The PFIC Rules Draw both Foreign Corporations and their Investors into the U.S. Tax System
By John Bowlby, Staff, Tax & Business Services
The end of a tax year brings with it the need to assemble records and calculate income, gains, credits, and sometimes, penalties. Usually this burden falls only on the person or entity that earns the income or gain or will use the credit. However, in one particular circumstance, this duty gets extended back to a party who really has nothing to do with the U.S. tax system at all. Foreign corporations that are not controlled foreign corporations (“CFCs”) can generally function outside the U.S. tax system. When a foreign corporation with U.S. owners has a large enough portion of passive assets or income, those U.S. owners, absent both careful planning and the aid of the foreign corporation, face a punitive tax regime. These passive foreign investment company (“PFIC”) rules are, at worst, a trap for the unwary, and at best, a burden to investors and the foreign corporations in which they invest.
Separating PFICs from CFCs
While the PFIC rules generally don’t affect U.S. shareholders of CFCs, “U.S. shareholder” in this context is a term of art and creates a very narrow exception that is conceptually tricky. When a PFIC is also a CFC, the PFIC rules do not apply, and the asset is taxed as a CFC in the hands of the “U.S. shareholder.”
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The tricky part comes from the aforementioned term of art. U.S. shareholder and PFIC shareholder are both terms that apply, on a person-by-person basis. Shares in a foreign corporation are only considered shares of a CFC to a U.S. person who is a U.S. shareholder in the CFC. A shareholder in a foreign corporation is only a U.S. shareholder of a CFC if the U.S. person owns at least 10% of the shares of the CFC. Furthermore, a foreign corporation is only a CFC if U.S. persons each owning at least 10% of the shares (the “U.S. shareholders”) together own more than 50% of the shares when their 10% interests are aggregated.
So, even if a U.S. person owns shares in a foreign corporation that is a CFC, but owns less than 10% of the total shares, the CFC rules do not apply, and that U.S. person may be subject to the PFIC rules. If enough of the corporation’s assets are passive, the foreign corporation will meet the PFIC definition, and the investor must either do some extra planning or face draconian taxation. Simply put, if a U.S. investor does not own at least 10% of a foreign corporation, or U.S. persons with 10% shares do not own more than 50% of that corporation, then the U.S. investor faces potential PFIC treatment.
Why is a Focus on PFICs Important?
Many high net worth U.S. persons have global (foreign) investment portfolios. However, to diversify their portfolios as effectively as possible, much of the invested wealth is placed in foreign funds or other foreign entities in which the U.S. person does not own 10% or more of the total shares. Very often, these foreign entities are classified as corporations pursuant to the IRS regulations. Even if a U.S. person does own more than 10% of a fund or other asset, more than 50% of the fund or asset is usually not owned by U.S. persons each owning 10% or more of the shares. The foreign fund is, therefore, not a CFC.
When dealing with pooled assets, real estate, debt issuances, and managed funds, the assets and income are considered almost exclusively passive. If these foreign funds have mostly passive assets and are not CFCs, then they are most likely PFICs.
The Three PFIC Taxation Regimes and Advantages of the Qualified Electing Fund Regime
PFICs are taxed one of three ways, with each method having some advantages and some disadvantages. For most taxpayers, the Qualified Electing Fund (“QEF”) regime is the least burdensome and is the primary focus of this article.
Absent any elections to tax a PFIC as a QEF or under the mark-to-market (“MTM”) rules, PFICs are taxed under the default regime. Under the default regime, tax is usually not due in any year in which there is not a sale or a distribution. In years in which tax is due, the punitive default rules impose a penalty and also require some of the more extensive calculations under the tax code, which means high accounting costs. PFIC income is taxed at maximum ordinary income rates, and capital gain treatment is unavailable. In all but the rarest of circumstances, the default regime is the most punitive option.
If PFIC stock is marketable (traded on a public exchange), then an election can be made to calculate income on a yearly basis, based on the annual change in market value. Any gain is treated as ordinary income. However, any losses in subsequent years are, to the extent of previous years’ gains, treated as ordinary losses. There is no penalty, and the income is taxed at marginal tax rates. Accurate records need to be maintained year-to-year to calculate accurate gains and losses. Although subject to some limits and yearly effort, the MTM method is usually better than the default method. As long as the U.S. person has the cash necessary to pay the tax every year, MTM is a good option. Even if cash is short, there is no penalty for selling PFIC shares that have been marked-to-market if liquidation is necessary to cover tax expense.
Most U.S. investors in PFICs will achieve the best tax results by electing QEF treatment. Income is included currently when making this election. Similar to MTM, ordinary income is taxed at marginal tax rates and is not subject to a penalty. However, unlike MTM, capital gain treatment is available on at least a portion of the PFIC income, and the PFIC stock does not need to be traded on an established securities market like it does for MTM.
QEF income must be calculated every year, and tax must be paid on the income. Ordinary income and capital gains are calculated separately and included as separate income items on the U.S. person’s tax return. Although tax must be paid annually, there is no penalty for selling the QEF if an investor needs cash to cover tax expense. The largest drawbacks are the recordkeeping, calculations, and participation of the foreign corporation that are required to make the QEF election and calculate income.
Demands on U.S. Persons Making the QEF Election
What does this all mean for U.S. persons investing in PFICs? The investor makes the QEF election by filing Form 8621 and attaching it to a timely filed tax return. The election, once made, is generally irrevocable, so the QEF calculations and reporting must be done every year that the U.S. person owns the PFIC. In the long run, the annual reporting makes the investor’s work less difficult, and certainly less expensive, that it would be without the QEF election.
Although the investor is charged with income inclusion under IRC §1295, in practice, most of the income calculation work for the QEF should be done by the foreign corporation. This is because in order for the U.S. investor to make the QEF election in the first place, the foreign corporation must issue a PFIC Annual Information Statement (discussed below) to the investor. The only alternatives available for the foreign corporation are to not issue the statement, thereby eliminating the U.S. investor’s ability to make the QEF election, or to require every QEF-electing U.S. investor to examine the foreign corporation’s books and records and independently determine their own shares of income and gain. It is easy to see how messy, and costly, this “to each his own” method would become.
QEF Reporting and Income Calculation Burden on Foreign Corporations
Non-CFC foreign corporations traditionally do not have a direct participatory role in the U.S. tax system. Conversely, U.S. taxpayers are taxed on their worldwide income, regardless of where the asset is located or where the income is earned. CFCs are majority owned by U.S. persons, and as such, there is some logic in subjecting them to the Internal Revenue Code. Reasoning forward from the spirit of the U.S. tax code, it is more difficult to justify the use of the tax code to compel a foreign corporation to take some action in a circumstance where U.S. persons might own just one of a foreign corporation’s million outstanding shares. The PFIC rules provide for this absurd treatment. Under the QEF rules, the regulations actually impose requirements on this type of foreign corporation. The Internal Revenue regulations describe the “annual election requirements of the PFIC or intermediary” and refer to procedures the PFIC must follow which includes providing a PFIC Annual Information Statement signed by the foreign 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 of, 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 foreign corporation’s books and records to establish that the income was calculated correctly.
Challenges to the Foreign Corporation’s Privacy
The annual statement requirements are structured this way to align incentives the way the IRS wants them. The foreign corporation has to agree to open its books and records to the shareholder, and since the statement is signed by the corporation’s representative, the shareholder can look at the books and records at any time. This scenario allows the IRS to incentivize the shareholder to obtain evidence supporting the income calculation while incentivizing the foreign corporation to produce the evidence by establishing privity of contract between the corporation and the shareholder. If any of these requirements go unsatisfied, then the shareholder is stuck with the punitive default PFIC regime.
Challenges in Calculating Income and Gains
The foreign corporation can provide for the income calculations necessary to facilitate the shareholder’s current inclusion of income for the year in one of three ways. The corporation can simply include a statement that the shareholder was 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 shareholder to calculate the shareholder’s share of ordinary earnings and net capital gain. Finally, the corporation can calculate the shareholder’s pro rata share of ordinary earnings and net capital gain.
The regulations define “net capital gain” as used for annual PFIC statement purposes. The calculations required for annual statement purposes are made according to U.S. tax law. This should not be a burden to U.S. persons who own shares in the PFIC. After all, U.S. persons need to calculate their ordinary income and capital gains every year anyway. However, in reality, it would be very difficult for the foreign corporation to facilitate every shareholder calculating the corporation’s income and gain and apportionment of those amounts based on ownership share. A foreign corporation that supports a QEF election has to do the income and gain calculation work itself.
Many times though, the foreign corporation is a fund in a foreign country that does not have a corporate tax, such as the Bahamas, or is located in a jurisdiction with a tax and accounting system that is very different from that used for U.S. tax purposes. This jurisdictional difference is often the reason for the entity’s situs in the first place, and the absence of compliance costs is part of the investment’s benefit. QEF election facilitation tends to increase these costs, although in reality the increase should be minor. From a competitive perspective though, if the beneficial reason for the higher cost is not known to investors, then the foreign corporation ends up at a disadvantage.
Benefits to Foreign Corporation of Facilitating the QEF Election
So, why would the fund incur these extra costs and erode its own privacy? A foreign fund is an attractive investment to a U.S. investor who wants portfolio diversity. However, a shareholder of a foreign corporation with passive assets is at risk for punitive taxation under the default PFIC regime. Even though a fund’s compliance costs might be slightly higher and the fund’s privacy might be reduced, savvy U.S. investors will still prefer to hold PFICs where the QEF election is available and will avoid those funds where the election is unavailable. This realization is an opportunity for foreign investment vehicles to not only provide the necessary information, but to also market themselves as providing a tax-saving service to their investors. The increased compliance costs and paperwork at tax time should be seen as a competitive advantage, rather than a disadvantage.
Maximizing the Value of the QEF Option
What can foreign corporations do to make the QEF process go well for investors, position themselves as more attractive investments, and protect their investors from IRS problems?
Doing the calculations necessary to provide pro rata shares of ordinary income and net capital gain is the most important step a foreign corporation can take to facilitate the QEF election and thus. investment by U.S. persons. The specific types of assets held in PFICs require the most difficult and detailed accounting and tax treatment. Passive assets in particular receive special treatment under the U.S. tax rules.
Engaging a specialist who can do the accounting and prepare the tax statements will serve the foreign corporation in two ways. First, the work will be done correctly in accordance with applicable accounting standards and tax law. Second, the foreign corporation will be able to market its association with experts as a source of additional value to prospective investors.
A foreign fund or corporation that can market itself as a QEF and back that statement up with the right relationships and a knowledge base for investors will position itself as a premier investment vehicle in a tax environment that is otherwise hostile to U.S. investment.
A U.S. person looking to invest in a foreign fund should search for a fund that satisfies the reporting requirements associated with a QEF election. The fund should provide the information necessary for shareholders to include their shares of income currently. The foreign corporation must provide the information timely, since late is the same as not at all. If an investor decides to forgo the QEF election and instead defers tax under the default regime, or the corporation is traded on an exchange and mark-to-market taxation is an option, those choices can be made. The QEF election is always a valuable option, can usually be made late, and should always be made available to investors.
As the world becomes smaller, U.S. investors will continue to invest globally. PFICs may continue to be a valuable part of a diversified portfolio, in spite of all the trouble they can create. A foreign fund operator or foreign corporate executive should always provide the information necessary to make the QEF election. The reporting requirements must be satisfied in one of the ways available under the Internal Revenue Code, and income and gains must be calculated according to U.S. tax law. For savvy investors, PFICs providing QEF information will set themselves apart from those that do not. Furthermore, among the corporations that facilitate the QEF election, information about which specialist carries out income and gain calculations and how that income and gain are calculated will set those PFICs apart.