Final Regulations Clarify and Modify Exceptions to PFIC Reporting
The IRS recently finalized regulations, previously in proposed and temporary form, which provide guidance on determining the ownership of a passive foreign investment company (PFIC) and the reporting obligations of PFIC owners. The final regulations make some changes to the proposed and temporary regulations based on comments that the IRS received from taxpayers and taxpayer organizations.
Importantly, the regulations modify and clarify the exceptions to PFIC reporting. But before we get to the exceptions, let’s start with a brief review of the PFIC regime.
What is a PFIC?
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 (as delineated in the finalized PFIC regulations), is subject to the PFIC rules.
Unbeknownst to many expats, 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).
PFIC Adverse Tax Consequences
PFIC investment income resulting from a distribution from a PFIC or a sale of a PFIC interest is generally subject to highly punitive U.S. federal tax rates, namely the highest marginal tax rate that can be imposed on an individual taxpayer (regardless of whether capital gains tax rates would normally apply). A non-deductible penalty interest charge can also compound regularly while holding an interest in a PFIC. Losses in PFICs generally cannot be used to offset gains in non-PFIC investments.
Several elections are available to mitigate the more onerous aspects of PFIC taxation (e.g., a so-called “QEF election” or “mark-to-market” election). Special rules apply if such elections are not made for the first year of PFIC stock ownership.
Aside from the high taxation rates associated with PFICs, there are specific reporting rules associated with PFICs. There is a specific form, Form 8621 for reporting your PFIC ownership interests. A separate Form 8621 must generally be filed for each PFIC in which stock is held directly or indirectly.
Internal Revenue Code Section 1298(f) provides the basic reporting requirement that all shareholders of a PFIC must file the Form 8621 each year.
Exceptions to Reporting in the New Regulations
One helpful aspect of the newly finalized PFIC regulations is that the exceptions to PFIC reporting under Section 1298(f) have been clarified and expanded.
Under the regulations, exceptions to PFIC reporting now include:
Dual-resident taxpayers – The final regulations add an exception from reporting for dual-resident taxpayers treated as residents of a foreign country under a treaty-tie breaker rule. This changes the rule in the proposed regulations, which subjected such dual-resident taxpayers to PFIC reporting.
Certain foreign pension funds – Generally, a U.S. person is exempt from PFIC reporting with respect to PFIC stock owned through a foreign trust that is a foreign pension fund operated principally to provide pension or retirement benefits, when, pursuant to a treaty, the income earned by the pension fund may be taxed as the income of the U.S. person only upon a distribution to the U.S. person. The proposed regulations provided an exemption only when the foreign pension fund was treated as a foreign trust for U.S. tax purposes. The final regulations expand the exception to PFICs held through a foreign pension fund covered by a treaty, regardless of the pension fund’s entity classification for U.S. tax purposes.
De minimis exceptions – The final regulations retain an exception to PFIC reporting if: (i) the shareholder has not made a QEF or mark-to-market election, (ii) is not treated as receiving an excess distribution or recognizing gain treated as such during the shareholder’s tax year, and (iii) either (A) the aggregate value of all PFIC stock owned at year-end does not exceed $25,000 ($50,000 for a joint return), or (B) the PFIC stock is owned through another PFIC, and the shareholder’s proportionate share of the upper-tier PFIC’s interest in the lower-tier PFIC does not exceed $5,000 in value.
Interestingly, the IRS and Treasury, in finalizing this provision, rejected a commentator’s request that the threshold amounts be increased for U.S. individuals living abroad.
Transitory ownership – The final regulations provide an exception to PFIC reporting with respect to PFICs owned for a short period of time (30 days or less) and during which time no PFIC taxation was imposed on the shareholder.
Domestic partnerships – The final regulations provide an exception for a domestic partnership that has an interest in a PFIC for a taxable year when none of its direct or indirect partners is required to file a Form 8621, because they are not subject to the PFIC rules – for example, tax exempt organizations.