When investing in a business overseas, expats should be wary of the passive foreign investment company (“PFIC”) rules, which trigger heightened reporting requirements and can have onerous tax implications.
Under the PFIC default rules (the Section 1291 rules), every U.S. person who owns any percentage of stock in a PFIC, directly or in some cases indirectly, is required to pay, as additional U.S. federal income tax, an amount computed as an interest charge on the deemed deferred tax liability attributable to any distributions made, or any gain recognized, on such stock. Any gain on the disposition of such stock will be treated as ordinary income.
The adverse effects of PFIC classification can be ameliorated if the shareholder elects “qualified electing fund” status under Section 1295 of the Code (the “QEF regime”) or makes a mark-to-market election under Section 1296 (the “MTM regime,” which is applicable only to publicly-traded PFIC stock) for the first taxable year of the foreign corporation in which the U.S. person held the stock or was deemed to hold the stock and in which the foreign corporation was a PFIC.
The QEF Election
The QEF regime is elective on the part of the U.S. shareholder. Where a QEF election is in effect, the U.S. shareholder, rather than being subject to the onerous default rules of Section 1291, is treated as receiving an annual distribution of his or her pro rata share of the PFIC’s ordinary earnings and net capital gain.
For each year of the PFIC ending in a tax year of a shareholder to which the QEF election applies, the PFIC must provide the shareholders with a PFIC Annual Information Statement, which is described in the Form 8621 instructions. The statement must contain certain information, including:
- The shareholder’s pro rata share of the PFIC’s ordinary earnings and net capital gain for that tax year, or
- Sufficient information to enable the shareholder to calculate its pro rata share of the PFIC’s ordinary earnings and net capital gain for that tax year.
A QEF election may be made for any taxable year of the U.S. shareholder at any time on or before the due date (including extensions) for filing the shareholder’s tax return for the taxable year for which the election is made.
Other Aspects of the QEF Election
Importantly, a foreign corporation that is controlled by U.S. persons, and thereby has the status of a controlled foreign corporation (“CFC”), is not treated as a PFIC with respect to the CFC’s 10% U.S. shareholders. Rather, such shareholders are subject to separate anti-deferral rules and reporting requirements under the CFC regime.
Therefore, typically, a situation that involves partial ownership is when PFIC classification has greater relevance.
The IRS has ruled (See PLR 9007014) that if a U.S. person owns a QEF that owns a PFIC, a distribution from the lower-tier PFIC to the QEF, or a disposition by the QEF of the lower-tier PFIC, should not implicate the default Section 1291 rule, but only if the lower-tier PFIC has also made a QEF election.
It should be noted that the benefits of qualified dividend income (i.e., tax at capital gains rates) are disallowed with respect to any foreign corporation that is, or was during the preceding taxable year, a PFIC. The rule applies irrespective of whether a QEF election has been made by the shareholder. If the corporation constitutes a PFIC under the asset test or income test for the year, even if treated as a QEF, dividends will not constitute QDI even though gain from the sale of shares would be capital gains.
Making a Retroactive QEF Election
There are two main regimes for filing a retroactive QEF election - the protective statement regime and the consent regime.
Under the protective statement regime, a retroactive election can be made if it is determined in a later year that a foreign corporation was a PFIC and if a protective statement is filed before the due date for filing the shareholder’s tax return for the taxable year for which the retroactive election will apply.
As a general rule, to make the election, a shareholder must have possessed a reasonable belief, as of the time the election was originally due, that the corporation was not a PFIC, and must describe the basis for its belief in the protective statement.
Reasonable belief may be based on a variety of factors, including reasonable asset valuations as well as reasonable interpretations of the applicable provisions of the Code, regulations, and administrative guidance regarding the direct and indirect ownership of the income or assets of the foreign corporation, the proper character of that income or those assets, and similar issues. Reasonable belief may be based on an analysis of generally available financial information of the foreign corporation. To determine whether a shareholder had reasonable belief that the foreign corporation was not a PFIC, the IRS may consider the size of the shareholder’s interest in the foreign corporation.
Under the consent regime, a shareholder that has not satisfied the requirements of the protective statement regime may request that the IRS permit a retroactive election. The consent regime applies only if:
- The shareholder reasonably relied on tax advice of a competent and qualified tax professional;
- The interest of the U.S. Government will not be prejudiced if the consent is granted;
- The shareholder requests consent before the PFIC status issue is raised on audit; and
- The shareholder satisfies certain additional procedural requirements.
In this regard, a shareholder is generally deemed to have reasonably relied on a qualified tax professional only if the shareholder reasonably relied on a qualified tax professional (including a tax professional employed by the shareholder) who failed to identify the foreign corporation as a PFIC or failed to advise the shareholder of the consequences of making, or failing to make, the QEF election.