Most tax related issues are complicated, and very few tax penalties are what some might call lenient. However, regulations for PFIC (Passive Foreign Investment Companies) put the rest to shame. It’s unfortunate when a expat thinks he’s coming to us for a simple tax return only to find that his investment in a non-US mutual fund changed the entire game plan. It would be nearly impossible to cover all the ins and outs of PFIC in a readable article, but what follows will provide a brief overview.
PFIC regulations came about as part of the 1986 Tax Reform Act. The purpose was to create an even playing field for US funds. Before the enactment of the Tax Reform Act, US mutual funds were required to pass all investment income to investors while foreign funds were allowed to shelter taxable income. Post Tax Reform Act, the advantage foreign funds had over US funds was obsolete, because it imposed penalties on all funds that would delay distribution. As a way of enforcing this new principle, the IRS obligates PFIC shareholders to report undistributed earnings and select one of three ways in which they would like them to be taxed.
First, it will be helpful to define exactly what a PFIC actually is. PFICs have...
There are a few PFICs that are exceptions but most will fall within the confines of the above rules. In general, foreign mutual funds, money markets and pension funds are good examples of passive foreign investment companies. If a company (real estate, for example) has passive investments, it will be subject to PFIC rules unless it was set up as a corporation.
If the taxpayer does not choose a method of taxation, Section 1291 will be chosen for him.
Under this particular regime, prior year’s “excess distributions” are taxed at the highest rate possible for the relevant years.Underpayment interest will also be collected.
Under 1291, the current year’s excess are included as “other income” on the standard US tax return.
In contrast, the current year “excess distributions” are added to the “Other income” line of one’s personal tax return. For the purposes of this election an “excess distributions” are either:
1. The part of the distribution received from a section 1291 fund in the current tax year that is
greater than 125% of the average distributions received in respect to such stock by the shareholder during the 3 preceding tax years (or, if shorter, the portion of the shareholder’s holding period before the current tax year; or
2. Any capital gains that result from the sale of PFIC shares
To add to the complexity- excess distributions that are taken (in either of the two aforementioned forms) must be allocated ratably over every year since the most recent excess distribution was taken (if any). Furthermore, all dividends are still required to be reported on Schedule B of the income tax return but any capital gains or losses do not get reported on Schedule D.
1 share of XYZ Inc. (a foreign mutual fund) that was purchased for $100,000 on January 1, 2008. It distributed $8,000 of dividends on July 4 of each year. On December 31, 2010, the share was sold for $400,000. Since the dividends for each year never exceeded the prior year’s amount, there are no excess distributions relating to the dividends. However, since the sale resulted in a capital gain of 100,000, the gain is an excess distribution and will be allocated ratably of each day the share was held. In particular, the excess distributions would result in $100,000 being allocated to 2008 and 2009 and taxed at the highest marginal tax rate (35% in 2008 and 2009). Also, interest would be charged to both years for the amount owed as of the due date for the particular tax year’s tax return- i.e. interest would accrue from April 15, 2009 for the 2008 excess distribution tax). Finally, the allocation of excess distribution for 2010 would be added to ordinary income line of the income tax return (line 21 for those filing Form 1040). Assuming the taxpayer was in the 33% income tax bracket for 2010, the additional tax caused by the PFIC regime would exceed $120,000. Please note that the transaction will not be recorded on the taxpayer’s Schedule D and that the dividends, though not taxed as part of the excess distribution regime, would still need to be reported on the taxpayer’s schedule B as non-qualified dividends.
To have perspective on the degree of additional taxation that can occur with the Excess Distribution method- if the $300,000 gain listed in the aforementioned scenario would have come from the sale of a non-PFIC, the tax would have been $45,000 (almost a third of the total PFIC tax liability). As you can clearly see- the IRS wants to discourage investing in foreign mutual funds.
A second, simpler option for shareholders of PFICs is the QEF election. A first glance, it would appear to be a much better option for most investors since effectively results in the PFIC being treated like a US based mutual fund- the ordinary and capital gains income of the PFIC separately flow through to the shareholder according to percentage of ownership. For example, a taxpayer with a 1% stake in a PFIC that earns $100,000 in ordinary income and another $50,000 in capital gains income will report $1,000 as “other income” on the tax return while $500 will be reported on Schedule D.
However, there is one huge obstacle to making this election- most PFICs are unable to be classified as a QEF since the IRS demands that a QEF comply with IRS reporting requirements (a large request for a non-US based company). Consequently, the QEF election is not frequently available.
The third option available to PFIC shareholders is to make a mark-to-market election. This method allows the shareholder to report the annual gain in market value (i.e. unrealized gain) of the PFIC shares as ordinary income on the “other income” line of their tax returns. Unrealized losses are only reportable to the extent that gains have been previously reported. The adjusted basis for PFIC stock must include the gains and losses previously reported as ordinary income. Upon the sale of the PFIC shares, all gains are reported as ordinary income whereas losses are reported on Schedule D.
To choose this method, the PFIC generally must be traded on a major international stock exchange and can only apply to the current and future tax years.
Also, this election is independent of prior PFIC elections (i.e. QEF or Sect 1291 election). for example: If stock X was purchased in 2007 for $100, has a FMV on 12/31/11 of $120, and no PFIC forms were filed until 2011 (when Sect 1296- Mark-to-market- election was made), no PFIC filings would be needed for the prior years as long distributions were less than 125% and no capital gains occurred. For the current year, 8621 would be filed using Mark to market and the ordinary income would be $20.