The Passive Foreign Investment Company (PFIC) rules are designed to prevent U.S. shareholders from escaping current taxation on certain foreign investments. A PFIC is a foreign corporation that meets a 75% passive income or 50% passive asset test.
By default, shareholders in PFICs are subject to a harsh anti-deferral regime — unless they make an election to currently include income from the PFIC. Operating under the “once a PFIC, always a PFIC” concept, shareholders continue to pay tax under the anti-deferral regime even after the corporation loses PFIC status. But for shareholders who have made an election, the PFIC rules no longer apply.
Absent an election, U.S. shareholders in a PFIC must pay a special tax, plus interest, on “excess distributions.” An excess distribution is the portion of a distribution that exceeds 125% of average distributions during the three preceding years (or, if shorter, the shareholder’s holding period). The non-excess portion is taxed as current income.
Excess distributions are treated as if they were received ratably over the holding period of the PFIC and taxed at the highest applicable rate in effect for each tax year. The shareholder pays interest as if the taxes allocated to prior years had not been remitted on time. This treatment applies regardless of whether the PFIC has any earnings. Accordingly, shareholders may be taxed on distributions that otherwise would be tax-free returns of capital.
When a shareholder disposes of PFIC stock, any gain is treated as an excess distribution. The shareholder pays interest and the gain is taxed at ordinary income rates.
Shareholders may avoid excess distribution treatment by making one of two elections for the first taxable year in which they hold PFIC shares:
1. Qualified Electing Fund (QEF). Shareholders who make a QEF election essentially treat the PFIC as a flow-through entity, reporting their pro-rata share of its ordinary earnings and net capital gain on their tax returns. To avoid double taxation, flow-through income increases a shareholder’s basis in PFIC stock, while distributions received from the PFIC, which are tax-free to the extent of previously taxed income, reduce basis.
2. Mark-to-market (MTM). Alternatively, some U.S. shareholders may be eligible for the MTM election, which is limited to publicly traded PFIC stock. This election allows shareholders to avoid the excess distribution rules by recognizing gain or loss each year based on the difference between their basis at the beginning of the year and the stock’s market value at year-end.
End of PFIC Status
When a foreign corporation ceases to be a PFIC, shareholders who made a QEF or MTM would no longer include earnings, pursuant to these elections in their income, unless the entity became a PFIC again. Thus, the elections are suspended during the time period that the entity ceases to be a PFIC.
Shareholders who did not make an election remain subject to the excess distribution rules, even after the corporation ceases to be a PFIC. The only way to remove this “PFIC taint” is to make a purging election, such as a deemed sale election. Any gain from a deemed sale is taxed as an excess distribution (loss is not recognized). Going forward, the shareholder avoids the PFIC rules unless the corporation later becomes a PFIC.
Review Your Investments
All U.S. investors should review their portfolios to see whether they own any PFIC shares. If so, they should consult with their Untracht Early tax advisor to discuss strategies for achieving the best tax results.