus 2) U.S. tax on the gain attributed to the year of disposition (or year of receipt of the distribution) and to years in which the foreign corporation was not a PFIC (for which no interest is due). Items (1) and (2) together are called the “deferred tax amount” in Section 1291. Item (2), the interest charge on the deferred tax, is computed for the period starting on the due date for the prior year to which the gain on distribution or disposition is attributed and ending on the due date for the current year in which the distribution or disposition occurs.

As indicated above, not only are the PFIC taxing rules complex, these rules can generate significant tax liabilities which, in curtain cases, exceed the value of the foreign stock.

Can a Tax Resident Avoid the PFIC Tax Regime by Not Selling the PFIC Stock Until He or She Terminates U.S. Residency?

Many foreign individuals become U.S. tax residents as a result of accepting employment in the United States. A number of these individuals have interests in foreign stocks that can be classified as PFICs. Some believe  they can avoid the PFIC tax regime by not liquidating these shares until they terminate their U.S. residency. In order to determine if this is a feasible option, we will take a closer look at the Internal Revenue Code and its regulations on point. The Internal Revenue Code characterizes a sale or exchange of PFIC shares as dispositions. A disposition is generally a triggering event only if gain is recognized, but “to the extent in regulations” gain must be recognized in the case of “any transfer of stock in a [PFIC].” See IRC Section 1291(f). The Proposed Regulations provide details as to when there is a taxable gain recognition. See Prop. Treas. Reg. Section 1.1291-3. According to Prop. Reg. Section 1.1291-3(2), if a shareholder of a [PFIC] becomes a nonresident alien for U.S. tax purposes, the shareholder will be treated as having disposed of the shareholder’s stock in a [PFIC] on the last day that the shareholder is a U.S. person. Prop. Treas. Reg. Section 1.1291-3(2) provides that when an individual terminates his or her U.S. residency, that individual’s shares subject to the PFIC tax regime will be treated as if they were sold on the last day of alien’s U.S. residency. Notice that the proposed regulation does not mention expatriation or “covered expatriates.” Thus, an alien will be treated as disposing his or her PFIC shares the day before cessation of lawful U.S. permanent residency. The simple act of returning to one’s home country can trigger significant U.S. tax consequences- even if the termination of residency cannot be classified as an expatriation.

Making a Qualified Electing Fund Election to Avoid the PFIC Tax Regime

A “Qualified Electing Fund” election taxes PFIC differently than the default PFIC regime. Every shareholder who has elected to make a qualified electing fund treatment with respect to a PFIC will currently include in gross income that shareholder’s pro rata share of the PFIC’s earnings and profits. See IRC Section 1293. Shareholders making a qualified electing fund election may decide to defer U.S. tax on amounts included in income for which no current distributions have been received. However, the shareholder must pay an interest charge on the deferred tax. See IRC Section 1294. A shareholder who has made a qualified electing fund election includes in gross income the shareholder’s pro rata share of the fund’s ordinary earnings earnings for the year as ordinary income and the pro rata share of the fund’s net capital gain for the year as long-term capital gain. See IRC Section 1293(a)(1). The election to have a PFIC as a qualified electing fund is made at the U.S. shareholder level on a shareholder-by-shareholder basis.

If a shareholder owns stock in a PFIC which was not a qualified electing fund for prior years but has now become a qualified electing fund, an election is available under Section 1291(d)(2)(A) that permits shareholders to purge the stock of the Section 1291 taint. The shareholder may make this election only for the first tax year in which the PFIC becomes a qualified electing fund. Under the election, the shareholder recognizes gain on the first day of the first tax year that the PFIC becomes a qualified electing fund as if the shareholder’s stock had been sold for its fair market value on that date. This gain is subject to the deferred tax and interest charge rules discussed in Internal Revenue Code Section 1291. A shareholder may also purge PFIC taint by including in gross income as a dividend its share of the corporation’s earnings and profits accumulated during the period the shareholder held the stock while the corporation was a PFIC. This dividend is treated as a distribution for purposes of Internal Revenue Code Section 1291.

Making a Mark-To-Market Election to Avoid the PFIC Tax Regime

Under Internal Revenue Code Section 1296, a shareholder owning stock in a PFIC may elect to mark-to-market the stock of a PFIC if it is “marketable stock.” Under Section 1296, if the fair market value of the stock in the PFIC at the end of the tax year exceeds the shareholder’s adjusted basis in the stock, the shareholder includes in income the amount of such excess. See IRC Section 1296(a)(1). Amounts included in a PFIC shareholder’s gross income under Section 1296 are not treated as favorable qualified dividends. If the shareholder’s adjusted basis in the PFIC’s stock exceeds the fair market value of the stock at the end of the tax year, the shareholder is entitled to a deduction equal to the lesser of (i) the amount of such excess or (ii) the “unreversed inclusions” with respect to the stock. See IRC Section 1296(a)(2). The “unreversed inclusions” are the excess of the prior inclusions in income under this election over the prior deductions taken under this election. See IRC Section 1296(d). Once made, the election applies to the tax year for which it is made and all later years unless 1) the stock ceases to be marketable stock, or 2) the election is revoked with the consent of the IRS.

Amounts included in income under the mark-to-market election and any gain on the sale of marketable stock in a PFIC with respect to which the election is made are treated as ordinary income. Any amounts deducted under this mark-to-market election and any loss on the sale of the marketable stock in a PFIC with respect to which the election is made are treated as an ordinary loss that is deductible in computing adjusted gross income. In the case of losses from the sale of stock, this characterization rule is limited to the extent that the loss does not exceed the “unreversed inclusion” with respect to the stock; any loss in excess of this amount is characterized under the normal rules regarding capital gains and losses. See IRC Section 1296(c)(1).

The mark-to-market election applies only to stock in a PFIC that meets the definition of “marketable stock” in Section 1296(e) of the Internal Revenue Code. To qualify as marketable stock, Internal Revenue Code Section 1296(e)(1)(A) provides that the stock in the PFIC must be regularly traded on either 1) a national market system exchange that is registered with the Securities and Exchange Commission; 2) the national market system established under the Securities and Exchange Act of 1934, or 3) an exchange that the IRS determines “has rules sufficient to ensure that the market price represents a legitimate and sound fair market value.” See Treas. Reg. Section 1.1296-2(a)-(c). Marketable stock also includes stock in a foreign corporation that is comparable to a U.S. regulated investment company and issues stock which is offered for sale or is outstanding and is redeemable at its net asset value. See IRC Section 1296(e)(1)(B).

Rules For Attributing Stock Ownership

In determining stock ownership for purposes of the PFIC provisions, a U.S. person is treated as owning its proportionate share of the stock of a PFIC owned by any partnership, trust or estate in which the U.S. person is a partner or beneficiary. In addition, if a U.S. person owns 50 percent or more in value of a foreign corporation’s stock, the U.S. person is deemed to own its proportionate share of stock of a PFIC owned by the foreign corporation. Under the 2022 proposed PFIC regulations, a partnership that controls a foreign corporation is no longer able to make elections with respect to the foreign corporation on behalf of its partners. Instead, an election will be required to be made by the controlling partner of the partnership that is the controlling domestic shareholder, and the partner is required to provide notice to the partnership. This means that treatment for inclusions from a PFIC under excess distribution regime, qualified electing fund, and mark-to-market methods is determined by the partner rather than the partnership.

Notwithstanding these attribution rules, a U.S. person that owns stock in an upper-tier PFIC is treated as owning its proportionate share of any lower-tier PFIC stock by the upper-tier PFIC, regardless of that U.S. person’s ownership percentage in the upper-tier PFIC. Moreover, the regulations may treat any person that has an option to acquire stock as owning such stock. These attribution rules apply to the extent that the effect is to treat a PFIC’s stock as owned by a U.S. person and generally do not treat stock owned by a U.S. person as owned by any other person. See IRC Section 1298(a).

If a U.S. person is treated as owning stock in a PFIC under these attribution rules, the regulations may treat any disposition of the PFIC stock (whether by the U.S. person or the actual owner of the stock) that results in the U.S. person being treated as no longer owning the stock as a disposition by the U.S. person. In addition, the regulations may treat any distribution of money or other property to the actual holder of the stock as a distribution to the U.S. person. See IRC Section 1298(b)(5).

Information Reporting for PFIC Shareholders

A U.S. person must file annually, with its federal income tax return for the year, 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. A Form 8621 must be filed by direct and indirect holders of PFICs for each tax year under the following five circumstances if the U.S. person:

1) Receives certain direct or indirect distributions of PFIC stock;

2) Recognizes gain on a direct or indirect disposition of PFIC stock;

3) Is reporting information with respect to a Qualified Electing Fund or Section 1296 mark-to-market election;

Generally, a U.S. person is an indirect shareholder of a PFIC if it is:

1) A 50% or more shareholder of a foreign corporation that is not a PFIC and that directly or indirectly owns stock of a PFIC;

2) A shareholder of a PFIC where the PFIC itself is a shareholder of another PFIC;

3) A 50% or more shareholder of a domestic corporation where the domestic corporation owns a Section 1291 fund; or

4) A direct or indirect owner of a pass-through entity where the pass-through entity itself is a direct or indirect shareholder of a PFIC;

5) A U.S. person that owns stock in a PFIC through a tax-exempt organization is not treated as a shareholder of a PFIC. This includes: i) an organization or an account that is exempt under Section 501(a); ii) a state college or university described in Section 511(a)(2)(B) of the Internal Revenue Code; iii) a state college or university described in Sections 511(a)(2)(B); v) a plan described in Section 403(b) or 457(b); vi) an individual retirement plan or annuity as defined in Section 7701(a); vii) a qualified tuition program defined in Sections 529 or 530; and viii) a qualified ABLE used to pay for disability expenses defined in Section 529A.

In general, the following interest holders must file Form 8621 of a PFIC:

1) A U.S. person that is an interest holder of a foreign pass-through entity that is a direct or indirect shareholder of a PFIC;

2) A U.S. person that is considered (under Sections 671 through 679) the shareholder of PFIC stock held in trust;

3) A U.S. partnership, S corporation, U.S. trust or U.S. estate that is direct or indirect shareholders of a PFIC.

Failing to timely file a Form 8621 leaves open the statute of limitations on all tax matters for that year indefinitely until the Form 821 is filed with the IRS. There is no Form 8621 penalty penalty.

The Form 8621 has six parts which are discussed below.

Part I of Form 8621. Summary of Annual Information

In general, all shareholders of PFICS must complete Part 1 of Form 8621. However, a shareholder of a PFIC that is marked to market is generally not required to complete Part 1 of Form 8621.

Part 1 of Form 8621 asks five questions.

Line 1 describes each class of shares held by the shareholder.

Line 2 asks the shareholder to provide the date during the tax year that the shares were acquired.

Line 3 asks the shareholder to list the number of shares held at the end of the tax year.

Line 4 asks the shareholder to state the value of the shares held at the end of the tax year. Shareholders may rely upon periodic account statements provided at least annually to determine the value of the PFIC unless the shareholder has actual knowledge of reason to know the value of the shares based on readily accessible information that the statements do not reflect a reasonable estimate of the PFIC value.

Line 5. The shareholder must indicate the type of the PFIC such as Section 1291 default classification, qualified electing fund method, or mark-to-market method. Line 5 also asks the shareholder to state the amount of any excess distribution or gain treated under Section 1291 of the Internal Revenue Code.

Part II of Form 8621. Elections

Part II of the Form 8621 is used by PFIC shareholders to determine excess distributions and gains. Part II is also used to make elections to treat PFICs as under the qualified electing fund method per Internal Revenue Code Section 1295. A separate election must be made for each PFIC that a shareholder wants to be treated under the qualified electing fund method. 

Part II of Form 8621 contains Boxes A through H. The shareholder must check the box that is applicable to its case,

A shareholder may check Box A of Part II to treat a PFIC as under the qualified electing method. A separate qualified electing must be made for each PFIC that the shareholder wants to be treated as a qualified electing fund election. Generally, a shareholder must make the election to be treated as a qualified electing fund election by the due due of the filing of a tax return, including extensions, for filing the shareholder’s income tax return for the first year to which the election will apply.

Box A.  A PFIC Shareholder should check Box A to treat a PFIC under the qualified electing fund method. The instructions to Form 8621 provide detailed instructions to PFIC shareholders that wish to make a late election to treat a PFIC under the qualified electing fund method. A shareholder may make a qualified electing fund election after the election due date on Part II of the Form 8621 if:

1) The shareholder has preserved its right to make a retroactive election under the protective statement regime.

2) The shareholder obtains the permission of the Internal Revenue Service (“IRS”) under the consent regime.

Protective Statement Regime

Under the protective statement regime, a shareholder may preserve the ability to make a retroactive election if the shareholder:

1. Reasonably believed, as of the due date for the making of the qualified electing fund method, that the foreign corporation was not a PFIC for its tax year that ended during that year (retroactive year);

2. Filed the protective statement with respect to the foreign corporation, applicable to the retroactive election year, in which the shareholder describes the basis for its reasonable belief;

3. Extended, in the Protective Statement, the periods of statute of limitations on the assessment of taxes under the PFIC rules for all tax years to which the protective statement applies; and

4. Complied with the other terms and conditions of the protective statements.

The protective statement must be attached to the shareholder’s tax return for the shareholder’s first tax year to which the statement will apply.

Under the consent regime, a shareholder that has not satisfied the requirements of the protective regime may request that the IRS permit a retroactive election. The consent regime applies only if:

1. The shareholder reasonably relied on tax advice of a competent and qualified tax professional;

2. The interest of the U.S. Government will not be prejudiced if the consent is granted;

3. The shareholder requests consent before the PFIC status issue is raised on audit; and

4. The shareholder satisfied the procedural requirements under Treasury Regulation Section 1.295-3(f)(4).

For each year of the PFIC ending in a tax year of a shareholder to which the qualified electing fund election applies, the PFIC must provide the shareholder with a PFIC Annual Information Statement. The statement must contain certain information, including:

1. The shareholder’s pro rata share of the PFIC’s ordinary earnings and net capital gain for that tax year, or

2. Sufficient information to enable the shareholder to calculate its pro rata share of the PFIC’s ordinary earnings and net capital gains for that tax year.

If the shareholder holds stock in a PFIC through an intermediary, an Annual Intermediary Statement may need to be issued in lieu of the PFIC Annual Intermediary Statement.

For all tax years subject to the qualified electing fund method, the shareholder must keep copies of all Form 8621, attachments, and PFIC Annual Information Statements or Annual Intermediary Statements. Failure to produce these documents at the request of the IRS may result in the invalidation or termination of the election.

Box B. A PFIC shareholder may make an election by Box B of Part II to extend the election for the payment of tax. If this election is made, interest will be imposed on the amount of the deferred tax. The interest must be paid on the termination of the election. This election must be made by the due date, including extensions, of the shareholder’s tax return for the tax year for which the shareholder reports the income related to the deferred tax.

To make an election to deferred tax, the shareholder must not only check Box B in Part II, the shareholder must also complete lines 8a through 9c of Part III of Form 8621.

Box C. A shareholder checks Box C of Part II to make a mark-to-market election. This election must be made on or before the due date (including extensions) of the U.S. person’s income tax return of the U.S. person’s income tax return for the tax year in which the stock is marked to market under Internal Revenue Code Section 1296.

Boxes D and E. A PFIC shareholder will check Box D or E to make a “Deemed Sale Election.” A PFIC shareholder may have made an election to treat a PFIC under the qualified electing fund method. However, if the foreign shares were classified as PFICs for previous years, the shares will be classified as unpedigreed QEF (“qualified electing fund”) and the shareholder should make an election to “purge” the PFIC taint thereby avoiding the excess distribution in the future with respect to the PFIC. A shareholder making this election is treated as receiving a dividend equal to its pro rata share of the post-1986 earnings and profits of the PFIC on the qualified date. The deemed dividend is taxed as an excess distribution, allocated only to the days in the shareholder’s holding period during which the foreign corporation qualifies as a PFIC.

Boxes F, G and H. A PFIC shareholder checks Box F, G, and H to make an election to recognize gain on deemed sale of a PFIC or Section 1297(e) PFIC. A PFIC shareholder may make certain purging elections with respect to a foreign corporation that qualifies as a “former PFIC” or a Section 1297(e) PFIC.” These purging elections result in the foreign corporate stock not being treated as a PFIC. A PFIC shareholder checks Box F or G if it is making a purging election under Section 1297(e) in connection with a sale of the stock.

Part III. Income from a Qualifying Electing Fund

Part III of Form 8621 is used to summarize the total tax and distributions received from a PFIC during the tax year. Part III of Form 8621 is also used to provide the IRS with a summary of any elections made in previous years under the default PFIC method, qualified electing fund method, and mark-to-market method.

Part IV. Gain or (Loss) from Mark-to-Market Election

If a PFIC shareholder has made a mark-to-market election under Section 1296, the shareholder is required to complete Part IV of Form 8621.

Part V. Distributing From Dispositions of a Section 1291

Part V must be completed for each excess distribution from a 1291 fund.

Part VI. Status of Prior Year Section 1294 Elections and Terminations of Section 1294 Elections

Section 1294 permits PFIC shareholders to make an election for time to pay any undistributed PFIC earnings. Shareholders that made a Section 1294 election must complete Part VI of the Form 8621.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.

Anthony Diosdi

Written By Anthony Diosdi

Partner

Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.

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