PFICs – The Gift That Keeps on Taxing
To get this blog started, let’s take the following situation (which is not so uncommon): A U.S. citizen living abroad holds a portfolio of foreign mutual fund investments and decides that he’d like to gift some of the investments to non-US family members.
Are there adverse U.S. tax implications for such a gift? Does income tax apply to the gift? What about the gift tax?
In this case, the answers lie mainly in the PFIC rules, which as we’ll see, continue to be underdeveloped in this area.
PFICs – A Technical Look
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.
Technically, a PFIC is a foreign corporation that has one of the following attributes: (i) At least 75% of its income is considered “passive” (e.g., interest, dividends, royalties), or (ii) At least 50% of its assets are passive-income producing assets. A U.S. person that holds any interest in a PFIC, directly or indirectly, is subject to the PFIC rules.
Speaking more practically, most foreign mutual funds fall within the definition of a PFIC. This can be the case even if such funds are held through a tax-deferred savings account (e.g., U.K. individual savings accounts (“ISAs”) and Canadian tax-free savings accounts (“TFSAs”)) or a non-qualified pension and retirement account (as is the case with most foreign pensions).
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 the “disposition” of such stock. A further adverse outcome is that any gain on the disposition of PFIC stock is treated as ordinary income. Certain elections can be made to ameliorate the harsh consequences of PFIC taxation.
Gifting PFICs – Reviewing the Authorities
The harshness of the PFIC tax regime begs the question – what exactly is considered a “disposition” for purposes of the PFIC rules? And getting back to our opening situation – is a gift considered a disposition that triggers the PFIC regime?
Interestingly, the answer to this question can’t be found in the Internal Revenue Code or the current iteration of the Treasury regulations.
Rather, the source that deals with this issue directly is a set of proposed regulations (Prop. Treas. Reg. 1.1291-6), which were introduced in 1992, but have never been finalized.
As an aside, the weight given to a proposed regulation in the eyes of the IRS depends on the type of regulation. In its Internal Revenue Manual, the IRS distinguishes between:
(1) proposed regulations that contradict final regulations already in force (which should not be relied upon),
(2) proposed regulations promulgated when there are no applicable final or temporary regulations in force and there is an express statement in the proposed regulations that taxpayers may rely on them currently (which can be relied upon), and
(3) proposed regulations promulgated when there are no applicable final or temporary regulations currently in force addressing a particular matter, but the proposed regulation is on point (which is not necessarily binding but does express the IRS Office of Chief Counsel’s position on the matter).
In this case, the proposed PFIC regulations defining the term “disposition” seem to fall in the third category (it’s also been around for a long time – since 1992) – so we believe it’s safe to assume they at least represent the IRS position on this issue.
Gifting PFICs – Income Tax Implications
Getting back to the issue at hand, do the proposed regulations define the term “disposition” to include gifts?
The answer, unfortunately for taxpayers, is yes!
Prop. Reg. Section 1.1291-6(b)(1) states: “a shareholder recognizes gain on any direct or indirect disposition of stock of a [PFIC], without regard to whether the disposition is a result of a nonrecognition transfer as defined in paragraph (a)(2) of this section.” Section (a)(2) defines non-recognition transfers to include gifts among other transactions.
As such, a gift of a PFIC does in fact trigger PFIC taxation, and for this reason gifting PFICs is generally not recommended because of the adverse PFIC implications.
Exceptions in the PFIC Proposed Regulations
To round out the income tax implications of gifting PFICs, we note that the proposed regulations describe a number of important exceptions.
Transferring PFICs will not trigger PFIC income taxation in the following scenarios:
- Gifts of PFICs to U.S. persons, unless gift tax is incurred (certain additional criteria apply as well)
- Gifts of PFICs for which a QEF election has been made
- Transfer of a PFICs (in a non-recognition transaction) in exchange for another PFIC
Gifting PFICs – Gift Tax Implications
As the PFIC proposed regulations make clear, gift tax can in fact apply to a gift of a PFIC, in addition to the income tax implications described above. Without getting too lost in the fine details, we note that the triggering of gift tax can affect the income tax implications, but in general, given the large current estate/gift lifetime exemption, this is often not an issue in practice.
In terms of applying the gift tax, it’s best thought of as acting as a backstop to the estate tax, which is a tax on the transfer of your property at death. In general, the estate tax is a tax up to the rate of 40%, which applies to all property owned by a U.S. citizen at the time of death.
A U.S. citizen can currently shield up to $12.92 million of property from estate and gift taxes ($25.84 million per married couple), the amount of which is decreased for each gift given during the individual’s lifetime (the so-called gift/estate lifetime exemption). While the lifetime exemption shields a U.S. person from gift or estate tax, it does not shield the U.S. person from gift tax reporting, unless an additional exclusion applies.
A gift to a non-US spouse is subject to an annual exclusion limitation amount ($175,000 in 2023), which means that gifts above this amount will be subject to gift tax reporting and will decrease the gift/estate lifetime exemption, but should not trigger actual gift tax until the gift/estate lifetime exemption threshold is passed. The annual exclusion, to avoid gift reporting in general (i.e., to someone other than your spouse), is $17,000 in 2023.