U.S. Tax Considerations of Foreign Stock Option Plans

With globalization, more and more Americans are working abroad and participating in foreign stock option plans. Americans are taxed on their worldwide income and as a result, Americans participating in foreign stock option plans are subject to U.S. federal income tax on any stock gains. Foreign stock options often create unexpected tax traps due to mismatched timing and anti-deferral rules. This article discusses how foreign stock options are taxed in the U.S.

Stock Option Plans Held Retirement Plans

Many foreign stock options are held in retirement plans. Since stock options are often held in plans, the tax consequences foreign retirement plans must be considered. Under U.S. tax law, a retirement plan can be classified as a “qualified plan” or Non qualified” or “nonexempt retirement plan.”

Section 401 of the Internal Revenue Code provides that a “qualified” pension must be created or organized in the United States and must be for the exclusive benefit of employees or their beneficiaries. In addition, the pension or retirement trust must satisfy a myriad of other requirements, e.g., it must meet the minimum participation standards of Section 401, must not discriminate in contributions or benefits in favor of highly compensated employees, must meet minimum vesting standards of Section 401, must comply with the limitations on contributions and benefits set forth in Section 415, must prohibit assignment or alienation of benefits, and satisfy minimum standards of Section 412.

If a plan is qualified, then the plan, the employer, and the employees all receive favorable tax treatment with respect to their plan-related income or expenses. To be qualified under U.S. tax law, a plan must comply with an elaborate set of standards. A plan will not be a qualified plan under Section 401(a) of the Internal Revenue Code unless its participation, vesting, and accrual standards meet the requirements of Title 1 of ERISA. Title 1 covers only plans established or maintained by: employers engaged in commerce or whose industry or activity affects commerce; unions representing employees engaged in commerce or in any industry or activity affecting commerce. The most important rule for a plan to be classified as a qualified pension plan is the nondiscriminatory rules. These rules prohibit a plan from favoring highly paid employees and insiders of the business with respect to coverage and benefits.

Under these rules, the minimum coverage standards limit discrimination in favor of highly compensated employees or, correlatively, against nonhighly compensated employees. The concept of a highly compensated employee is a fundamental one for the nondiscriminatory rules. In general, an employee is highly compensated for any given year (the determination year) if he or she: (A) was a 5-percent owner in that year or the preceding one; or (B) in the preceding year received compensation from the employer in excess of a sum indexed for inflation and, if the employer elects, was in the top-paid group of employees for that year.

A 5-percent owner of a corporation in a given year is a person who at any time in the year owns more than 5% of the outstanding stock or stock possessing more than 5% of the combined voting power. A 5 percent owner of a non-corporate employer in a given year is a person who at any time in the year owns more than 5% of the capital or profit interest. Ownership includes constructive ownership. Generally, a foreign pension plan will not satisfy the Section 401(a) qualification rules because these types of pensions must be created or organized in the United States. Thus, the vast majority of foreign pension plans cannot be taxed as a “qualified plan” for U.S. tax purposes. If a foreign pension plan could be taxed as a qualified plan, the employer’s contribution to the plan would be deductible, up to specified limits. The deduction is limited to the amount necessary to fund the plan properly under actuarial method and assumptions used. The income of the pension plan or trust would be tax-exempt pursuant to Section 501(a) of the Internal Revenue Code. Investments in the pension plan would accumulate free of any tax. The participant would only be taxed when he or she received distributions from the pension plan. Premature distributions would be subject to a 10% federal penalty.

As a general rule, in order for a retirement plan to be treated as a qualified plan, the plan must be created in the United States. Since a retirement plan must generally be established in the United States in order for it to be classified as a qualified plan, a foreign retirement plan typically cannot be classified as a qualified retirement plan.

U.S. Tax Concepts Applied to the U.S. Taxation of Foreign Pension Plans Tax as a Nonexempt Employee Trust Under Section 402(b)

As discussed above, most foreign pension plans cannot be classified as a qualified plan. Although the vast majority of foreign pension plans cannot be characterized as qualified plans for U.S. tax purposes, some foreign pension plans can be classified as nonexempt plans under Section 402(b) of the Internal Revenue Code.

Section 402(b) governs the taxation of funded employee benefit trusts that are not exempt from tax under Section 501(a), which exempts trusts that satisfy the requirements of Section 401. Section 402(b) typically applies to funded nonqualified deferred compensation arrangements. Section 402(b)(1) provides that employer contributions to a nonexempt employees’ trust are included in an employee’s gross income in accordance with Section 83 of the Internal Revenue Code, except that the value of the employee’s interest is substituted for the property’s fair market value in the first year in which the contributions are transferable or no longer subject to substantial risk of forfeiture. The presence of a substantial risk of forfeiture is determined under Section 83 and its regulations.

Internal Revenue Code Section 402(a)(1) specifies that distributions from a qualified plan (other than rollovers and certain lump sum distributions) are taxable in the year in which they are made, in accordance with Section 72 of the Internal Revenue Code. Section 72 deals with the taxation of annuities, including annuities from plans. Its basic rule is that amounts received in the form of annuity is that amounts are taxed as ordinary income. See IRC Section 72(a). Section 402(b)(2) provides that amounts held in a Section 402(b) trust are not taxed until they are distributed or more available to the individual and taxed under Section 72, with the exception that distributions of income before the annuity starting date (as defined in Section 72) are included in the individual’s gross income without regard to Section 72(e)(5) (relating to special rules for amounts not received as annuities). This means that the amounts are taxed as an annuity; i.e., a portion of the amounts is treated as nontaxable basis recovery, and the remainder is treated as taxable income.

U.S. taxation under Section 402(b) depends on whether the nonexempt trust is discriminatory. A Section 402(b) trust is considered discriminatory if one of the reasons it is not an exempt trust under Section 501(a) is the plan’s failure to satisfy the requirements of either Section 401(a)(26) (participation requirement for qualified defined benefit plans) or Section 410(b) (coverage requirements for qualified defined contribution and defined benefit plans). If the Section 402(b) trust is not discriminatory, employees who participate in the underlying plan are taxed under Sections 402(b)(1) and (2). In contrast, if the trust is discriminatory, highly compensated employees (as described in Section 414(q) are taxed under Section 402(b)(4), which provides that they are taxed each year on the employee’s vested accrued benefits as of the close of the trust’s tax year, less the employee’s investment in the contract.

The concept of “highly compensated employee” is a fundamental one for the nondiscrimination rules. In general, an employee is highly compensated for a given year (the determination year) if he: (A) was a 5-percent owner in that year or the preceding one; or (B) in the preceding year received compensation from the employer in excess of a sum indexed for inflation ($160,000 in 2026) and, if the employer elects, was in the top-paid group of employees for that year. See IRC Section 72(a). A 5-percent owner of a corporation in a given year is a person who at any time in the year owns more than 5% of the outstanding stock or stocks possessing more than 5% of the combined voting power. A 5-percent owner of a non-corporate employer in a given year is a person who at any time in the year owns more than 5% of the capital or profit interest. Ownership includes constructive ownership. Section 318 is one of several sets of constructive ownership rules in the Internal Revenue Code. Its principal role is to treat a taxpayer as “owning” stock that is actually owned by various related parties. The attribution rules in Section 318 fall into the following four categories:

Family Attribution. An individual is considered as owning stock owned by his or her spouse, children, grandchildren, and parents. See IRC Section 318(a)(1).

Entity to Beneficiary Attribution. Stock owned by or for a partnership or estate is considered as owned by the partners or beneficiaries in proportion to their beneficial interests. IRC Section 318(a)(2)(A). Stock owned by a corporation is considered owned proportionately (comparing the value of the shareholder’s stock to the value of all stock) by a shareholder who owns, directly or through the attribution rules, 50 percent or more in value of that corporation’s stock. IRC Section 318(a)(2)(C).

Compensation includes not only wages, salary, commission, and other items includable in gross income, but as well elective deferrals and elective contributions to other deferred compensation plans. A top-paid employee for a year is an employee in the top 20% for that year, ranked by compensation. IRC Section 414(q)(3). In determining the number of employees equal to 20%, the following employees are not counted: those who normally work less than 17 ½ hours per week; those who normally work no more than 6 months during any year; those younger than 21; certain employees covered by a collective bargaining agreement; and certain nonresident aliens. IRC Section 414(q)(5) & (8). An employer may elect less stringent exclusions. Or none at all. Then, the so-called “top 20%” may consist of fewer than 20% of all employees. The exclusions just described are only for purposes of determining the size of the top 20%, not its membership. A top-paid employee may, for example, have completed only 3 months of service. Section 414(q)(6) states that “A former employee shall be treated as a highly compensated employee if he or she separated from service before the determination year and was a highly compensated employee either for the year of separation or any year after he or she reached 55. IRC Section 414(q)(6). After the determinations are made regarding whether or not the plan is discriminatory and whether or not the participant is highly compensated the tax treatment can be narrowed based on: (1) plans that are not discriminatory, or plans that are discriminatory but the participant is not highly compensated, and (2) plans that are discriminatory and the participant is highly compensated.

Taxation of Foreign Pension Under Section 402(b) If the Plan is Not Discriminatory

If a U.S. taxpayer is fully vested (The term “vesting” in a retirement plan means ownership) in a foreign pension plan that is not discriminatory, the amount contributed to the plan is included in U.S. taxable income. IRC Section 402(b)(1). However, plan earnings are not included in U.S. taxable income until the funds are distributed or made available to the U.S. participant under Section 72. IRC Section 402(b)(2). Section 72 deals with the taxation of annuities, including annuities from plans. Section 72 is complex. Its complexities, though, result mainly from the need to exclude portions of annuity payments on which the participant has already been taxed- for example, portions attributable to her own after-tax contributions. Of course, where only non-taxable employer contributions were made on behalf of the participant, the rule is very simple: the annuity payments are taxable in full.

The basic exclusion rule of Section 72 deals with amounts received as an annuity. An annuity payment are defined as amounts payable at regular intervals, over a period of more than one full year from the annuity starting date, for which the total amount payable can be determined as the annuity starting date, either from the terms of the annuity contract or from actuarial tables. Treas. Reg. Section 1.72-4(b)(1). For amounts received as an annuity, the following proportion- the exclusion ratio – is excluded from gross income: investment in the contract as of the annuity starting date/expected return under the contract as of that date. IRC Section 72(b)(1). Thus, if an annuity pays $500 per month, and the exclusion ratio is 10%, $50 of each monthly payment is excluded from U.S. gross income.

The investment in the contract is the total of the participant’s after-tax considerations plus any amount of the participant’s contributions that were includible in the participant’s gross income, less the amount received to date under the annuity contract to the extent it was excludible from gross income. IRC Section 72(c)(1) & (f). It is essentially the undistributed amount that has already been taxed. The expected return is the total amount expected to be received under the annuity contract, either as fixed by the terms of the contract or from actuarial tables. IRC Section 72(c)(3). The exclusion continues until the participant’s investment in the contract has been distributed to her. IRC Section 72(c)(3). After that time, the entire amount of the annuity payment is subject to U.S. tax.  As a result, the amount ultimately excluded from taxable income for U.S. tax purposes will be equal to the taxpayer’s investment in the contract. The U.S. participant’s investment in the contract or foreign pension plan will generally include contributions and earnings that were previously included in the participant’s U.S. taxable income, as well as amounts that were previously included in the participant’s non-U.S. taxable income during a period when the taxpayer was a nonresident alien of the U.S.

If contributions to a U.S. participant’s foreign pension that is treated as a non-exempt trust, the contributions for U.S. purposes because these amounts are non-vested (i.e., the participant has a substantial risk of forfeiture pursuant to Section 83), but such amounts become vested in a later period, then the vested amount is included in the

taxpayer’s taxable income pursuant to the rules of Treas. Reg. Section 1.402(b)-1(b). For purposes of Section 83, a substantial risk of forfeiture exists when the employee’s right to property or compensation is contingent upon the performance of substantial services or the occurrence of other significant conditions, and there is a real risk of losing those benefits if the conditions are not met.

An example of a foreign pension taxed under Section 402(b)(1) is a Singaporean Central Provident Fund. As per IRS Memorandum PMTA 2007-00173, for an employee who is taxed under the rules of Section 402(b)(1), contributions paid by the employer to the Fund are taxable pursuant to Section 402(b)(1). This is because non-elective contributions are withheld from an employee’s salary without the consent of the employee. Because contributions to the pension are withheld without consent of the employee, the contributions to the plan are not constructively received by the employee for U.S. tax purposes and as a result, these contributions are considered employer contributions and are taxed under Section 401(b)(1).

It is often very difficult to determine if a foreign pension plan is discriminatory. Since it is often difficult to determine if a foreign pension plan is discriminatory, foreign retirement plans are often presumed to be discriminatory for U.S. tax purposes.

Taxation of Foreign Pensions if Plan is Discriminary or if Plan is Not Discriminatory, but the Participant is Highly Compensated

If a U.S. taxpayer is fully vested in a foreign pension plan that is discriminatory, the amount contributed to the plan is included in U.S. taxable income the amount to be reported as income in a given year is equal to the vested accrued benefit, less the taxpayer’s investment in the contract (i.e., amounts previously included in income). The net effect of these provisions is that the taxpayer essentially marks the foreign pension to market each year and includes the net vested increase in value in income. In the event the value of the foreign pension decreases for a given year (e.g., the decrease

in value for the year exceeds any current year contributions) the taxpayer would not be entitled to a current deduction, but the taxpayer’s investment in the contract would exceed the vested accrued benefit and additional income would not be reportable until such time as the vested accrued benefit exceeded the investment in the contract.

Assuming the U.S. participant is fully vested in the plan, current earnings are effectively included in U.S. taxable income since current earnings would factor into the taxpayer’s vested accrued benefit. Distributions are taxed in the year distributed or made available to the taxpayer in accordance with the rules for taxation of annuities pursuant to Internal Revenue Code Section 72. As a result, the amount ultimately excluded from taxable income for U.S. tax purposes will be equal to the taxpayer’s investment in the contract. The U.S. participant’s investment in the contract will generally include contributions and earnings that were previously included in the participant’s U.S. taxable income, as well as amounts that were previously included in the participant’s contributions before the individual became a U.S. resident for income tax purposes under Section 7701(b) of the Internal Revenue Code.

If a foreign pension plan participant is not highly compensated (regardless of whether the plan is discriminatory), the U.S. tax implications of fully vested contributions are included in U.S. gross income. However, non-elective contributions to the foreign pension are not included in U.S. gross income for income tax purposes. Foreign pension plan earnings are not subject to U.S. income tax until distributed. Distributions from the foreign pension plan are taxed under the annuity rules of Section 72 of the Internal Revenue Code.

If the participant of a foreign pension plan is highly compensated (and the plan is discriminatory), the U.S. participant includes in U.S. gross income the “vested accrued benefit” for the applicable year. A vested accrued benefit is the portion of a retirement benefit that a participant owns and has a non-forfeitable right to, even if they leave the company before they retire. It represents the portion of the retirement benefit that has been earned and is guaranteed.  The participant’s vested accrued benefit may be expressed in the form of an annual benefit payable at normal retirement age. Mathematically, a participant’s accrued benefit is multiplied by the applicable vesting percentage (based on the plan’s vesting schedule). The plan’s vesting schedule should be at least as favorable as one of the vesting schedules identified in Section 411(a)(2) and 416(b). A participant’s vested accrued benefits are typically expressed as annual (or monthly) benefits payable over the life of the participant (life annuity), payable at normal retirement age. As a result, the U.S. participant “mark-to-mark,” effectively including contributions and earnings in the taxable year on a current basis. If contributions to the foreign pension plan are not taxable in the year of contribution because such amounts are non-vested (i.e., the taxpayer has a substantial risk of forfeiture pursuant to Internal Revenue Code Section 83), but such amounts become vested in a later period, then the vested amount is included in the U.S. participant’s U.S. taxable income.

Foreign stock options are often held in plans treated as discriminatory plans for U.S. tax purposes. It is not uncommon for these plans to have vesting schedules. If a foreign stock option plan contains a vesting schedule, under Section 401(b)(4), the U.S. participant is each year on the participant’s vested accrued benefit as of the close of the trust’s tax year, less the employee’s investment in the contract. The participant is not taxed on the year he or she receives a distribution from the plan. This may come as a surprise to many participants in foreign retirement plans that stock options. In certain cases, participants of foreign stock option plans can take a tax treaty position and defer the tax consequences of a vesting schedule. Some tax treaties abrogate this general rule. For example, Paragraph 7 of Article 13 of the U.S.-Canada Income Tax Treaty provides a rule with respect to the taxation of natural persons on income accrued in a pension or employee benefit plan in the other Contracting State. Thus, paragraph 7 of Article 13 applies where an individual is a citizen or resident of a Contracting State and is a beneficiary of a trust, company, organization, or other arrangement that is a resident of the other Contracting State, where such trust, company, organization, or other arrangement is generally exempt from income taxation in that other State, and is operated exclusively to provide pension, or employee benefits. In such cases, the beneficiary may elect to defer taxation in her State of residence on income accrued in the plan until it is distributed from the plan.

The U.S. Tax Consequences of Gains

Now since we determine the timing of a stock option for U.S. tax consequences, we must discuss the general tax consequence of stock gains. Typically, stock options are either taxed as an Incentive Stock Option (“ISO”) or Non-Qualified Stock Option (“NQSO”). ISOs offer special tax benefits because there is no regular income tax due at the time of exercise. Instead, taxes are delayed until the stocks are sold. A foreign company typically cannot issue an ISOs under U.S. tax law. Thus, ISOs are typically not a consideration for U.S. participants of a foreign stock option plan. Foreign stock option plans are typically taxed as NQSOs for U.S. tax purposes. If a foreign stock option is treated as a NQSO, the distribution from the plan will be taxed as ordinary income at the time of exercise (on the spread between the fair market value and the strike price), rather than a sale which is taxed at a favorable capital gain rate.

Anytime a U.S. investor receives stock in a foreign corporation, a consideration must be given to the Passive Foreign Investment Company (“PFIC”) tax regime. Although an NQSO itself is not a corporation and cannot be a PFIC, the underlying foreign corporate stock held by the U.S. investor or right to purchase such a share can be classified as a PFIC. 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 can have extremely negative tax consequences to any U.S. holders of such stock.

The next subsection of this article will discuss the U.S. tax consequences if a foreign stock can be classified as a PFIC.

Definition of PFIC

We will begin this subsection of this article by defining the term “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.

Many U.S. holders of foreign stock options fail to realize that the options they are granted are taxed as PFIC because either because they are passive investors in the foreign stocks and/or the foreign corporation that granted them the stock options satisfy the asset test. We will next discuss how a PFIC is taxed.

Taxation of a PFIC

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:

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.

Sometimes a U.S. individual that has been granted a stock option can make either a Qualified Electing Fund or Mark-to-Market Election to reduce his or her exposure to the PFIC tax regime. However, these elections must be made timely and it is not always possible to make Qualified Electing Fund and Mark-to-Market Elections. A close examination must be made of the stock option plan and grant to determine if a Qualified Electing Fund or Mark-to-Market Election can be made on a case-by-case basis. Below, this article will briefly discuss these elections.

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).

Conclusion

When a U.S. person participates in a foreign corporation’s stock option plan, the U.S. participant must consider the U.S. tax consequences of the option plan, the timing of the U.S. tax, if a tax treaty may be utilized to mitigate the U.S. tax consequences of the stock option, and the PFIC tax regime. Obviously, this is a very complex area of tax law.

U.S. participants in a foreign stock option plan should consult with a skilled international tax attorney they are considering participating in a foreign stock option plan.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony has advised various Fortune 500 companies and large privately held businesses in their cross-border tax planning. Anthony is a frequent author and speaker on international tax topics.

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.