The PFIC regime was not introduced until 1986. Prior to 1986, U.S. taxation of foreign corporations was strictly tied to control of the corporation held by U.S. persons. This allowed not only the foreign mutual fund to avoid U.S. taxation, but also U.S. persons who invested in the fund. How so?
For starters, the fund itself avoided U.S. taxation because it was a foreign corporation that derived only foreign-source income. The fund was able to avoid the taint of being classified as a controlled foreign corporation, or “CFC” because it was owned by a large number of U.S. and foreign investors, each of whom owned a relatively small percentage.
U.S. investors avoided U.S. taxation in two primary ways. First, the fund paid no dividends. And second, when U.S. investors eventually did realize the fund’s earnings through the sale of stock, they were able to convert the fund’s ordinary income – i.e., dividends and interest – into capital gains.
The enactment in 1986 of the passive foreign investment company (or “PFIC”) changed all of that. For starters, it significantly expanded the reach of U.S. taxing authorities with respect to passive investment income earned by U.S. persons through foreign corporations. An important feature of PFIC taxation is that it applies without regard to the extent of U.S. ownership.
The taxation of PFICs is built on the idea of denying to United States persons – and hence capturing for the U.S. Treasury – the value of deferral of U.S. taxation on all passive investments channeled through foreign entities. The rules achieve this end in one of two ways: first, by directly taxing U.S. investors in PFICs, and second, by indirectly imposing an interest charge on the deferred distributions and gains of these investors.
Two central elements form the basis of PFIC taxation: (1) the definition of a PFIC and (2) the tax regime imposed on U.S. owners of shares. A PFIC is defined as an entity that receives mainly passive investment income or holds mainly passive investment assets.
U.S. shareholders of a PFIC are subject to a special, indeed unique, income tax regime. The specifics depend on whether the shareholders of the PFIC have elected to be taxed as shareholders of a “qualified electing fund,” or whether the “pure” PFIC tax regime of section 1291 applies.
Each method is designed to eliminate the benefits of deferral. However, each differs in the way it accomplishes this objective. The qualified election fund (or “QEF” for short) is designed to ease the complexities of PFIC taxation for U.S. investors in foreign mutual funds. It accomplishes this goal by allowing shareholders the opportunity to elect to be taxed currently on their pro rata share of the PFIC’s earning and profits. The included income is treated as ordinary income to the extent of the taxpayer’s pro rata share of the QEF’s ordinary income, and capital gains to the extent of the taxpayer’s pro rata share of the QEF’s net capital gain.
To prevent double taxation of the QEF’s earnings, any actual distributions made by a QEF out of its previously taxed earnings and profits are tax-free to the investor. The shareholder’s basis is adjusted up or down to reflect amounts included or deducted pursuant to this election. For example, a U.S. investor increases his or her basis in the QEF’s stock for any income inclusions and reduces his or her basis in the stock upon receipt of distributions of previously taxed income.
A taxpayer who does not make a QEF election is taxed under the pure PFIC tax regime of Section 1291. Under this regime, taxpayers are permitted to defer taxation of a PFIC’s undistributed income until the PFIC makes an excess distribution. An excess distribution includes the following:
i. A gain realized on the sale of PFIC stock, and
ii. Any actual distribution made by the PFIC, but only to the extent that the total actual distributions received for the year exceed 125% of the average actual distribution received in the preceding three taxable years (or, if shorter, the taxpayer’s holding period before the current taxable year).
Section 1291 very roughly negates the tax benefit of deferral. Taking a “big picture” view makes it easier to understand how PFIC taxation undoes this advantage. First, the economic value of deferral of U.S. taxation is the time value of the deferral itself. And second, PFIC taxation takes back the time value of deferral through the deferred tax amount.
Critical to understanding how PFIC taxation takes back the time value of deferral through the deferred tax amount is the treatment of excess distributions. 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.
A question that comes up frequently is what happens if any of the distributions fall below the 125% threshold? Such distributions are treated as dividends (assuming they represent a distribution of earnings and profits), which are taxable in the year of receipt and are not subject to the special interest charge.
An example will help illustrate how Section 1291 operates. Fred is a U.S. citizen who invests in mutual funds. On the advice of his broker, on January 1, 2006, he buys 1% of FORmut, a mutual fund incorporated in a tax-haven entity. Because FORmut only earns passive income on passive assets, it is a PFIC.
Not having any knowledge of international tax or the PFIC rules, Fred and his accountant fail to make a QEF election. During 2006, 2007, and 2008, FORmut accumulates earnings and profits of $ 30 million (USD). On December 31, 2008, FORmut pays Fred a dividend of $ 300,000 (USD).
Because Fred never made a QEF election and because FORmut never paid a dividend to Fred, Fred must “throw-back” the entire $ 300,000 dividend received over the entire period that he owned the FORmut shares: $ 100,000 to 2006, $ 100,000 to 2007, and $ 100,000 to 2008. For each of these years, Fred will pay tax on the thrown-back dividend at the highest rate in effect that year with interest.
As far as filing requirements go, a U.S. person must file annually a separate Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, for each PFIC for which the taxpayer was a shareholder during the taxable year. You owned an interest in three PFICs in tax year 2011: (1) SCBLT1, (2) RMFR4, and (3) SCBSET. Therefore, you had an obligation to file Form 8621 for each one. But you didn’t.
What are the consequences of failing to file Form 8621? Section 1298(f) and the regulations do not impose a specific penalty for failing to file Form 8621. However, the regulations coordinate the Form 8621 filing requirements with the Form 8938, Statement of Specified Foreign Financial Assets, filing requirements.
Here’s how it works. Under Section 6038D, a U.S. individual must disclose any directly held foreign financial assets on Form 8938 if the aggregate value of the individual’s foreign financial assets exceeds a certain filing threshold. An exception to this requirement applies to any foreign financial asset the individual reports on another disclosure form, such as Form 8621.
A U.S. individual shareholder who fails to disclose a directly held PFIC investment on either Form 8621 or Form 8938 can be subject to a $ 10,000 penalty under Section 6038D(d). In addition, failure to file a required Form 8621 can result in suspension of the statute of limitations with respect to the shareholder’s entire tax return until Form 8621 is filed.
This means that the IRS could potentially have an unlimited amount of time to audit a U.S. shareholder’s tax return and assess tax if the shareholder fails to file Form 8621. However, this comes with an important caveat. To the extent that the shareholder has reasonable cause for failing to file Form 8621 (i.e., a defense), the statute of limitations is suspended only with respect to unreported PFIC investments and not to any unrelated portions of the shareholder’s tax return.