The Complex Universe of Passive Foreign Investment Companies
The passage of the foreign account tax compliance act (FATCA) in 2010 signaled a renewed focus by the internal revenue service (IRS) on non-compliance of U.S. taxpayers with ownership of foreign accounts and assets. As part of an initiative to encourage taxpayers with undeclared foreign assets to come forward, the IRS continued and expanded on the original 2009 offshore voluntary disclosure program (OVDP).
The current program offers protection from criminal penalties and a reduction in civil penalties as an incentive for taxpayers to disclose foreign assets when they file past-due or amended tax returns and pay the taxes, interest and penalties on unreported income.
Commonly held foreign assets include interests in foreign mutual funds and foreign exchange-traded funds (ETFs). Most taxpayers are unaware that such funds are treated differently, and more harshly, than U.S. mutual funds or domestic ETFs. A foreign mutual fund or ETF is generally considered to be a Passive Foreign Investment Company (PFIC), which subjects the taxpayer to severe tax and reporting requirements. As part of the voluntary disclosure program, the IRS provides relief for taxpayers failing to make timely elections through an alternative method for reporting PFICs. This article discusses the tax treatment of PFICs and the various elections available.
The current taxation of PFICs was established as part of the Tax Reform Act of 1986. Prior to this, taxpayers were able to defer taxes, without consequence, on income earned in their PFICs provided the income was undistributed. Today, undistributed earnings still remain untaxed under the default rules; however the taxation upon distribution no longer comes without consequence. The PFIC provisions enacted were originally designed to bring foreign funds in line with U.S. funds. As written, they are decisively punitive to non-U.S. investments.
What is a PFIC?
The Internal Revenue Code (IRC) defines a PFIC as a foreign corporation that meets one of the following:
- Seventy-five percent or more of the corporation’s gross income for its taxable year is passive income (Income Test); or
- At least fifty percent of the assets held by the foreign corporation are assets that produce passive income, or are held for the production of passive income (Asset Test).
In this regard, the term “passive income” is defined as any income that would be considered foreign personal holding company income as defined in Internal Revenue Code Section 954(c). This generally includes interest, dividends, capital gains from the sale of stock, royalties, and rental income (unless part of an active trade or business).
Assets producing passive income, such as cash, which can yield interest, and securities, which can issue interest, dividends or capital gains, would be included in the Asset Test under this meaning.
There are certain exceptions to the above rules for corporations engaged in banking or insurance, and for U.S. shareholders of a controlled foreign corporation. Further discussion of these exceptions is beyond the scope of this article.
Reporting and Taxation
1. Section 1291 Fund (“Code” Method)
This is the default taxation method. Under the code method, shareholders are subject to tax when they receive a distribution. Any part that is deemed to be an “excess distribution” will then be subject to special reporting requirements. A distribution received in a tax year that is greater than 125 percent of the average distributions received during the three preceding tax years, or if fewer than three years, the amount of years in the holding period before the current tax year, is considered to be an excess distribution. Additionally, 100 percent of any gain from the disposition of a PFIC will be considered an excess distribution taxed as ordinary income. Any loss from disposition will be a capital loss in the year of disposition. A pure example of this is when a taxpayer sells shares or units in the PFIC. Excess distributions are considered to be earned evenly throughout a shareholder’s entire holding period. The portion of the distribution deemed to be earned in the current tax year is taxed as ordinary income. The portion deemed to be earned in prior years is subject to a separate tax and interest charge. This portion is taxed at the highest marginal individual income tax rate in effect for each taxable year, regardless of the taxpayer’s level of income, plus an interest charge beginning on the original due date for each prior year. For example, an individual paying a 10 percent tax rate on all other income would still be charged the highest tax rate of 39.6 percent as of January 1, 2013. Taxpayers may avoid the punitive, complicated, and burdensome nature of a section 1291 fund by electing to be taxed under one of the other two alternatives.
2. Mark-to-Market Election (MTM)
The second method is to make a mark-to-market election as described in section 1296 of the IRC. This option is only available if the PFIC is a marketable stock. For purposes of this election, the term “marketable stock” is generally considered to be any stock, mutual fund, or ETF that is regularly traded on a U.S. or foreign securities exchange.
By making this election, a shareholder marks each PFIC stock to its year-end market value and reports the increase as ordinary income. Essentially, a taxpayer is choosing to be taxed currently on any unrealized gains. In the case of any unrealized losses, a taxpayer can recognize an ordinary loss, but only to the extent that there have been gains previously recognized, which is called “unreversed inclusions”; thus a taxpayer cannot use the mark-to-market election to mark a stock below its original cost. The gains and losses recognized will determine the taxpayer’s adjusted tax basis in the stock. Upon disposition, the gain or loss will be recognized as the difference between the proceeds and the adjusted basis.
3. Qualifying Electing Fund (QEF) Election
The third option available to taxpayers is to make a QEF election. Under this method, a taxpayer will annually report his or her share of earnings and net capital gain of the PFIC. The earnings will be taxed as ordinary income, while the net capital gains will be taxed as long-term capital gains. The income reported will increase the adjusted tax basis and, upon disposition of the stock, the taxpayer will recognize a capital gain or capital loss. While this election is generally more favorable in terms of taxes, it is more restrictive than the others. In order to be considered a QEF, a foreign corporation must agree to allow the IRS access to their books and records; additionally, the foreign corporation must also supply statements for each U.S. shareholder stating their share of earnings and gains. This can be a heavy request for a non-US company. Generally, only large funds with a substantial amount of U.S.- based investors agree to these reporting requirements.
Coordination with the OVOP
Taxpayers entering into the OVDP must file eight years of past-due or amended tax returns and Reports of Foreign Bank and Financial Accounts (FBARs) to disclose their foreign assets. They also must pay taxes, penalties, and interest on any unreported income. In order to utilize an MTM or QEF election, the election must have been made with a timely filed return. As a result, these elections are not available under the OVDP. For those filing under the OVDP the IRS offers an alternative MTM method as a resolution.
Alternative MTM Method
Under the alternative MTM method, a taxpayer will calculate the amount of gains and losses in the same manner as the MTM method discussed earlier. When electing this method though, the taxpayer applies this methodology to every PFIC held during the voluntary disclosure period. The initial MTM computation will begin the first year of the OVDP period, meaning all unrealized gains in pre-OVDP years will also be included in this marked-to-market amount. However, unlike the regular MTM method, these gains are not reported as ordinary income on the tax return. Instead, the alternative MTM method states that Regular and Alternative Minimum Tax are computed without regard to any MTM gain, MTM loss, or gain on disposition. A tax rate of 20 percent is applied to the MTM gain and reported on the tax return as other taxes. There is also a charge of seven percent on the calculated tax in the initial year. MTM losses are still limited to the extent of previously recognized gains, with the benefit limited to the same rate of 20 percent. The 20 percent rate also applies to gains on the disposition of the PFIC stock. Losses on dispositions in excess of previously recognized gains are reported as capital losses in the year of disposition. At the end of the program, taxpayers who choose the alternative resolution will be required to continue using the regular MTM method on any PFIC investments that were part of the disclosure and continue to be held. Also, unreversed MTM gains remaining with these investments are considered to be zero meaning the taxpayer can no longer take MTM losses against these amounts.
Generally, using the alternative MTM method is more beneficial to a majority of taxpayers. It allows taxpayers who failed to make timely elections to utilize the simpler MTM method and avoid being taxed at maximum rates along with an interest charge. Of course, there are instances in which the alternative MTM method may not be the best option. Taxpayers who did not dispose of or receive distributions from their PFIC investments, and taxpayers who disposed of PFIC investments at a loss are two examples of situations that call for a further analysis.
The concept of a PFIC is extremely complicated and can result in expensive consequences if not handled properly. Taxpayers need to be aware of the investments being made in their foreign as well as domestic portfolios. They should also understand the options and potential tax burdens they assume when holding PFICs. Making timely elections is crucial. For taxpayers who choose to enter into voluntary disclosure, the alternative MTM method can provide a simpler and more beneficial path back into compliance.