Tax Management Portfolio No. 6300, PFICs, discusses the passive foreign investment company (PFIC) provisions. These provisions attempt to deny the benefit of tax deferral to U.S. persons who invest in PFICs, i.e., foreign corporations that generate primarily passive income but whose investors are not subject to the anti-deferral rules for controlled foreign corporations (CFCs).
A foreign corporation is a PFIC if it satisfies either of two tests — an income test or an asset test. Under the income test, a foreign corporation is a PFIC if 75% or more of its gross income is passive income. Under the asset test, a foreign corporation is a PFIC if 50% or more of the average value of its assets consists of assets that would produce passive income. For purposes of both tests, certain look-through rules apply.
There are three possible taxation regimes under the PFIC provisions — the “default” regime and two elective regimes. Under the excess distribution regime, which is the default regime, an interest charge is imposed on the U.S. tax on excess distributions from a PFIC. Under the qualified electing fund (QEF) regime, a U.S. shareholder is taxed on its share of the QEF's ordinary income and net capital gains annually. Under the mark-to-market election, which is available only where PFIC stock is marketable, the U.S. shareholder marks its stock to market on an annual basis.
If the U.S. shareholder fails to elect the QEF regime or the mark-to-market regime in the first year PFIC stock is held, but subsequently elects one of those regimes, both the interest charge regime and the elective regime may apply simultaneously unless the investor “purges the PFIC taint.” This may be accomplished by making a deemed sale election, or if the PFIC is a CFC, by making a deemed dividend election to treat all earnings and profits earned during the period of PFIC status (while the investor held the stock) as an excess distribution.
This portfolio may be cited as Blanchard, 6300 T.M., PFICs.
Kimberly S. Blanchard, Esq.
Kimberly S. Blanchard, Esq., B.A., Dartmouth College (1976); M.S., University of Wisconsin (1978); J.D., New York University School of Law (1981); Partner, Weil, Gotshal & Manges LLP; member: Tax Management International Journal's Panel of Leading International Tax Practitioners, Bloomberg BNA Tax Management's U.S. International Advisory Board, Tax Section of the New York State Bar Association (former Chair), American Bar Association's international tax committees, Bar of the State of New York, U.S. Tax Court; Fellow, American College of Tax Counsel. This Portfolio is a revision of 923-2nd T.M., which was written by Thomas A. O'Donnell, Esq., Baker & McKenzie, Zurich, Switzerland, and Ozzie A. Schindler, Esq., Greenberg Traurig, Miami, Florida.
Table of Contents
Detailed Analysis I. Introduction A. Background Note on the Organization of the PFIC Provisions B. Organization of the Portfolio II. Overview of the PFIC Rules A. Background 1. Purpose of the PFIC Rules 2. Legislative History of the PFIC Provisions B. Consequences of PFIC Status C. Determination of PFIC Status D. Shareholder-Specific PFIC Determinations E. Taxation Under the PFIC Provisions 1. Excess Distribution Regime 2. QEF Regime 3. MTM Regime 4. Net Investment Income Tax F. Purging the PFIC Taint G. Ineligibility for Special Dividend Tax Rate H. Overlap with Other Anti-Abuse Regimes I. Reporting Rules III. Determining PFIC Status — §1297 A. Overview B. Income Test 1. Definition of Gross Income 2. Definition of Passive Income 3. Active Banking Exception a. U.S. Licensed Banks b. Banks Not Licensed in the United States (1) Banking Activity Test/Banking Business (2) Gross Income Test (3) Licensing Requirement c. Qualified Affiliates d. Income Treated as Active e. Other Foreign Corporations 4. Insurance Income Exception a. Application Of Insurance Income Exception Before 2018 b. Application Of Insurance Income Exception After 2017 C. Asset Test 1. In General 2. Characterization of Assets a. General Rule b. Depreciable Property Used in a Trade or Business c. Trade or Service Receivables d. Intangible Assets e. Stock and Securities f. Tax-Exempt Assets g. Working Capital — The Treatment of Cash 3. Adjusted Basis Versus Fair Market Value 4. Special Rules for Measuring Assets a. Leased Property — §1298(d) b. Capitalization of R&D D. Look-Through Rules 1. The 25% Subsidiary Look-Through Rule 2. Related Person Look-Through Rule 3. Domestic Corporation Look-Through Rule 4. Classification of Income and Assets in Respect of Partnership Interests and Trusts E. Exceptions to PFIC Classification 1. Start-Up Year Exception 2. Change of Business Exception 3. Active Securities Dealer Exception — Repealed 4. Foreign Trade Exception 5. Tax-Exempt Holders 6. Exception for U.S. Shareholders of CFCs a. In General b. Overlap Period F. Unexpected PFIC Status 1. Start-Up Businesses 2. Companies with One-Time Capital Infusions 3. Sales and Service Companies 4. Manufacturing Companies with Losses 5. Leasing Companies IV. Indirect Ownership and Attribution Rules — §1298(a) A. In General B. Corporations C. Partnerships, S Corporations, and Estates D. Trusts 1. Grantor Trusts 2. “Proportionate” Ownership Through Nongrantor Trusts a. Indirect Ownership Generally b. Overlap of Indirect Ownership Through Foreign Nongrantor Trusts and Accumulation Distribution Rules E. Options F. Successive Application G. Status Changes Under the Consolidated Return Rules 1. Overview of Consolidated Return Rules 2. QEF Issues 3. Section 1291 Issues V. Excess Distribution Regime — §1291 A. Overview B. Definition and Amount of Excess Distribution 1. Distributions Generally a. Definition of “Distribution” b. Timing of Distributions c. Determining the Amount of an Excess Distribution 2. Indirect Distributions a. Definitional Issues b. Basis Adjustments 3. Dispositions a. In General b. Pledge Rule c. Installment Sales d. Ceasing to Be a U.S. Person 4. Indirect Dispositions a. Definitional Issues b. Taxation of Indirect Distributions c. Basis d. Phantom Gain Problems C. Operating Rules for Excess Distributions 1. Allocation of Excess Distributions to Holding Period 2. Holding Period Rules a. In General b. Becoming a U.S. Resident for the First Time c. Tacked Holding Periods 3. Foreign Currency 4. Shares Purchased on Different Dates 5. Reduction of E&P 6. Section 453A(c) Interest D. Taxation of Excess Distributions 1. In General 2. Determining the Deferred Tax Amount a. Step 1 — Aggregate Increase in Taxes b. Step 2 — Aggregate Amount of Interest on Increases in Taxes c. Step 3 — Deferred Tax Amount E. Application to Foreign Nongrantor Trusts F. Foreign Tax Credit for Excess Distributions 1. Overview 2. Procedure for Determining the Foreign Tax Credit 3. Other Aspects of the Foreign Tax Credit Rules for Excess Distributions G. Nonrecognition Transfers 1. General Rule: Recognition of Gain 2. Basis and Holding Period 3. Exceptions to Gain Recognition a. Exception for Transfers of PFIC Stock for PFIC Stock b. Exceptions for Transfers to U.S. Persons c. Exceptions for Transfers Involving Pass-Through Entities d. Transfers to Nonresident Alien Spouses Filing Joint Returns 4. Boot Received in a Nonrecognition Exchange 5. Coordination with §367(b) 6. Information Reporting Requirements 7. Effective Date Issues H. Treatment of Transfers Upon Death 1. Taxable Dispositions and Exceptions 2. Basis of Inherited PFIC Shares a. Law Prior to 2001 b. The Economic Growth and Tax Relief Reconciliation Act c. Decedents Dying During 2010 d. Summary and Going Forward I. Transfers by Gift J. Special Rules 1. Pooled Income Funds 2. Charitable Deductions for Trusts 3. Special Rules for Regulated Investment Companies 4. Section 1411 5. Offshore Voluntary Disclosure Program K. Tiered PFICs 1. MTM Issues 2. Intervening QEFs 3. Distributions Through PFICs VI. Electing QEF Treatment — §1295 A. Overview B. Election Requirements 1. Who May Make the QEF Election 2. What the Foreign Corporation Must Do C. Time for Making Election 1. In General 2. Retroactive Elections D. Manner of Making the Election 1. In General 2. Annual Election Requirements 3. PFIC Annual Information Statement 4. Annual Intermediary Statement 5. Combined Statements E. Revocation, Termination, or Invalidation of QEF Election 1. In General 2. Termination by MTM Election 3. Revocation with IRS Consent 4. Failure to Satisfy Compliance Obligations F. Effect of Changes in Stock Ownership on QEF Election VII. Income Inclusions Under the QEF Regime — §1293 A. Current Inclusion Rules 1. Ordinary Earnings a. E&P in General b. Other Adjustments to E&P (1) Distributions of Previously Included Earnings (2) Section 78 Gross-Up (3) Foreign-to-Foreign §332 Liquidations c. Tax-Exempt Interest Income 2. Net Capital Gains 3. Pro Rata Share B. Actual Distributions from a QEF 1. In General 2. Foreign Currency Gains and Losses on Distribution of Previously Included Earnings C. Basis Adjustments 1. In General 2. Adjustment for Deemed Distributions on Loan to Investor D. Prevention of Double Taxation E. Foreign Tax Credit 1. Source of QEF Inclusions 2. Characterization of QEF Inclusions Under §904(d) F. Gains on Disposition of QEF Stock G. Treatment of Current Losses H. Proposed Special QEF Election for Preferred Shareholders 1. Making the Special Election 2. Annual Inclusion Rules for Electing Shareholders VIII. Election to Defer Payment of Tax on Undistributed QEF Inclusions — §1294 A. In General B. Undistributed PFIC Earnings Tax Liability C. Termination of Deferral 1. Transfers of PFIC Stock a. In General b. Exception for Nonrecognition Transfers 2. Revocation of QEF Election or Termination of PFIC Status 3. Failure to Comply 4. Jeopardy 5. Direct or Indirect Loan to the Investor D. Procedural Matters 1. Making the Election 2. Suspension of Statute of Limitations 3. Annual Reporting Requirement IX. Mark-to-Market Election to Include Gain or Loss from Publicly Traded PFIC Stock — §1296 A. In General B. Who Can Make the Election 1. Indirect Ownership 2. Marketable PFIC Stock Held by a CFC 3. Election Requirements C. Marketable Stock 1. Regularly Traded on a Qualified Exchange or Other Market 2. Other PFIC Stock Not Regularly Traded 3. Options on Marketable PFIC Stock D. Taxation of U.S. Shareholders 1. In General 2. Unreversed Inclusions 3. Basis Adjustments 4. Character of Mark-to-Market Gain and Holding Period 5. Source of Mark-to-Market Gain 6. Termination or Suspension of PFIC Status E. Unpedigreed Funds F. Special Rules Applicable to PFIC Stock Held by a RIC G. Stock Acquired from a Decedent H. Coordination with Other Mark-to-Market Regimes I. Coordination with QEF Election 1. Termination of QEF Election 2. Special Rule for Re-Electing QEF Status After Termination Due to Mark-to-Market Election X. Purging the PFIC Taint A. “Once a PFIC, Always a PFIC” 1. In General 2. Simultaneous Application of Both the Excess Distribution and QEF Rules — The Case of the Unpedigreed QEF B. You Realize Too Late That You (May) Own Shares in a PFIC: What Do You Do Now? 1. The Problem 2. The Solution — Purging Elections a. When to Consider a Purging Election b. Who Can Make a Purging Election c. Forms of Purging Elections 3. The Regular Deemed Sale Election for a Foreign Corporation that Remains a PFIC — Reg. §1.1291-10 4. The Deemed Sale Election for a Foreign Corporation that Is No Longer a PFIC — Reg. §1.1298-3 5. The Regular Deemed Dividend Election for a CFC that Remains a PFIC — Reg. §1.1291-9 6. The Deemed Dividend Election that Applies for a CFC that Is No Longer a PFIC — Reg. §1.1298-3 7. The Deemed Sale and Deemed Dividend Elections for CFC Inclusion Shareholders — Reg. §1.1297-3 8. Late Purging Elections XI. Information Reporting Requirements A. Rules in Effect Prior to March 18, 2010 B. Rules in Effect Since March 18, 2010 — §1298(f) C. Foreign Financial Asset Reporting — §6038D D. FBAR E. Form 5471 XII. State and Local Considerations XIII. Some Suggestions for Improving the PFIC Rules A. Allow Use of Audited Financial Statements B. Make the QEF Election More User-Friendly C. Expand the Scope of the MTM Election D. Define PFIC Narrowly, and Put the Burden of Proof on the IRS to Apply the Definition More Expansively 1. Treat Working Capital as an Active Asset 2. Issue Guidance on How to Apply §954(c) Where Purposes of Subpart F and PFIC Rules Differ E. Consider Election Out of the PFIC Rules Into the CFC Rules, or Vice Versa F. Options G. Coordinate §1291 Excess Distribution Rules with Accumulation Distribution Rules Applicable to Foreign Nongrantor Trusts
Table of Worksheets Worksheet 1 1986 Tax Reform Act Conference Report Worksheet 2 1986 Blue Book (General Explanation of the Tax Reform Act of 1986) Worksheet 3 1988 TAMRA House Report Worksheet 4 1988 TAMRA Conference Report Worksheet 5 1997 Blue Book (General Explanation of Tax Legislation Enacted in 1997) Worksheet 6 Sample PFIC Annual Information Statement Worksheet 7 Sample §1291 Tax Calculation
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