(This is a continuation from the article posted yesterday. Click here to read it.)

Ok, it is PFIC. So what?

In 1986, Congress added the PFIC rules to the Internal Revenue Code because of concerns that American taxpayers investing in passive assets indirectly through a foreign investment company have an inappropriate tax benefit compared to direct investments in these assets. The purpose of the PFIC rules was to eliminate this advantage. PFIC include mutual funds based abroad. Most American investors in PFICs must pay taxes on distributions and the value of appreciated stock, regardless of whether the tax rate on capital gains would normally apply. PFIC are subject to complex and strict fiscal guidelines set forth in sections 1291 through 1297 of the Internal Revenue Code. These strict guidelines are in place to discourage the ownership of PFIC and mutual funds in particular foreigners by American investors. In fact, the rules are clearly intended to deter investors from the United States to use a foreign company as an investment fund.

The different regime for the taxation of PFICs

Excess distribution (section 1291 of the Internal Revenue Code):

• This is the default regime – this is the one which will be applied to those taxpayers who do not make an election to be taxed under another regime. It also happens to be the most punitive in most cases.
• Losses disallowed – “Buy low, sell high!”  How hard can that be?
• Default if no election made
• Any excess distribution (over 125% of the prior 3 years, but in the case of a capital gain of a security which didn’t previously pay dividend/interest, it would be the whole capital gain) will be taxed at top marginal tax rates (39.6%)
• If holding period covers several years, the excess distribution would be allocated over several years and interest and failure to pay penalties would be added to the tax liability
• This is reported as another tax on the 1040 meaning that the personal exemption/ itemized deduction or any other mechanism to reduce tax usually available is not available here. Only relief: one can claim a foreign tax credit on the form 8621 BUT this credit can only be applied on the tax itself, not on the interest/failure to pay penalty
• Information needed: Purchase date, cost, cash flows occurring since purchase date (including disposition price). A typical T3 only shows income for the year.

Under the excess distribution regime, distributions in excess of 125% of the average distributions of the past three years will be taxed. So, if you have a security which does not pay a dividend or interest, the 125% will be zero, hence the total capital gain will be taxed. How will it be taxed? 1) At the maximum marginal rate (currently 39.6%) 2) Allocated to prior periods with interest applied.

An excess distribution is treated as if it has been realized pro rata over the holding period for the PFIC’s stock.

With that in mind, the effect of a pro rata realization of an excess distribution becomes painfully obvious: the tax due on such a distribution is the sum of deferred yearly tax amounts plus interest.  But the worst is yet to come.  And that is that the sum of the deferred yearly tax amounts is calculated using the highest tax rate in effect in the years that the income was accumulated.

Very simply, this method unilaterally eviscerates the benefits of deferral by assessing an interest charge on the deferred yearly tax amounts.  While there is no silver-lining, taxpayers can take some comfort in the fact that they can claim a direct foreign tax credit with respect to any withholding taxes imposed on PFIC distributions.

Mark-to-Market:

• Taxpayer would simply record as capital gain/loss the unrealized portion of capital gains/loss due to fluctuation of value of the PFIC. This is the alternative that makes the most sense. While one can not record a capital loss (below basis), it is possible to reverse prior year capital gains.
• Requires an election to be made on first year of holding the PFIC. And only available for securities traded on an exchange.
• Change in FMV is taxed as other income on 1040. Lower tax rate for LT capital gain/ qualified dividend not available but personal exemption/ itemized deduction can offset the tax.
• Losses disallowed, except to offset earlier/later years mark-to-market gains
• Information needed: FMV at the beginning and end of the year but again only available for securities traded on an exchange.

A QEF election – most advantageous:

• Direct U.S. investors can make a QEF election and report the realized income attributable to PFIC shares, which most U.S. investors do. The fund must provide an annual statement to shareholders, reporting their share of income (in U.S. dollars) based up on their ownership of shares of stock.
• Income from a QEF is classified as ordinary or long-term capital gain. While losses may not be deducted currently, short-term gains are included in ordinary income. QEF election is made on Form 8621 and is binding for subsequent tax years.
• Requires an election to be made on first year of holding the PFIC – and enough info to actually report it.
• A shareholder of a QEF must annually include in gross income as ordinary income its pro rata share of the ordinary earnings and as long-term capital gain its pro rata share of the net capital gain of the QEF.
• Doesn’t sound like much, but it means that the amounts will be on the 1040, taxed at regular rates (including lower rate for LT capital gains). The idea being that taxation would be similar to the one of a US mutual fund.
• Only 2 firms in Canada provide the info to compute it (Mackenzie  & Fidelity)
• Information needed: Prorata share of earnings using US concepts