By Anthony Diosdi
Disclosing foreign financial accounts on U.S. tax returns is no simple process. This is because many foreign financial accounts contain mutual funds or foreign stocks. The taxation of foreign mutual funds and/or stocks is extremely difficult and can result in unintended tax consequences. Unintended tax consequences are the result of tax laws enacted by Congress over thirty years ago. Concerned that U.S. investors were receiving tax breaks by investing in offshore mutual funds or securities, in 1986, Congress added the Passive Foreign Investment Company (“PFIC”) provisions to the Internal Revenue Code. The object of the PFIC provisions is to deprive a U.S. taxpayer of the economic benefit of deferral of U.S. tax on the taxpayer’s share of the undistributed income of a foreign investment.
The legislative history contains the following statements:
“[E]limating the economic benefit of deferral [for PFIC shareholders] is necessary to eliminate the tax advantages that U.S. shareholders in foreign investment funds have heretofore had over U.S. persons investing in domestic investment funds.”
“Congress did not believe that tax rules should effectively operate to provide U.S. investors tax incentives to make investments outside the United States rather than inside the United States. Since current taxation generally is required for passive investments in the United States, Congress did not believe that U.S. persons who invest in passive assets should avoid the economic equivalent of current taxation merely because they invest in those assets indirectly through a foreign corporation. Congress further believed that the nationality of the owners of controlling interests of a corporation which invests in passive assets should not determine the U.S. tax treatment of its U.S. owners. In Congress’ view, the absence of U.S. control did not necessitate preferential U.S. tax treatment to U.S. persons who invest in passive assets through a foreign corporation. Moreover, Congress recognized that U.S. persons who invested in passive assets through a foreign corporation obtained a substantial tax advantage vis-a-vis U.S. investors in domestic investment companies because they not only were able to avoid current taxation but also were able to convert income that would be ordinary income if received directly or received from a domestic company into capital gain income.” See JOINT COMMITTEE ON TAXATION, GENERAL EXPLANATION OF THE TAX REFORM ACT OF 1986, 1023 (1987).
As discussed in more detail below, one can easily view the PFIC statute and regulations as going well beyond the legislative purpose of Congress. In order for a foreign corporate stock to be classified as a PFIC, the corporation that issued the stock must satisfies one or both of the following tests:
Passive Income Test
75 percent or more of the corporation’s gross income for the year is “passive income” (i.e., dividends, interest, rents, and royalties not derived in the active conduct of a trade or business, net gains on sales of property producing passive income, and other income classified as “foreign personal holding company income” for purposes of Subpart F. See IRC Sections 954(c), 1297(b)(1).
A foreign corporation is a PFIC under the passive asset test if at least 50 percent of its assets during the taxable year produce passive income or are held for the production of passive income.
1) An asset is passive “if it has generated [passive income for the corporation] (or is reasonably expected to generate such income in the reasonably foreseeable future.
2) Cash and other assets readily convertible into cash are passive even when held as working capital in an active business.
3) Publicly traded corporations must always use fair market value for purposes of the asset test. Non-publicly traded corporations may elect to use adjusted basis, rather than fair market value.
4) The asset test is applied using the average value of the corporation’s assets at the end of each quarter of the taxable year.
5) The results of this test may change due to fluctuations in the fair market value of the corporation.
The Asset Test should not be taken lightly. This is because it can classify many stocks as PFICs that one would not suspect as being a PFIC. For example, suppose if a U.S. citizen purchases 100 shares of Samsung stocks. If the Samsung corporation were hoard cash in a particular year and as a result of the corporation’s large cash reserves equal to at least fifty percent of its assets, the Samsung stock could be classified as PFICs. The Asset Test may trigger a PFIC classification to many foreign securities which one would not suspect as being PFICs.
There are three alternatives tax regimes apply to PFIC shareholders. These regimes are discussed in detail below.
Current Inclusion Under Qualified Electing Fund Election
Under one set of rules, which apply to PFICs that are “qualified electing funds” (“QEF”) the electing U.S. persons holding stock in the PFIC include in their gross income their pro rata shares of the PFIC’s earnings. These U.S. persons may elect to defer payment of the tax, subject to an interest charge, on the portion of the PFIC’s earnings not currently received. The QEf’s income for each year is split between its “ordinary earnings” (earnings and profits reduced by net long-term capital gain over net short-term capital loss, but not more than earnings and profits). See IRC Section 1293(a). Each category of income is prorated among the days of the year, and the amount for each day is deemed distributed on that day. See IRC Section 1293(b). A separate election is available to defer payment of tax, subject to an interest charge, on income not currently received. See IRC Section 1294. The shareholder’s basis in the stock is increased by amounts taxed to the shareholder and is reduced by tax-free distributions. See IRC Section 1293(d).
The corporation corporation must provide to an electing shareholder a “PFIC Annual Information Statement” in which it specifies 1) its taxable year; 2) the shareholder’s ratable share of the corporation’s ordinary earnings and net capital gain for the year and the amounts distributed to the shareholder during the year; and 3) that the shareholder may inspect and copy the PFIC’s books to whatever extent necessary to establish earnings and net capital gain have been computed in accordance with U.S. tax rules. See Treas. Reg. Section 1.1295-1(g)(1).
A QEF election must be made for any taxable year on or before the due date for filing a return for such taxable year on an IRS Form 8621. The election applies to all subsequent years unless and until revoked by the IRS. A QEF can be an extremely favorable position to take regarding the taxation of a PFIC. However, as indicated above, meeting the requirements of a QEF can be a difficult task. Because a lack of planning and understanding of the PFIC rules, few investors are able to meet the QEF reporting requirements.
Current Taxation Under Mark-to Market Election
Under a second set of rules, if the stock of a U.S. person owning stock in the PFIC may elect to market the value of the PFIC’s stock each year. If this election is made, the U.S. person includes in gross income the excess of the fair market value of the PFIC’s stock at the end of the year over the U.S. person’s adjusted basis in the stock. Alternatively, if the U.S. person’s basis in the PFIC’s stock exceeds the fair market value of the stock at the end of the year, the U.S. person is allowed to deduct such excess (subject to limitation). This method is known as the “mark to Market (“MTM”) method may be utilized to avoid the harsh PFIC rules. a person may make an MTM election with respect to “marketable” PFIC stock and thereby subject the appreciation or devaluation of the stock to the U.S. tax laws.
For purposes of this provision, stock of a PFIC is “marketable” if it regularly traded on: 1) a national securities exchange that is registered with the Securities and Exchange Commission; 2) the national market system established pursuant to Section 11 of the Securities and Exchange Act of 1934; or 3) any exchange or exchange or other market that is determined by the Secretary to satisfy this position. An electing shareholder must annually report as ordinary income any amount by which the fair market value of the stock at year-end exceeds the taxpayer’s basis for the stock. Any amount by which the stock’s basis exceeds the fair market value at year-end is an ordinary deduction to the extent of the “unreversed inclusion with respect to such stock,” which equals the sum of the gross income inclusion for all prior years, less any deduction allowed under this rule for prior years. See IRC Section 1296(c). Gain on a sale or other disposition of the stock is ordinary income, and loss on a disposition is deductible as an ordinary loss to the extent it does not exceed the unreversed inclusions attributable to the stock. See IRC Section 1296(c)(1).