PFICs: Retroactive QEF Elections: IRS Consent to Make Retroactive Election
A recent private letter ruling illustrates how a taxpayer can get relief from the inadvertent failure to make an election where the taxpayer has invested in certain foreign corporations known as PFICs.
A foreign corporation is a passive foreign investment company (“PFIC”) if 75% or more of its gross income for the taxable year is passive income, or if at least 50% of its assets produce, or are held for the production of, passive income. If no elections are made with regard to a PFIC investment, any distributions with respect to the PFIC will be taxed as ordinary income to a U.S. taxable investor, even if the underlying income is capital gain income. There is also an interest charge imposed on any so-called “excess distributions” from the PFIC. However, if a qualified electing fund (“QEF”) election is made, the investor reports PFIC income on a current basis for the taxable year on Form 8621. Under this election, the investor is treated as having received an annual distribution of income. The investor must include in gross income its portion of the PFIC’s income, split pro-rata between long-term capital gain and ordinary income.
Generally, the QEF election must be made by the extended due date of the tax return for the first taxable year to which the election will apply. Once made, this election can only be revoked with permission from the IRS. Under certain circumstances, a retroactive election is permissible under the Regulations where a shareholder failed to make a timely election because the shareholder reasonably believed that the company was not a PFIC. Letter Ruling 201220006 (the “Ruling”), dated February 22, 2012, highlights certain criteria that must be met in order for a shareholder to be granted a retroactive QEF election.
In the Ruling, the shareholder was a limited partnership owned by U.S. taxable individuals. The shareholder purchased shares in a foreign corporation (“FC”) over a four year span and then sold all of the shares in the fifth year. During years one through five, the shareholder’s management company engaged an experienced tax advisor (“Advisor”) to prepare the shareholder’s federal tax return. The shareholder represented in the Ruling that (1) it “relied on Advisor to provide advice with respect to filing and reporting requirements in general, as well as any elections or statements that would be necessary to elect a specific tax treatment;” (2) information received by the management company with respect to the shareholder’s initial investment in FC did not indicate that FC was a PFIC; (3) the management company had intended to invest in an active development company, and (4) the shareholder, management company and FC considered FC to be engaged in an active business and had no reason to believe that FC could be categorized as a PFIC.
In year 6, the shareholder engaged Advisor for tax preparation services. Advisor then conducted annual PFIC testing and determined that FC may have been a PFIC starting with the first year of the shareholder’s investment. As of the date of the ruling request, the issue of whether FC was a PFIC had not been raised by the IRS on audit for any of the taxable years.
The shareholder requested a retroactive PFIC election under Treasury Regulations Section 1.1295-3(f). The Regulation states certain conditions that must be met in order for a retroactive QEF election to be granted. These criteria include the following:
- The shareholder reasonably relied on a qualified tax professional.
- Granting consent will not prejudice the interest of the United States government, i.e., will not lower the shareholder’s tax liability by a significant amount when time value calculations are taken into account.
- The IRS has not raised, upon audit, the PFIC status of the corporation for any taxable year of the shareholder at the time the shareholder requests consent for a retroactive QEF election, and
- The shareholder satisfies certain procedural requirements for requesting a retroactive QEF election, including:
- filing the request with the appropriate IRS office and paying a user fee
- submitting an affidavit from the shareholder or authorized person detailing the facts surrounding the failure to make the election, including the investor’s reliance on a tax professional, and
- submitting affidavits from individuals having knowledge about the events that led to the failure to make a QEF election and the discovery of the failure.
In the Ruling, the shareholder’s request for a retroactive QEF election was accepted, as it was deemed to have satisfied the above requirements.
A shareholder that is granted a retroactive QEF election must attach Form 8621 to an amended return and must file an amended return for each subsequent tax year affected by the election.