In an article I recently submitted to Business Entities (WG&L), Mar/Apr 2014, in which I serve as the (outside) Editor-in-Chief, I discussed the stock ownership and filing requirements for a passive foreign investment company or “PFIC” under recently issued regulations to §1298(f). These regulations provide guidance on reporting requirements for U.S. taxpayers owning interests in PFICs. The regulations were welcome but concerns were expressed that the Service left many or at least several important questions unanswered, including the treatment of tax-exempt organizations under the interest charge method.
Approximately three years following enactment of the filing requirement for shareholders in passive foreign investment companies (PFICs) in § 1298(f), the Service issued regulations in 1992 requiring direct and indirect U.S. holders of PFIC shares to annually file Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.” However, this information return requirement was never finalized. In the interim period between 1992 and 2013, the Service issued final regulations on PFIC purging elections, deemed sale elections, mark-to-market (MTM) elections, and qualified electing fund (QEF) elections.
In TD 9650, the Service issued immediately effective in 2013, temporary (and final) regulations to be used as guidance in determining PFIC ownership and filing requirements. The regulations further clarify an exception to ]the requirement that some shareholders of certain foreign corporations (CFCs) file Form 5471, “Information Return of U.S. Persons with Respect to Certain Foreign Corporations.” Guidance is provided in proposed regulations on determining ownership of a PFIC, and annual filing responsibilities. The regulations to §1298(f) attempt to avoid duplicative information return filings for U.S. shareholders of PFICs and to provide better guidance on determining indirect ownership. Additional regulations were issued on PFICs (definitional rules) in December 2013.
Ok; What are PFICs?
The PFIC provisions were enacted into law as part of TRA ’86. Under §1297(a), a PFIC is a foreign corporation that, during any tax year, has either: (1) 75 % of its gross income as passive income (per §1297(b)(1)) or (2) 50% (by value) of its assets as passive assets. Obviously, there will be overlap between the PFIC rules and the controlled foreign corporation (CFC) provisions. This would occur with respect to any tax year where a 10% U.S. shareholder meets the control test for CFC status under § 957(a), and the foreign corporation meets either one of the PFIC requirements. TRA ’97 provided that the CFC rules would, subject to a special grandfather provision, control if there was overlap. The purpose of the PFIC legislation was to limit opportunities for U.S. taxpayers to avoid taxation by making investments in foreign corporations holding passive assets. Deferral of foreign-source passive income was not the sole target of the legislation. Also at issue was the ability of such U.S. taxpayers to convert ordinary income into capital gains, by not receiving distributions of foreign passive income and later selling their stock (to generate long-term capital gains). The main regime imposed was an interest charge on such tax deferrals until the earnings were distributed to U.S. taxpayers in the form of dividends (or there was an intervening sale of stock in the PFIC). While Congress was concerned that some U.S. investors may lack access to tax records with respect to PFICs, it allowed for current reporting of income from a PFIC by special election, i.e., qualified electing fund (QEF).
General PFIC Rules
Sections 1291 through 1298 provide three separate methods or regimes for computing taxable income for PFIC shareholders: (1) The excess distribution rules under §1291. (2) The QEF rules under Section 1293. (3) The marked-to-market (“MTM”) rules under §1296.
Special terms used in the PFIC tax provisions include the “pedigreed QEF” and the “unpedigreed QEF.” A pedigreed QEF is a PFIC that has been a QEF as to a U.S. shareholder for all years during the shareholder’s holding period in the PFIC. Under §1291(d)(2), a U.S. shareholder may make a QEF (deemed sale) election as to a prior unpedigreed QEF eliminating further application of § 1291. An unpedigreed QEF is a PFIC which is a QEF for the taxpayer year but the company has not been a QEF for the years required for pedigreed qualified electing fund status and with respect to which the U.S. shareholder has not made a purging election under §1291(d)(2). Section 1291, therefore, applies to a shareholder with respect to an unpedigreed QEF.
In general, §1291 imposes a special (income) tax and interest charge with respect to the deferred taxes on a U.S. person’s share of PFIC income, when such U.S. shareholder receives an excess distribution (within the meaning of § 1291(b)) from a PFIC or recognizes gain derived from a disposition of stock in a PFIC that is treated as an excess distribution (within the meaning of §1291(a)(2)). Section 1291 imposes the PFIC interest charge on all distributions, including dividends from current or accumulated earnings and profits. In this regard, §1291 can impose tax and interest on what would otherwise be a tax-free recovery of basis under §301(c)(2).
Under §1297(e), the CFC rules will override application of the PFIC provisions, including § 1291, without regard to whether a QEF election is made with respect to its U.S. shareholders (as per §951(b)).
Dispositions of stock subject to the “§ 1291 fund” rules are subject to the interest charge provision. Indirect dispositions falling within this provision include: (1) The disposition of §1291 fund stock by a PFIC through which the U.S. shareholder owns the §1291 fund; (2) A disposition of§ 1291 fund stock by a foreign corporation that is not a PFIC where the U.S. shareholder owns, directly or indirectly, 50% or more (by value) of the foreign corporation; (3) A disposition of stock by the U.S. shareholder (or any other person) in a person through whom stock in the §1291 fund is attributable to the U.S. shareholder; and (4) A transaction which reduces a U.S. shareholder’s indirect ownership in a §1291 fund.
The 1992 proposed regulations provided for the override of certain nonrecognition provisions. For example, the exchange of PFIC stock for equivalent PFIC stock would not trigger gain recognition; and in a carryover basis transaction involving PFIC stock, the PFIC gain and holding period would carry over and avoid gain recognition. A shareholder who is subject to the QEF rules includes amounts in gross income under §1293 on the undistributed earnings of the PFIC. The election, which again is made at the shareholder level, in accordance with §1295, is irrevocable. The shareholder can, however, defer payment of the tax on his or her share of undistributed income per §1293 by electing an extension of time to pay such tax under §1294.
In 1997, Congress added an elective MTM regime for shareholders of a publicly traded PFIC. If MTM is elected, year-end “marked” gains constitute ordinary losses, “marked” losses are losses (but only to the extent of previously included gains), basis is adjusted to reflect the “marked gains and losses,” and source of income is based on the residence of the seller (e.g., sale of personal property rules) and is irremovable once made.
Section 1298 sets forth special rules applicable to shareholders of PFICs, including attribution rules that treat a U.S. person as the owner of PFIC stock that is owned by another person (other than an individual).
Comments and Suggested Changes to Rules
Following publication of the 1992 proposed regulations under §§ 1291, 1293, 1295, and 1297, the Service received numerous comments for revisions to the PFIC rules. Nearly all comments submitted seek modifications that shrink the universe of entities qualifying as PFICs and that make it easier for U.S. shareholders to make QEF elections (e.g., by allowing some shareholders to use the foreign corporation’s financial statements to both determine whether the corporation qualifies as a PFIC and to compute the holder’s pro rata share of PFIC income). Two particularly good critiques of the PFIC rules were issued by the New York State Bar Association, Section of Taxation (NYSBA Section), in May 2001 and March 2010.The NYSBA Section’s 2001 Report felt that the PFIC rules as then in place would, in some instances, cause active businesses to be illogically classified as PFICs . More particularly, the NYSBA Section recommended: (1) Providing a QEF election for shareholders and option holders of PFICs that do not have net earnings. (2) Offering a modified QEF election to option holders. (3) Specifying that liquid assets held for the reasonable needs of an active business will not constitute “passive assets.” (4) Allowing for more retroactive QEF elections. The NYSBA Section subsequently issued a report in March 2010 on making improvements to the PFIC rules through the regulatory, rulemaking process. This second report addressed various parts of the PFIC rules including their application to banking and financial institutions. as to the non-banking reforms, the report made several recommendations including that the final regulations treat working capital, if held for use in an active trade or business, as a nonpassive asset so long as the amount is reasonable.
Taxpayer Relief Act of 1997
Congress changed certain PFIC rules in TRA ’97. Section 1122(a) of TRA ’97 added the MTM regime under §1296, and §1121 of the Taxpayer Relief Act added §1297(d). Section 1297(d) provides that, in certain situations, a PFIC that is also a CFC is not treated as a PFIC with respect to certain shareholders. However,§ 1298(a)(2)(B) provides that a foreign corporation that would, but for the rules of § 1297(d), be a PFIC is treated as a PFIC with respect to its shareholders for purposes of determining whether the shareholders own an interest in any PFIC held by the foreign corporation. Nonrecognition events can be overridden by regulations to the PFIC rules in accordance with § 1291(f). Under this grant of authority, regulations issued in proposed form in 1992 pertaining to an exchange of PFIC stock resemble examples of exchanges of FIRPTA property described in §§ 897(d) and 897(e). More particularly, under Prop. Reg.§ 1.1291-6(b)(1), subject to §1297(e) (CFC override), gain realized on the exchange of PFIC stock is taxable unless the transaction qualifies for an exemption contained in the proposed regulations.
Hiring Incentives to Restore Employment Act of 2010.
In the Hiring Incentives to Restore Employment Act of 2010 (HIRE), new paragraph (f) was added to §1298 effective as of the date of the act, 3/18/2010. Section 1298(f) requires a U.S. person who owns stock in a PFIC to file an annual report with respect to his stock ownership. HIRE also amended §6501(c)(8) to extend the statute of limitations for assessment of tax for shareholders that fail to comply with the reporting requirements of §1298(f).
In Notice 2010-34 the IRS announced that further guidance would be issued for the reporting obligations under §1298(f) and, adding a change in effective dates, eliminated the filing requirement for tax years beginning before 3/18/2010.
In Notice 2011-55 the government announced that regulations would be issued under §1298(f) including a revised Form 8621 modified to reflect the reporting requirements under Section 1298(f). Notice 2011-55 suspended the §1298(f) reporting requirements until the release of the revised Form 8621 for PFIC shareholders that were not otherwise required to file Form 8621 under the then-current Instructions to Form 8621. The notice stated that PFIC shareholders with Form 8621 reporting obligations as provided in the then-current Instructions to Form 8621 were required to continue filing Form 8621 with an income tax or information return filed prior to the release of the revised Form 8621.
Notice 2011-55 further provided that following the release of revised Form 8621, PFIC shareholders for which the filing of Form 8621 had been suspended under the notice would be required to attach the form for the suspended tax year to their next required income tax or information return. The Notice also provided that a failure to furnish Form 8621 for a suspended tax year could result in the extension of the statute of limitations for such year under §6501(c)(8), and penalties could apply.
However, subsequent to issuance of Notice 2011-55, the IRS determined that it is not necessary for taxpayers to file a Form 8621 under §1298(f) for suspended tax years. Accordingly, the recently issued temporary regulations provide that PFIC shareholders are not required to file Form 8621 under §1298(f) with respect to tax years ending before 12/31/2013.
The recently (2013) issued regulations also make corresponding changes to §§ 6038 and 6046 and take into account certain statutory changes made in TAMRA and § 1146 of TRA ’97. The first statutory change relates to the requirement for persons treated as U.S. shareholders under §953(c) to file an information return under § 6046. The specifics of these changes are set forth in the temporary regulations and still others remain in proposed form. The stock ownership percentage in a PFIC requiring the filing of an annual report under Section 6046 was 5%. The newly issued temporary regulations revise Treas. Reg. §1.6046-1 to a 10% ownership threshold made under TRA ’97. Finally, these regulations revise Treas. Reg.§ 1.6046-1 to reflect the current name and form number of the information return required to be filed pursuant to Section 6046.
Specific Provisions of the Temp. Treas Reg. §1.1291-9(j)(2)(ii) contains a definition of the term pedigreed QEF that is similar to what was included in the 1992 proposed regulations. Temp. Reg. §1.1291-1T(b)(2)(ii) adopts the 1992 proposed regulations’ definition of pedigreed QEF without substantive modification. The definition of pedigreed QEF in the 1992 proposed regulations is withdrawn.
Definition of Section 1291 Fund. The 1992 proposed regulations referred to § 1291 fund as an unpedigreed QEF or a nonqualified fund. The new temporary regulations adopt the 1992 proposed regulations’ definition of §1291 funds with some modifications to reflect the enactment of the MTM rules under §1296, which occurred after the 1992 proposed regulations were published.
Under Temp. Reg. 1.1291-1T(b)(2)(v), a PFIC is a §1291 fund with respect to a shareholder unless the PFIC is a pedigreed QEF as to such shareholder, or, alternatively, if the U.S. shareholder made a MTM election under §1296. The definition of §1291 funds in the 1992 proposed regulations was withdrawn.
“Shareholder” and “Indirect Shareholder” Defined. The 1992 proposed regulations defined the terms “shareholder” and “indirect shareholder” in §1291. These definitions are cross-referenced in the definition of shareholder provided in Treas. Reg. 1.1291-9(j)(3). However Treas, Reg. 1.1295-1(j) defines shareholder for QEF purposes, and §1296(g) and Treas.Reg. §1.1296-1(e) provide a separate set of attribution rules for purposes of applying the MTM rules to U.S. persons that own an interest in a PFIC.
The temporary regulations, in general, adopt the definition of shareholder set forth in the 1992 proposed regulations. Under Temp Reg. §1.1291-1T(b)(7), the term shareholder means any U.S. person that owns stock of a PFIC directly or indirectly. A domestic partnership or an S corporation is treated as a shareholder of a PFIC only for purposes of the information reporting requirements of §§1291 and 1298, including §1298(f). The 2013 regulations provide that a domestic grantor trust is treated as a shareholder of a PFIC only for purposes of the information reporting requirement set forth at Temp. Reg.§ 1.1298-1T(b)(3)(i), which applies to domestic liquidating trusts and fixed investment trusts.T he definition of “indirect shareholder” as set forth in the 1992 proposed regulations is revised in Temp. Reg. §1.1291-1T(b)(8) defines the term indirect shareholder as a U.S. person that indirectly owns stock in a PFIC and provides rules for attributing ownership of PFIC stock through corporations, partnerships, S corporations, estates, and trusts.
The rule in the 1992 proposed regulations concerning ownership through a PFIC has been revised in Temp. Reg. 1.1291-1T(b)(8)(ii)(B) to incorporate a subsequent statutory change to §1298(a)(2)(B) which provides that § 1297(d) does not apply for purposes of determining whether a U.S. person owns a PFIC indirectly through a foreign corporation. Therefore, where a U.S. person owns stock of a PFIC that is also a CFC, notwithstanding that under §1297(d) such corporation may not be treated as a PFIC with respect to certain shareholders, the foreign corporation is treated as a PFIC with respect to the shareholder for purposes of determining whether the shareholder owns an interest in any stock of a PFIC held by the foreign corporation.
The article in Business Entities also addresses other important aspects of the 2013 regulations which are recommended for your further review. The recently issued regulations are helpful, particularly with respect to the information return requirements and applying the stock ownership test to pass-through entities. However, the guidance fails to address much of what was sought in prior comments (and criticisms) of the PFIC rules in the form of modifications, changes, and clarifications. Readers should consult the NYSBA Section’s recommendations in order to identify the rulemaking that remains to be considered and issued in this area.
IRS Notice 2014-28, 2014 IRB 990 (4/14/2014)
Last Spring the government issued guidance on §1291, and in particular, concerning the interest on tax deferral rule on PFIC stock owned by a tax exempt organization, including a qualified retirement plan or IRA. As discussed, §1291 imposes a special tax and interest charge on a U.S. person that is a shareholder of a PFIC and receives an excess distribution (within the meaning of §1291(b)) from the PFIC or recognizes gain derived from a disposition of the PFIC that is treated as an excess distribution (within the meaning of §1291(a)(2)). Section 1298(a) contains attribution rules that treat a U.S. person as the owner of PFIC stock that is owned by another person. The §1298(a) attribution rules will not apply to treat stock owned (or treated as owned) by a U.S. person as owned by any other person, except to the extent provided in regulations. Section 1298(f) provides that a U.S. person that is a shareholder of a PFIC must file an annual report containing the information required by the Secretary. Section 1298(g) provides that the Secretary shall provide such regulations as may be necessary or appropriate to carry out the purposes of §§1291 through 1298.
In Notice 2014-28, the Treasury and IRS stated their view that the application of the PFIC rules to a U.S. person treated as owning stock of a PFIC through a tax exempt organization or account described in Treas. Reg. § 1.1298-1T(c)(1) would be inconsistent with the tax policies underlying the PFIC rules and the tax provisions applicable to tax exempt organizations and accounts. For example, applying the PFIC rules to a U.S. person that is treated as a shareholder of a PFIC through the U.S. person’s ownership of an individual retirement account (IRA) described in § 408(a) that owns stock of a PFIC would be inconsistent with the principle of deferred taxation provided by IRAs. Therefore, the Treasury and Service announced it would amend the definition of shareholder in the § 1291 regulations to provide that a U.S. person that owns stock of a PFIC through a tax exempt organization or account (as described in Treas. Reg. § 1.1298-1T(c)(1)) is not treated as a shareholder of the PFIC. The regulations incorporating the guidance described in this notice will be effective for taxable years of U.S. persons that own stock of a PFIC through a tax exempt organization or account ending on or after December 31, 2013.