The PFIC Rules and Their Impact on Private Investment Funds
The world is changing. Technological innovation and the internet have combined to make it a smaller place. The U.S. economy, while still the largest, is shrinking as a percentage of the global economy. Collectively, these factors have created opportunities for U.S. investment funds (“funds”) to diversify and broaden their portfolios by investing in corporations located in offshore jurisdictions. While these investments can produce attractive economic returns, funds need to be wary of the tax pitfalls they may encounter. Unlike investments in U.S. corporations, where the fund is taxed when it receives a distribution from or sells shares of the corporation, investments in offshore corporations that are classified as passive foreign investment companies (“PFICs”) face a potentially punitive tax regime.
What is a PFIC?
A PFIC is a foreign-based corporation that meets either an income test or an asset test. The income test is met if more than 75% of the corporation’s gross income is passive, such as interest, dividends or capital gains. The asset test is met if more than 50% of the average value of the corporation’s assets produce passive income. Should either of these two tests be met, the corporation is treated as a PFIC.
The Three PFIC Taxation Regimes and Advantages of the Qualified Electing Fund Regime
The PFIC rules were implemented to prevent U.S. taxpayers from deferring tax on passive income earned by corporations in low tax jurisdictions. Absent an election to tax the PFIC as a Qualified Electing Fund (“QEF”) or tax it under the mark-to-market (“MTM”) rules (discussed below), PFICs are taxed under the default or excess distribution) regime. Under this regime, if a taxpayer receives a distribution or there is a sale of shares, the income or gain is treated as ordinary income and taxed at the highest ordinary rate. None of the gain is treated as capital gain. In addition, interest is charged on tax allocated to prior tax years. The default regime is the most punitive of the regimes applying to a taxpayer.
A taxpayer wishing to avoid this punitive regime can avail itself of either one of two options. If the PFIC stock is marketable (traded on a public exchange), then an election can be made to MTM the PFIC stock and include income annually. This income is included regardless of whether the taxpayer receives a distribution or sells shares. The inclusion amount is calculated by comparing the change in market value from the beginning of the year to the end of the year. Any increase in value is treated as ordinary income. Decreases in value, to the extent of previous years’ inclusions, are treated as ordinary losses. If there are no prior year inclusions, then the loss cannot be used by the taxpayer and is not carried forward to future tax years. The taxpayer does not incur any additional interest charge, and the income is taxed at regular marginal tax rates. Accurate records need to be maintained year-to-year to calculate proper gains and losses. However, no information is required from the offshore corporation. Although subject to limitations and yearly effort, the MTM regime is usually more advantageous than the default regime.
The second option is for the taxpayer to make the QEF election. Most taxpayers investing in PFICs will achieve the best tax results by electing QEF treatment. This election does not require the corporation to be traded on a national exchange. It generally requires the offshore corporation to issue a PFIC Annual Information Statement (discussed below) to the taxpayer. In lieu of providing the Annual Information Statement, the offshore corporation can provide the taxpayer sufficient information in regard to its ordinary income and capital gains to enable the taxpayer to make the QEF election. Should the offshore corporation fail to provide either the statement or sufficient information for the taxpayer to calculate taxable income, the taxpayer generally loses its ability to make the QEF election.
Similar to making the MTM election, income is included currently even if there are no distributions or sales of shares. Unlike making the MTM election, however, QEF income will be treated as either ordinary income or net capital gain. Tax will be assessed at regular marginal tax rates for ordinary income and the more beneficial long-term capital gain rates on the net capital gain. The taxpayer will not incur any additional interest charge.
QEF income must be calculated every year. Ordinary income and capital gains are calculated separately and included as separate income items on the taxpayer’s tax return. The largest drawbacks are the recordkeeping, calculations, and necessity of the offshore corporation’s cooperation required in order for the taxpayer to make the QEF election.
Requirements for Making the QEF Election
The fund, as the first U.S. investor, makes the QEF election by filing Form 8621 and attaching it to a timely filed tax return. The fund discloses that it made and timely filed the QEF election to its partners. The election, once made, is binding to all U.S. taxable partners and is generally irrevocable. The QEF calculations and reporting must be done every year that the fund owns the PFIC.
PFIC Impact on U.S. Tax Exempt Investors
Tax exempt taxpayers are not subject to the PFIC rules. Fortuitously, the Treasury Department recognized that U.S. tax exempt investors should not be affected by the PFIC rules designed to curb tax deferral by U.S. taxpayers.
PFIC Annual Information Statement
The Internal Revenue regulations describe the “annual election requirements of the PFIC or intermediary” and refer to procedures the PFIC must follow, including providing a PFIC Annual Information Statement signed by the offshore corporation’s authorized representative. The Annual Information Statement must include the following information:
- The first and last days of the tax year of the PFIC to which the statement applies;
- Calculations or provision of the data necessary to allow the shareholder to calculate the shareholder’s correct income and gains under the QEF rules;
- The fair market value of any cash and property distributed to the shareholder; and
- A statement that the shareholder will be allowed to examine the offshore corporation’s books and records to establish that the income was calculated correctly.
Challenges in Calculating Income and Gains
The offshore corporation can provide the income calculations necessary to facilitate the taxpayer’s current inclusion of income for the year in one of three ways. The corporation can simply provide notice to the taxpayer that it will allowed to examine the books and records to figure out the income calculation on its own. Alternatively, the corporation can provide sufficient information to enable the taxpayer to calculate the taxpayer’s share of ordinary earnings and net capital gain. Finally, the corporation can calculate the taxpayer’s pro rata share of ordinary earnings and net capital gain and provide an Annual Information Statement.
Calculating ordinary income and gains under U.S. tax law can be challenging, as many times, the offshore corporation is a fund in a foreign country that does not levy a corporate tax, such as the Cayman Islands. Alternatively, the offshore corporation will be located in a jurisdiction with a tax and accounting system that is very different from that used for U.S. tax purposes.
Benefits to Offshore Corporation of Facilitating the QEF Election
Offshore corporations are attractive investment vehicles to a fund that wants portfolio diversity. Faced with a punitive tax regime, savvy taxpayers prefer to own PFICs where the QEF election is available and will avoid those corporations where the election is unavailable. Thus, offshore corporations should carefully consider any decision to forego QEF reporting.
A Fund looking to invest in an offshore corporation should search for a corporation that satisfies the reporting requirements associated with a QEF election. The offshore corporation should calculate the income and gains under U.S. tax law and provide the information necessary for taxpayers to include their share of income each year. To be useful, this information must be provided timely. PFICs providing QEF information will set themselves apart from those that do not.