With the heightened interest in U.S. connected people and businesses in offshore banking, it is important to understand the importance of properly to the Internal Revenue Service and various State taxing agencies of foreign bank accounts and investments.
The Federal income tax rules regarding those who have interest in any Passive Foreign Investment Company (“PFIC”) are complicated, to say the least. However, it is important to have a basic understanding of PFIC treatment for income tax purposes so that a holder will be able to have an adequate dialogue with his or her tax and legal professional. Full detail of the treatment of PFICs can be found in the United States Tax Code 1291-1298; below are some very basic notes to summarize the law.
A foreign corporation is categorized as a Passive Foreign Investment Company when it passes either the “asset test” or the “income test,” both of which relate to passive income. Passive income is different from the standard income produced by the operation of a business and generally includes (but is not limited to) dividends, interest, royalties, rents, annuities, and certain gains from property transactions, commodities trading, and foreign currency, with exceptions. The asset test is passed when at least 50 percent of the assets produce or are intended to produce passive income. The income test is passed when at least 75 percent of the gross income is passive income. Shareholders of a PFIC must file a form 8621 with the Internal Revenue Service every year during which the person recognizes certain gains or distributions, or makes a certain “election” (discussed below).
Making a QEF Election
It is almost always advantageous for a U.S. taxpayer to elect to treat the PFIC as a Qualified Electing Fund (QEF), which can be done by the first U.S. person who is a direct or indirect shareholder of the PFIC. The election should be made by the shareholder’s due date for filing taxes for the year for which the election applies and it will remain active until revocation. When a PFIC is treated as a QEF, the income or gains will be included in income and increase the PFIC stock basis, with the income treated as ordinary income and the capital gain treated as long-term capital gain. Distribution of income that is currently or was previously recognized will be excluded from income but will reduce the PFIC stock basis; however, any excess distributions will be treated as a capital gain.
If a QEF is Not Elected
When a QEF is not elected, distributions are subject to taxation in the current year. “Excess distributions,” which are those greater than 125 percent of the average annual distributions received in the preceding three years (or shorter time period if held for less than three years) are allocated pro rata to every day the taxpayer held the shares. For those days in the current year, QEF is treated as ordinary gross income. For the amount allocated to previous years the amount is subject to the highest rate of tax applicable for the taxpayer plus interest.
Making the QEF Election in Later Years
While a taxpayer can make a QEF election in later years, there are complicated rules associated with not having the QEF in place from the first year, since the PFIC will be subject to both sets of rules. Fortunately, taxpayers have some options to help with the situation. One option is to treat PFIC shares as if they were sold at the beginning of the QEF election and pay any deferred tax. Another option is to treat the PFIC shares as if they actually were part of a QEF from the beginning, either by taxing them appropriately or by filing a “protective statement.” Certain requirements must be met to take advantage of any of these options.
Making a Mark-to-Market Election
If the PFIC stock is “marketable,” a defined term that basically requires it to be traded on certain listed systems or marketable under other listed circumstances, the shareholder can make the “mark-to-market” election and may include in his or her income the excess of the fair market value of the stock over the adjusted basis. Alternatively, the taxpayer will be allowed a deduction which must be the lesser of: (a) any excess of the adjusted basis over the fair market value or; (b) the excess of the amount of gain included in his or her gross income for prior tax years over the amount allowed as a deduction for a loss in prior tax years.
A Note on Controlled Foreign Corporations
Some PFICs are also Controlled Foreign Corporations (CFCs), which are defined as foreign corporations controlled more than 50 percent by U.S. shareholders who each own at least 10% of the foreign corporation. The Taxpayers Relief Act of 1997 helped to simplify the rules associated with PFICs that are also CFCs by making the PFIC not subject to certain CFC pass-through rules for those U.S. shareholders that own at least 10 percent.
It is imperative to remember that this is an oversimplification of the rules relating to PFICs and there are many exceptions, qualifications and further requirements regarding most of the circumstances discussed. Additionally, these rules are based on the U.S. tax code and discussion of California tax treatment was beyond the scope of this article as it differs from the federal treatment.
Should you have any questions regarding your interest or potential interest in a PFIC, feel free to contact the professionals at the Law Office of Stephen Moskowitz, LLP.