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Preparation of Form 8621 and PFIC Reporting
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Preparation of Form 8621 and PFIC Reporting

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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.

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 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.

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).

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).

Information Reporting for PFIC Shareholders

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 account 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. The attorneys at Diosdi & Liu, LLP prepare the Form 8621 and provide planning to reduce the harsh consequences of the PFIC tax.

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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