This is a question sent to us through email:

I invested in Australian stapled securities. Do I have a PFIC problem?

In this post, I will introduce the concept of stapled securities and go through the questions we ask to determine whether the US person holds a PFIC. Because we have limited space, I am going to assume that the particular stapled security we are discussing is used to hold real estate investments.

What are stapled securities?

It is a type of securities arrangement in Australia.

You have a unit trust that holds property. The unit trust hires a limited company to manage the property. The units of the unit trust and some of the shares of the limited company are contractually bound to be sold together. When the units and shares are bound together this way, they form a stapled security.

In this post, we assume the unit trust is holding rental real estate.

What are PFICs?

Passive foreign investment company (PFIC) is a classification under US tax law. When a US person receives a distribution from a PFIC or sells shares in a PFIC for a gain, special rules apply. The rules are less than desirable for the taxpayer, so it is desirable to avoid PFIC classification.

A PFIC is a foreign corporation that meets at least 1 of 2 tests:

• Income test: At least 75% of the corporation’s income is passive income.
• Asset test: At least 50% of the corporation’s assets produce passive income or are held for the production of passive income. IRC §1297(a).

Let us check whether the unit trust is a PFIC first.

Maybe the unit trust is a trust under US tax law

A PFIC is a type of corporation. If the unit trust is not a corporation, then it cannot be a PFIC.

US tax law has its own classification of entities that may not correspond to the entity’s classification under foreign or state law. Reg. §301.7701-1(a). For example, business trusts and certain investment trusts are classified as business entities under US tax law, even though they are organized as trusts under foreign or state law. Reg. §301.7701-4(b), (c).

The unit trust is most likely an investment trust: It is a vehicle to pool investments rather than to protect assets for beneficiaries. Reg. §301.7701-4(a).

When an investment trust’s trustee can vary the investments the trust makes, it is a business entity. Reg. §301.7701-4(c). If the trustee must hold specific investment or investments, it is a trust. Reg. §301.7701-4(c).

Check whether the trust agreement for the unit trust permits the trustee to change what properties it holds.

If the trust does not permit the trustee to change the assets held in trust, then it is a trust, not a business entity. A corporation is a type of business entity. Reg. §301.7701-2(b). Because the trust is not a business entity, it cannot be a corporation. Therefore, it cannot be a PFIC.

Maybe the unit trust is a partnership under US tax law

If we the unit trust is a business entity, it might be a partnership rather than a corporation.

An Australian unit trust that is classified as a business entity under US tax law may elect its US tax classification. Reg. §§301.7701-2(b)(8), -3(a). So if the unit trust has elected to be classified as a partnership under US tax law (by filing Form 8832 and choosing partnership classification), then it is a partnership.

If the unit trust does not choose, then it receives a default classification based on the liability of the unit holders. Reg. §301.7701-3(b). If all unit holders have limited liability, then it is a corporation. If at least one unit holder has personal liability for the unit trust’s debts, then it is a partnership.

Look at the trust agreement. If the trust agreement says that unit holders are personally liable for the trust’s debts, then the trust is by default a partnership. If the trust agreement says the unit holders are not personally liable, check with a solicitor in Australia on the unit holders’ liability: Unit holders by default are personally liable for the trust’s debts in proportion to their unit holders. J W Broomhead (Vic) Pty Ltd vs J W Broomhead Pty Ltd, (1985) 3 ACLR 355 (Vic S C). I do not know if the default result can be changed through the trust agreement.

If at least one unit holder has personal liability for the unit trust’s debts, then the unit trust is a partnership and cannot be a PFIC.

The unit trust’s income is passive

Let us assume that the unit trust is a corporation. It is foreign, because it is organized under Australian law and not US law. Reg. §301.7701-5(a). Now we ask whether the unit trust satisfies either the income test or the asset test.

Passive income is any income that is foreign personal holding company income as defined under IRC §954(c). IRC §1297(b). This includes rent. IRC §954(c)(1)(A). We now check if any of the exceptions apply.

Related person rent exceptions probably do not apply

Under the PFIC rules, there is an exception for rent from a related person, as long as the rent is not allocable to the related person’s passive income. IRC §1297(b)(2)(C). You can check the tenants of the unit trust to see if the tenants are related persons. Usually this exception does not apply.

Active rent exception does not apply

There is another exception to foreign personal holding company income: It does not include rent derived from the active conduct of a trade or business. IRC §954(c)(2)(A). Because the management company is running the rental business in an active manner, it is tempting to assume that the rental income is rent from an active trade or business.

The active rent exception is far narrower than the statutory language makes it sound: It only works if the corporation runs the business through its own officers or staff of employees. Reg. §1.954-2(c)(1). Here, the unit trust is not using its own officers or staff of employees to run the rental business. The officers and staff of employees of a separate corporation (the limited company) run the rental business. The rent does not fit the active rent exception.

It is tempting to argue that because the unit trust and limited company’s shares are stapled together, they are related persons, so the limited company’s employees should be attributed to the unit trust.

Unfortunately, there is no language in the regulations that permit a company to import a related person’s employees as its own for the active rent exception.

By choosing a stapled securities arrangement, where management was delegated to a limited company, the unit trust forwent the active rent exception. The rent is passive income. Because the rent is passive income, the unit trust meets the income test. It is a PFIC.

Not discussed: Is the stapled security itself a PFIC?

This post discusses the unit trust in a stapled security arrangement only. I will leave the discussion of whether the stapled security itself is a PFIC for another post.

The post Unit Trust in Stapled Security Arrangements appeared first on HodgenLaw PC – International Tax.

Cash held for customers

This is a war story from client work:

I own shares of a Chinese investment firm. The firm’s balance sheet, produced under Chinese accounting standards, shows cash of $X, with line below that said $Y out of $X is customer deposits. The total asset on the balance sheet showed $X to be the cash included in the sum. Should I include $X or $X-Y of cash for the asset test for PFICs?

Today’s post is a bit of a followup to a previous post about assets held in trust. It is not about assets held in trust, but it applies the principles outlined in that post in a concrete example.

What are PFICs?

Passive foreign investment company (PFIC) is a specific classification under US tax law. When a US person receives a distribution from a PFIC or sells shares in a PFIC for gain, there are special rules that apply. The rules are less than desirable for the taxpayer, so it is useful to avoid the PFIC classification when it is possible.

A PFIC is a foreign corporation that meets at least 1 of 2 tests:

• Income test: At least 75% of the corporation’s income is passive income.
• Asset test: At least 50% of the corporation’s assets produce passive income or are held for the production of passive income. IRC §1297(a).

We are only concerned about the asset test today, so we will skip the income test. Cash is always passive, because it generates interest. See Notice 88-22; IRC §954(c)(1)(A). We want to know whether to include $X of cash (all the cash held) or $X-Y of cash (excluding the cash held for customers).

The investment firm was a foreign corporation

For this particular case, the investment firm was a joint stock company (股份有限公司, or gu fen you xian gong si). A Chinese joint stock company is a corporation, and it cannot elect out of that status. Reg. §301.7701-2(b)(8). This means we cannot get out of PFIC classification by having the investment firm elect to be classified as a partnership.

The investment firm is foreign, because it is organized outside the US. Reg. §301.7701-5(a).

We need to look at the income test and the asset test to determine if it is a PFIC. We are only looking at how cash affects the asset test today.

Look at foreign law for who owns the cash

We got the balance sheet under Chinese financial reporting standards, not GAAP. It is a fair question to ask whether the separately listed customer deposits really should be counted as the investment firm’s assets under the asset test.

We looked at the reasons behind this in more depth in this post, but more likely than not, you look at who owns the cash under foreign law, not how foreign accounting standards require the cash to be reported.

The short version of this is that foreign or state law determine rights to property, and federal tax law determines how those rights are taxed. If the cash belongs to the customers under foreign law, then US tax law should treat the cash as the customer’s, not the investment firm’s. If we follow accounting standards, then the exact same underlying right can be taxed differently depending on how the accounting standards say the assets should be reported.

Chinese law: The cash belongs to the customers

A Chinese securities company must keep customer funds in an account segregated from the company’s own funds, track the customer funds separately from the company’s own funds, and manage the customer funds separately from the company’s own funds. Zhongguo Zhengjuan jiandu guanli weiyuan huiling di 3 hao [China Sec. Reg. Comm. decree no. 3] (promulgated by the China Securities Regulatory Commission, 2001-05-16, effective 2002-01-01), art. 6, St. Council Gaz. 2002 no. 13 (2002) (PRC).

All these requirements about separate management suggests that the investment firm is acting as a custodian or manager of the customer deposits. They cannot use the cash for their own purposes or mingle the cash with their own. And presumably the proceeds from these cash belong to the customers, with the investment firm entitled to only management or transaction fees.

These laws suggest that the customer deposits belong to the customers, not the investment firm. So the cash should be excluded from the asset test. You include $X-Y of cash as passive assets and $X-Y of cash under total assets for the asset test for PFIC classification.

Different rules for bank deposits

Note that this firm is an investment firm. It is not a bank.

While I do not have a citation, I am reasonably confident that Chinese banks function just like any other bank: The bank can take cash deposits you make and use it for its own purposes, such as paying off debts, making investments, making loans, etc. They are only required to pay you an interest. Any return on investments that the bank makes using the cash belongs to the bank. In a bank deposit, you are really lending money to a bank in return for interest. The bank owns the cash and owes you a debt equal to the deposit plus interest.

The relationship is quite different than the investment firm, which holds money for its customers.

The post Customer Deposit in a Chinese Investment Firm under the PFIC Asset Test appeared first on HodgenLaw PC – International Tax.

This is a question that sometimes comes in an email:

I am a US citizen living abroad. I sold a PFIC. I paid foreign tax on the gain. Can I use the foreign tax as a foreign tax credit?

We do not have a definitive answer to this question, because there is very little guidance from the IRS on this matter. This post discusses the positions you can take and our preferred approach.

What are PFICs?

Passive foreign investment company (PFIC) is a specific classification under US tax law. When a US person receives a distribution from a PFIC or sells shares in a PFIC for gain, there are special rules that apply. There are 3 possible ways to tax income from a PFIC:

• Default rules
• Under a qualified electing fund (QEF) election
• Under a mark-to-market (MTM) election

In this post, I assume the PFIC is taxed using the default rules.

How is the gain taxed?

This is a very abbreviated summary of the default rules as applied to gains.

• The entire gain is treated as “excess distribution” from a PFIC. IRC §1291(a)(2).
• The excess distribution is allocated on a per day basis to the seller’s entire holding period. IRC §1291(a)(1)(A).
• Excess distribution allocated to the current year is included as ordinary income. IRC §1291(a)(1)(B).
• Excess distribution allocated to prior years is taxed at maximum ordinary income tax rates in effect for the year to which the excess distribution is allocated. IRC §1291(c)(2).
• The tax on prior year excess distribution is subject to an interest charge as if the taxpayer owed the amount in the prior years. IRC §1291(c)(3).

How is foreign tax credit applied on a distribution?

To understand the problem with taking a foreign tax credit for foreign tax on gains from a PFIC, it is useful to first understand how foreign tax credit works when the PFIC makes a distribution.

There is a special rule for foreign tax credits “with respect to any distribution in respect of stock”. IRC §1291(g). A distribution from a PFIC may include both an “excess distribution” portion and a “non-excess distribution” portion. For the sake of simplicity, let us assume the entire distribution is excess distribution.

• Separate the foreign tax paid on distribution from each PFIC. Prop. Treas. Reg. §1.1291-5(a). This means you cannot cross credit the foreign tax paid on one PFIC against the US tax on a different PFIC.
• You allocate the foreign tax on a per day basis to the entire holding period. IRC §1291(g)(1)(B).
• Tax allocated to the current year is available as a foreign tax credit normally. IRC §1291(g)(1)(C)(i).
• Tax allocated to prior years can be used to reduce the US tax on the same year on the same PFIC only. IRC §1291(g)(1)(C)(ii).

On a high level, the rules more or less mirror how tax is calculated on the excess distribution. The basic idea is that foreign tax credit should be available on a per PFIC and per year basis.

How is foreign tax credit applied to a gain?

When a taxpayer sells a PFIC, the Code and regulation address only a special case: When a controlled foreign corporation is involved.

I will look at the general case only: What happens when the PFIC is not a controlled foreign corporation? Because there is no specific guidance, there are several possible theories.

No foreign tax credit is provided

Under this theory, section 1291(g) is the sole basis for providing a foreign tax credit. Because it does not provide for a foreign tax credit for any foreign taxes paid on the gain from the sale of a PFIC, none is allowed.

Foreign tax credit is made available on the same terms as a distribution

Under this theory, gain from selling a PFIC is treated as an excess distribution, so foreign tax credit should be granted as if the gain were a distribution.

Under this theory, foreign tax credit is available only when it is possible to allocate the foreign tax to a specific PFIC. In many cases, the taxpayer pays a general, annual personal income tax on the sale of a PFIC. The tax cannot be allocated to the gain from any specific PFIC.

Foreign tax credit is available normally under §901

Under this theory, there is nothing in the PFIC rules that says section 1291(g) is the only basis for claiming a foreign tax credit, so we turn to the general rules for foreign tax credit under section 901. And because the taxpayer properly paid foreign taxes on the gain, he is entitled to use the foreign tax as a credit.

We tend to use option 2

We tend to forgo the foreign tax credit when it is not possible to allocate the foreign tax to a specific PFIC. This is not because we think it is absolutely the correct interpretation of the ambiguous statute. It is because many of clients are planning to expatriate or filing late. In these situations, the client and our preference is to avoid aggressive tax positions that can lead to adverse changes in an audit.

The post Foreign Tax Credit on Sale of a PFIC appeared first on HodgenLaw PC – International Tax.

Distributions from a PFIC under a mark-to-market election

This is a question we received through an email:

I own stock of a PFIC. I made a mark-to-market election for the PFIC stock. The PFIC made a distribution of cash during the year. How is the distribution taxed?

In this post, I will discuss why the distribution is mostly treated like a distribution from a normal corporation (with the exception that the dividend never can be a qualified dividend).

What are PFICs?

Passive foreign investment company (PFIC) is a specific classification under US tax law. It applies to a foreign corporation if it satisfies either:

• An income test: 75% or more of its gross income is passive income, or
• An asset test: 50% or more of its gross assets produce passive income or are held for the production of passive income.

There are 3 ways income from a PFIC is taxed to a US person:

• Under default rules (without any election);
• Under a qualified electing fund (QEF) election; or
• Under a mark-to-market (MTM) election

In this post, we assume that the US person has made a MTM election for the PFIC stock he owns.

MTM election results in deemed sale of stock annually

When a taxpayer makes a mark-to-market election for a PFIC stock, there is a deemed sale of the stock at the end of every year. IRC §1296(a).

Code section 1296 and the underlying regulations go into detail about how the deemed sale affects income and basis, and how an actual sale of the MTM stock is taxed. Because this post is concerned about distributions from the MTM stock only, I will not go into details about how the deemed sale works.

What Code section 1296 and the underlying regulations conspicuously leave out is any discussion about taxing distributions from the MTM stock.

Distribution: Dividend, return of capital, or gain

Neither the Code nor the regulations for the MTM election says how distributions are taxed. But we can make a deduction.

Proposed regulations 1.1291-2 and 1.1291-3 contain how PFIC distributions and gains are taxed under the default rules. By the terms of the proposed regulations, the default rules apply to “1291 funds”. Prop. Treas. Reg. §§1.1291-2(a), -3(a). Or, to put it another way, if the PFIC stock is not a 1291 fund, then the default rules do not apply.

This is how the regulations define a 1291 fund:

A PFIC is a section 1291 fund with respect to a shareholder unless the PFIC is a pedigreed QEF with respect to the shareholder or a section 1296 election is in effect with respect to the shareholder. Reg. §1.1291-1(b)(2)(v).

The 1296 election is the MTM election. Our PFIC stock is under a MTM election, so it is not a 1291 fund. Therefore, the default rules for distributions from a PFIC do not apply.

Without a special rule for distributions from MTM stock, we are left with the general rules for distributions under the Code: section 301. The distribution is a dividend up to the PFIC’s earnings and profits, a return of capital in excess of earnings and profits and up to the shareholder’s basis, and a gain in excess of basis. IRC §301(c).

The dividend is probably ordinary dividend

Qualified dividends are taxed at long-term capital gain rates. IRC §1(h)(11). Ordinary dividends are taxed at ordinary income tax rates. A PFIC cannot distribute a qualified dividend, so any dividend that the shareholder receives is an ordinary dividend. IRC §1(h)(11)(C)(iii).

Making the MTM election means that the owner does not treat the MTM stock as a 1291 fund, so he avoids the default rules for PFICs, but nothing in the PFIC rules suggests that the MTM stock stops being treated as PFIC stock. Therefore, the MTM stock is PFIC stock. This means any dividend it distributes is an ordinary dividend.

The gain is ordinary income

Any gain from the sale of a MTM stock is ordinary gain. IRC §1296(c)(1)(A).

If you receive a distribution from a corporation in excess of its earnings and profits and your basis, then the excess is treated as gain from the sale of your stock. IRC §301(c)(3)(A). Under the MTM rules, the gain is ordinary gain.

The post Cash Distribution from a Mark-to-Market PFIC Stock appeared first on HodgenLaw PC – International Tax.

This is a question we received through an email:

I own stock of a PFIC. I made a qualified electing fund election for the PFIC stock. The QEF received a distribution of qualified dividends during the year. Later, I sold the QEF for a loss. Can I use the loss to offset income from the QEF?

In this post, I will introduce how QEF works and why the loss from the sale of the stock cannot be used to offset the passthrough of income from the QEF.

What are PFICs?

Passive foreign investment company (PFIC) is a specific classification under US tax law. It applies to a foreign corporation if it satisfies either:

• An income test: 75% or more of its gross income is passive income, or
• An asset test: 50% or more of its gross assets produce passive income or are held for the production of passive income.

There are 3 ways income from a PFIC is taxed to a US person:

• Default rules
• Under a qualified electing fund (QEF) election
• Under a mark-to-market (MTM) election

In this post, we assume that the US person has made a QEF election for the PFIC stock he owns.

QEF election sort of results in passthrough of income

When a US person makes a QEF election with respect to a stock in a PFIC, every year he must take into account his share of the QEF’s ordinary earnings for the year as ordinary income and his share of the QEF’s net capital gain for the year as long-term capital gain. IRC §1293(a).

The QEF provides a PFIC Annual Information Statement to the shareholder, which tells the shareholder his share of the QEF’s ordinary earnings and net capital gain. Reg. §1.1295-1(g).

There is no passthrough of losses. There is no passthrough of foreign tax credit, except for 10% corporate shareholders. IRC §1293(f). This is why it is not quite a full passthrough of income.

The qualified dividend is part of net capital gain

The QEF rules do not define what net capital gain means. The rest of the Code offers 2 different definitions of net capital gain:

• Section 1222(11) defines net capital gain as net long-term capital gain minus net short-term capital loss (minimum of 0). IRC §1222(11).
• Section 1(h) defines net capital gain as net capital gain defined by section 1222(11) plus qualified dividend income. IRC §1(h)(11).

Under QEF rules, we may determine net capital gain by “calculat[ing] and report[ing] the amount of each category of long-term capital gain provided in section 1(h) that was recognized by the PFIC…” Reg. §1.1293-1(a)(2)(i)(A). This implies that we use net capital gain as defined by section 1(h), which includes qualified dividends.

The qualified dividends that the QEF received is passed to the shareholder as net capital gain.

Limited to $1,500 of deduction of capital loss

The QEF regulations give us 3 ways of passing the QEF’s net capital gain to its shareholder, which the QEF chooses when it issues the PFIC Annual Information Statement to the shareholders. Reg. 1.1293-1(a)(2)(i).

• Calculate each category of long-term capital gain provided in section 1(h);
• Calculate the total net capital gain and state that the amount is subject to the highest capital gain rate of tax to the shareholder; or
• Calculate the E&P for the year and report the entire amount as ordinary earnings.

Under the first method, the QEF would pass qualified dividend income to the shareholder. Normally, a person is limited to a deduction of $1,500 of capital loss against qualified dividend income. Having the qualified dividend income pass through the QEF does not change the result.

The second method is ambiguous, but I suspect the QEF simply passes a net capital gain that is to be directly added to the total amount subject to the highest capital gain rate (28%). This amount is simply added to line 18 of schedule D of Form 1040.

Under the third method, the shareholder receives a passthrough of ordinary income. He is limited to a deduction of $1,500 of capital loss against ordinary income.

In all cases, the loss from the sale of the QEF stock provides a deduction of up to $1,500.

The post Distributions from a PFIC under a QEF Election appeared first on HodgenLaw PC – International Tax.

Pre-1997 unit trusts

This scenario is loosely based on some analysis we did for a client:

I bought 10% of units in a private unit trust in a foreign country back in 1990. All other unit holders are nonresident aliens. We could transfer the units by giving notice to the trust without seeking permission. All unit holders are personally liable for the debts of the trust in proportion to their unit holding. It invested in stocks and bonds. It and its nonresident alien shareholders never filed anything in the US tax system.

In this post, I will discuss why this unit trust was a PFIC when it was bought and why it underwent a deemed liquidation in 1997.

What are PFICs?

Passive foreign investment company (PFIC) is a classification under US tax law. When a US person receives a distribution from a PFIC or sells shares in a PFIC for a gain, special rules apply. The rules are less than desirable for the taxpayer, so it is desirable to avoid PFIC classification.

A PFIC is a foreign corporation that meets at least 1 of 2 tests:

• Income test: At least 75% of the corporation’s income is passive income.
• Asset test: At least 50% of the corporation’s assets produce passive income or are held for the production of passive income. IRC §1297(a).

Passive income includes items such as dividends, interest, and gains from selling assets that produce dividends and interest. IRC §§1297(b), 954(c)(1). Because this unit trust invests in stocks and bonds only, all its income is from dividends, interest, or gains from selling property that produce dividends and interest.

The unit trust meets both the income test and the asset test. The only way to avoid classifying the unit trust as a PFIC is for it to be not a foreign corporation.

The unit trust is a business entity

A corporation is a type of business entity. Reg. §301.7701-2(b).

The unit trust is organized as a trust, but tax law recognizes a special category of trusts called investment trusts. See Reg. §301.7701-4(c). When the trustee of an investment trust may vary the investments of the trust, then the investment trust is a business entity. Reg. §301.7701-4(c).

The point of the unit trust is that the trustee should use its expertise (or its agents’ expertise) to determine which investments produce the best return on income, and adjust its investments accordingly. It is a trust organized for investment, and it permits the trustee to vary the investments. It is a business entity under US trust law.

The unit trust is a foreign business entity

A domestic business entity is organized under US law. Reg. §301.7701-5(a). A foreign business entity is any business entity that is not domestic. Reg. §301.7701-5(a). This unit trust is organized in a foreign country under foreign law, not under US law. It is a foreign business entity.

The unit trust was a corporation in 1990

If you read regulation sections 301.7701-2 and -3, you will find that this type of unit trust is not a per se corporation. Reg. §301.7701-2(b)(8). Because all unit holders are personally liable for the trust’s debts, it is a partnership by default. Reg. §301.7701-3(b)(2)(i)(A).

This is true under the current rules, but this shareholder had the unit trust in 1990.

In 1997, the IRS adopted the current rules for classifying entities. TD 8697, 61 FR 66589. Under the former regulations, a business entity is a corporation if it possessed more than half the following characteristics; otherwise it is a partnership (Notice 95-14; 1995-1 CB 297, citing former Reg. §301.7701-2):

• It had continuity of life
• It had centralization of management
• The members’ liability for the organization’s debts is limited to the organization’s assets; and
• There is free transfer of interests

Continuity of life means that the entity continues to exist independently of its members. A unit trust can continue to exist if any or all unit holders change. It has continuity of life.

One or more trustees manage the trust on behalf of the unit holders. It has centralization of management.

Each unit holder is personally liable for the unit trust’s debts in proportion to his unit holding. This means the members’ liabilities are not limited to the unit trust’s assets.

This particular unit trust permits its unit holders to transfer interests freely, i.e. without seeking any other members’ permission or the permission of the unit trust. The person making the transfer merely needs to provide notice.

This unit trust meets 3 out of 4 criteria. It was a corporation under the pre-1997 regulations. Notice, though, that the unit trust could have toggled its classification to partnership by restricting the transfer of units.

The unit trust underwent a deemed liquidation in 1997

In 1997, the current classification rules came into effect, and the current rules reclassify the unit trust as a partnership. Reg. §301.7701-3(h)(1). There is a transition rule: “The entity’s claimed classification(s) will be respected for all periods prior to January 1, 1997, if [3 criteria are met].” Reg. §301.7701-3(h)(2).

That this transition rule talks about periods before 1997 only suggests that the entity does not keep its classification from before 1997 under the new rules. This is not surprising: The new rules permit the entity to choose its classification, and the IRS expected the entity to choose.

Here, the unit trust did not make a choice, so it changed from a corporation to a partnership in 1997. There was a deemed liquidation in 1997.

The unit trust would not have been reclassified as a partnership if it were publicly traded

Under the current regulations, the regulations classify the unit trust as a partnership. Suppose the unit trust is publicly traded rather than private.

The Code says that a publicly traded partnership is a corporation. IRC §7704(a). If more than 90% of its income is interest, dividends, real property rents, gain from the sale of real property, certain mineral income, or capital gain from the sale of assets that produce the previous types of income, the partnership might be exempt from this rule. IRC §7701(c), (d). But this exception does not apply if the partnership would be a regulated investment company had it been organized in the US. IRC §7704(c)(3).

This particular unit trust, which holds itself to be an investor in the securities market, likely would be a regulated investment company in the US. IRC §851(a); 15 USC 80a-3(a), -4(2), (3). Thus, a publicly traded unit trust of this type would be a corporation even under the current rules.

The post Pre-1997 Unit Trust Funds appeared first on HodgenLaw PC – International Tax.

Foreign mutual funds investing in the US

This is a question from an email:

I have a foreign mutual fund that invests in stocks of US corporations. Is the mutual fund a PFIC?

In this post, I will discuss why this mutual fund is a PFIC. Here is the tl;dr version: There is no exception in the PFIC rules for invests in the US.

What are PFICs?

Passive foreign investment company (PFIC) is a classification under US tax law. When a US person receives a distribution from a PFIC or sells shares in a PFIC for a gain, special rules apply. The rules are less than desirable for the taxpayer, so it is desirable to avoid PFIC classification.

A PFIC is a foreign corporation that meets at least 1 of 2 tests:

• Income test: At least 75% of the corporation’s income is passive income.
• Asset test: At least 50% of the corporation’s assets produce passive income or are held for the production of passive income. IRC §1297(a).

We need to verify that the foreign mutual fund is a foreign corporation, and that it meets either of the tests for PFICs.

The mutual fund is foreign

“Foreign” is easy. A business entity is domestic if it is organized in the US; otherwise, it is foreign. Reg. §301.7701-5(a). I assume “foreign mutual fund” means a mutual fund that is organized outside the US. Therefore, it is a foreign business entity.

The mutual fund is a corporation

There are several alternative reasons why the mutual fund is almost certainly a corporation.

• (Rare) The mutual fund is organized as a publicly traded limited company and is listed as an entity type that is always a corporation. Reg. §301.7701-2(b)(8).
• The mutual fund provides limited liability for all its members and is a corporation by default. Reg. §301.7701-3(b)(2).
• The mutual fund is classified as a partnership under the regulations, but because it is publicly traded, it is classified as a corporation under a special Code provision for publicly traded partnerships. IRC §7704.

Any one of the reasons is sufficient. The mutual fund almost certainly falls under at least one of these categories. The mutual fund almost certainly is a corporation.

The mutual fund satisfies the income test and asset test

Passive income is income that would be foreign personal holding company income in the hands of a controlled foreign corporation. IRC §1297(b).

These include interest, dividends, rent, royalties, annuities, gains from the sale of property that produce these types of income, and gains from the sale of property that produce no income. IRC §954(c)(1).

Stocks produce dividends, and they produce gains when sold. The mutual fund likely holds some cash that produces interest. The mutual fund’s income is almost entirely passive. Because all its property produce passive income or are held for producing passive income, almost all its assets are passive.

The mutual fund satisfies the income test and the asset test.

No exception for mutual funds investing in the US

It is tempting to think that there is some exception for foreign mutual funds that invests in the US, because the US gets to tax the mutual fund on its US source income, and it encourages investments in the US.

This assumption is wrong. There is no special exception for mutual funds that invest in the US. See IRC §§1297, 1298, 954(c).

It is not surprising that the PFIC rules do not contain such an exception.

First, a foreign corporation is not subject to tax when it sells US stocks for a gain. See IRC §§881, 882. A US person is taxed on capital gains from the sale of stocks. IRC §61(a)(2). Thus, the foreign mutual fund has a much smaller tax base than US investors. Congress would not want US persons to use foreign investment vehicles to defer tax on capital gains.

Second, the PFIC rules function as a protective measure for US based mutual funds and their investment advisers.

A foreign mutual fund that invests in stocks in US corporation is classified as a PFIC (or not) under the same rules as a foreign mutual fund that invests in foreign stocks. It almost certainly is a PFIC.

The post Foreign Mutual Funds Investing in the US Are Still PFICs appeared first on HodgenLaw PC – International Tax.

This is a war story:

I have owned shares of a foreign company that rents out a warehouse for years. It operates on a fiscal year ending 31 March, 2017. I immigrated to the US on 1 February, 2017. I believe it is a PFIC. I would like to make a QEF election. When do I make this election, and is there anything else I need to do?

In this post, I will explain why the shareholder would make a QEF election with his 2017 tax return, why he does not need to do a deemed sale election, and how the passthrough of income works for 2017.

What are PFICs?

Passive foreign investment company (PFIC) is a specific classification under US tax law. It applies to a foreign corporation if it satisfies either:

• An income test: 75% or more of its gross income is passive income, or
• An asset test: 50% or more of its gross assets produce passive income or are held for the production of passive income.

The warehouse rental company is likely a PFIC, because it collects rent (and probably does not actively manage the warehouses). IRC §§1297(b), 954(c)(1)(A). There are 3 ways income from a PFIC is taxed to a US person:

• Default rules
• Under a qualified electing fund (QEF) election
• Under a mark-to-market (MTM) election

In general (though not always), the the QEF election gives the best tax results, so if it is possible to make the election, it is desirable to make it. There are some requirements for making the QEF election, which I omit from this post for brevity. Debra has written about the requirements for the election here.

QEF election sort of results in passthrough of income

When a US person makes a QEF election with respect to a stock in a PFIC, every year he must take into account his share of the QEF’s ordinary earnings for the year as ordinary income and his share of the QEF’s net capital gain for the year as long-term capital gain. IRC §1293(a).

The QEF provides a PFIC Annual Information Statement to the shareholder, which tells the shareholder his share of the QEF’s ordinary earnings and net capital gain. Reg. §1.1295-1(g).

There is no provision for passthrough of losses. There is no no passthrough of foreign tax credit, except for 10% corporate shareholders. IRC §1293(f). This is why it is only sort of a passthrough of income.

Make the QEF election with the 2017 return

A shareholder makes the QEF election on or before the due date for the income tax return for the first taxable year to which the election will apply. Reg. §1.1295-1(e)(1). The first year for which the shareholder is a US person is 2017, so he needs to make the election on or before the due date of his 2017 income tax return.

He makes this election by completing Form 8621, checking the box for the QEF election, and attaching it to his income tax return for 2017. Reg. §1.1295-1(f)(1).

There is no need for a deemed sale election to purge PFIC taint

You may have heard about a “once a PFIC, always a PFIC” rule, which forces you to make a purging election once you have treated the shares as shares of a PFIC.

The basic idea is this: If you do not make any election for a PFIC, then you use the default rules under section 1291. Congress did not want taxpayers to get out of the default PFIC rules by making the (usually) more favorable QEF election, so they require the taxpayer to make a purging election to end the treatment under default rules. The process works (in brief) like this:

If you then make a QEF election, then it becomes an unpedigreed QEF, because within your holding period, there were years when it was a PFIC but not a QEF. Reg. §1.1291-9(j)(2)(iii). You must continue to use the default rules for unpedigreed QEFs in addition to the QEF rules. Reg. §1.1291-1(b)(2)(v); Prop. Reg. §1.1291-2. You can end the use of the default rules by making a purging election. Reg. §§1.1291-9, -10.

Debra has written about how to make the purging election here.

Fortunately, there is no need to make a deemed sale election in our situation. This is because when you are a nonresident alien, you do not treat your shares as shares of a PFIC, even if the foreign corporation satisfies the tests for PFICs. Reg. §1.1291-9(j)(1).

This means 2017 was your first year in which you owned shares in a PFIC. If you make a QEF election in 2017, then for all years when the foreign corporation was a PFIC during your holding period, it was also a QEF.

In this situation, the QEF is a pedigreed QEF, and the default rules do not apply. You do not need to make a purging election.

In short, make the QEF election on the tax return due with the first year of residency, and you are good.

The post QEF Election for a Fiscal Year Company in the Year of Immigration appeared first on HodgenLaw PC – International Tax.

Effect of the tax cut on PFICs

These are some notes I took about how the tax cut affects passive foreign investment companies (PFICs)–or does not affect PFICs.

The short answer is that not much changed, particularly if you are an individual. PFICs stay more or less as bad as they were before. The dramatic changes to tax law that just passed do not affect PFIC owners much.

Code references are to the amended provisions

The Code citations used in this post refer to provisions as amended by the tax cut–unless, of course, the citation notes that it refers to the provisions without amendment.

No territorial system for PFIC income

One of the touted features of the tax cut is that corporations are now taxed on a territorial basis, meaning profits earned abroad are not taxed. It is not quite like that, but it is beyond the scope of this post to go into depth about corporate taxation in general.

The way the territorial system works is that if a US corporation owns 10% or more of a “specified 10-percent owned foreign corporation”, then it gets to deduct dividends received from the foreign corporation that can be attributed to foreign profits. IRC §245A(a).

This territorial system only works for corporations, not individuals. US citizens living abroad who own shares of foreign corporations do not get this benefit.

PFICs are specifically excluded from the definition of a specified 10-percent owned foreign corporation. IRC §245A(b)(2). This territorial system does not work for PFIC income.

No deemed repatriation of PFIC income

One of the features of the tax cut is that there is a deemed repatriation of accumulated profits of foreign corporations.

The deemed repatriation applies to 10% shareholders of “deferred foreign income corporations”. IRC §965(a). A deferred foreign income corporation is a “specified foreign corporation” that has accumulated foreign income since 1986. IRC §965(d)(1). And a PFIC is excluded from specified foreign corporations. IRC §965(e)(3).

There is no deemed repatriation of profits from PFICs.

Indirect tax credit limited to QEFs

The tax cut eliminated the indirect tax credit for income taxes that foreign corporations pay. §14301(a). This eliminated the indirect tax credit that US corporations used to get if they own 10% or more of a PFIC, and the PFIC paid foreign taxes. IRC §1291(g)(2).

But if you are a US corporation that owns 10% or more of a qualified electing fund (QEF), then you get an indirect tax credit for the foreign taxes that the QEF paid. IRC §1293(f).

Insurance exception tightened

At the moment, if a company is in the business of insurance, and it would be taxed as an insurance company in the US, then its insurance income is nonpassive for determining whether it is a PFIC. IRC §1297(b)(2)(B), before amendment.

The tax cut adds another requirement: insurance liabilities need to be more than 25% of its total assets, determined using financial statements (presumably GAAP). IRC §1297(f)(1)(B). The IRS can loosen the 25% requirement slightly for insurance companies whose insurance liabilities dip below the requirement because of runoffs. IRC §1297(f)(2).

The post Tax Cuts on PFICs: Not Much Changed appeared first on HodgenLaw PC – International Tax.

Active rental income

This is a question we received through an email:

I own stock of a foreign real estate investment trust (REIT). It is a corporation under US tax law. It owns a hotel and rents rooms directly. It outsources the management of the hotel to an unrelated entity, but it has all the legal and contractual relationships with the guests.

In this post, I will discuss why this type of rental income is passive, which causes the REIT to be a passive foreign investment company (PFIC).

What are PFICs?

Passive foreign investment company (PFIC) is a specific classification under US tax law. It applies to a foreign corporation if it satisfies either: * An income test: 75% or more of its gross income is passive income, or * An asset test: 50% or more of its gross assets produce passive income or are held for the production of passive income. A foreign corporation that satisfies either test is a PFIC.

Rent usually is passive

Passive income is income that would be foreign personal holding company income in the hands of a controlled foreign corporation. IRC §1297(b). Foreign personal holding company income includes dividends, interest, royalties, rent, annuities, gains from properties that produce the above income, gains from properties that do not produce income, commodities gains, foreign currency gains, and payment in lieu of these types of income. IRC §954(c). It covers income that we normally think of as passive investment income. Rent normally is passive income.

Exception for active rent

There is an exception when the rent is from an active business:

[Passive income] does not include rents and royalties which are derived in the active conduct of a trade or business and which are derived from a person other than a related person… IRC §954(c)(2)(A).

Here, the hotel rental is an active trade or business: It requires many people to manage the hotel. The hotel has to provide services to its guests. The hotel has to advertise itself. It takes a lot of time and resources to run the hotel. Certainly the hotel is an active business.

The REIT needs to be engaged in the business

The regulations narrow the active rent exception into 4 categories, each of which requires the foreign corporation claiming the exception to participate in an active trade or business. Reg. §1.954-2(c)(1). Let us go through each category and see why none applies.

REIT is not a construction company

Under the first exception, rent is nonpassive if it is from leasing:

Property that the lessor, through its own officers or staff of employees, has manufactured or produced […] but only if the lessor, through its officers or staff of employees, is regularly engaged in the manufacture or production of […] property of such kind. Reg. §1.954-2(c)(1)(i).

This is an exception for construction companies that also rent out what they build. It does not apply to a REIT that holds only 1 hotel. Also, it requires the company to construct the property through its own officers or staff of employees. The REIT in our scenario outsources all its activities to an unrelated third party.

REIT is not actively managing or operating the hotel

Under the second exception, rent is nonpassive if it is from leasing:

Real property with respect to which the lessor, through its own officers or staff of employees, regularly performs active and substantial management and operational functions while the property is leased. Reg. §1.954-2(c)(1)(ii).

Here, the REIT outsources all management activities to an unrelated third party. It does little in managing the hotel business, either through its own officers or its own employees. The REIT’s rental income does not qualify for this exception.

Not temporary rental of business property

Under the third exception, rent is nonpassive if it is from leasing:

Property ordinarily used by the lessor in the active conduct of a trade or business, leased temporarily during a period when the property would, but for such leasing, be idle. Reg. §1.954-2(c)(1)(iii).

This exception exists for a business that wants to get some extra use out of business property that is idle temporarily. For example, a trucking business might rent one of its trucks to another business if its own business is slow, but it does not want to leave its trucks idle. Here, the REIT does not have a business other than the hotel business in which it uses the hotel. This exception does not apply to the hotel.

REIT does not perform marketing

Under the fourth exception, rent is nonpassive if it is from leasing:

Property that is leased as a result of the performance of marketing functions by such lessor through its own officers or staff of employees located in a foreign country or countries, if the lessor, through its officers or staff of employees, maintains and operates an organization either in such country or in such countries (collectively), as applicable, that is regularly engaged in the business of marketing, or of marketing and servicing, the leased property and that is substantial in relation to the amount of rents derived from the leasing of such property. Reg. §1.954-2(c)(1)(iv).

A corporation can claim this exception if it outsources management of its properties to a third party, but it reserves for itself the marketing function for the property. Here, there is nothing that suggests the REIT is in the business of marketing its own property, so it cannot claim this exception. Because it meets none of the 4 categories described in the Regulations, the REIT’s rent does not qualify for the active rent exception to passive income. There is an active hotel business, but because the REIT does not participate in the business, it cannot use the active rent exception. The REIT is a PFIC.

The post Active Rental Income Exception to Passive Income appeared first on HodgenLaw PC – International Tax.

This post notes a change in the way controlled foreign corporation (CFC) rules work now that the newly passed tax law is in effect. This change makes it more likely that a person would fall under the CFC rules instead of the passive foreign investment company (PFIC) rules. Unfortunately, it may have caused some persons to be subject to both the CFC rules and PFIC rules.

What are PFICs and CFCs?

Passive foreign investment company (PFIC) is a classification under US tax law. It is designed to discourage US persons from investing abroad through foreign investment vehicles. When a US person owns shares in a PFIC, the US person is subject to extremely punitive tax and reporting rules. IRC §1291.

Controlled foreign corporation (CFC) is another classification under US tax law. It is designed to reduce the ability of US persons to defer US tax by using foreign corporations to earn income. It does so by requiring “United States shareholders” of the CFC to include the CFC’s subpart F income and global intangible low-taxed income in the shareholder’s income each year. IRC §§951, 951A.

The term “United States shareholder” is in quotes, because it has a specific meaning in the tax Code. United States shareholders of a CFC that is also a PFIC use special overlap rules, and the new tax law changes the definition of United States shareholder.

The CFC-PFIC overlap rule

PFIC and CFC rules are supposed to be complementary. CFC rules apply when US persons control the foreign corporation as the Code defines it. CFCs require US shareholders to include their share of some of the CFC’s income each year. When CFC rules apply, there is no need to apply the PFIC rules.

But it is possible for a CFC to satisfy the definition of a PFIC. There is a rule that addresses the CFC-PFIC overlap in section 1297(d). The overlap rule works like this:

(1) In general For purposes of this part, a corporation shall not be treated with respect to a shareholder as a passive foreign investment during the qualified portion of such shareholder’s holding period with respect to stock in such corporation. (2) Qualified portion For purposes of this subsection, the term “qualified portion” means the portion of the shareholder’s holding period–

(A) which is after December 31, 1997, and (B) during which the shareholder is a United States shareholder (as defined in section 951(b)) of the corporation and the corporation is a controlled foreign corporation. IRC §1297(d).

What this says is that if you are a “United States shareholder”, as that term is defined under section 951(b), of a foreign corporation, and the foreign corporation is a CFC, then you do not treat your shares in the CFC as shares of a PFIC. You avoid the PFIC rules.

Let us assume that you have a foreign corporation, and that it is both a PFIC and a CFC. We need to know if you are a “United States shareholder” to see if you get to use the CFC rules instead of (or in addition to) the PFIC rules.

”United States shareholder” before and after the tax law changes

Here is how the term “United States shareholder” was defined before the tax law changed:

For purposes of this subpart, the term “United States shareholder” means, with respect to any foreign corporation, a United States person (as defined in section 957(c)) who owns (within the meaning of section 958(a)), or is considered as owning by applying the rules of ownership of section 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation. IRC §951(b) (2017).

Here is how the term “United States shareholder” is defined after the change in tax law:

For purposes of this subpart, the term “United States shareholder” means, with respect to any foreign corporation, a United States person (as defined in section 957(c)) who owns (within the meaning of section 958(a)), or is considered as owning by applying the rules of ownership of section 958(b), 10 percent or more of the total combined voting power of all classes of stock entitled to vote of such foreign corporation, or 10 percent or more of the total value of shares of all classes of stock of such foreign corporation. IRC §951(b) (2018).

The difference? Before the change, “United States shareholder” includes only those US persons who hold 10% or more of the voting power of the corporation. After the change, you are a United States shareholder if you hold 10% or more of either the voting power or the value of the corporation.

For example, suppose you have a foreign corporation with 2 series of shares. Shareholder 1 owns all series 1 shares, and shareholder 2 owns all series 2 shares. Both are US citizens. Series 1 has voting power but no right to profits or liquidation proceeds. Series 2 has no voting power but has all rights to profits or liquidation proceeds.

Under the previous rules, shareholder 2 is not a United States shareholder, because he holds no voting power. Under the new rules, shareholder 2 may (and probably does) hold sufficient shares to be a United States shareholder, because the nonvoting shares have value.

Because it is now easier to be a United States shareholder of a foreign corporation, more people would be subject to CFC rules, and more people would fall into the CFC-PFIC overlap.

It is easier for a corporation to be a CFC

A CFC is defined as follows (IRC §957(a)):

• Find all United States shareholders of a foreign corporation
• Add all shares of United States shareholders
• If the result is more than 50% of the foreign corporation’s shares by value or by voting power, then the corporation is a CFC.

After the tax law change, there are more United States shareholders. This means we are counting more shares when we determine whether a foreign corporation is a CFC. This means more foreign corporations would be classified as CFCs. This effect also contributes to why more people would fall into the CFC-PFIC overlap rule.

Some may need to purge a PFIC taint

Unfortunately, there is a “once a PFIC, always a PFIC rule”. What it says is that if you treated a share of a foreign as a PFIC share within your holding period of the share, then you must continue to apply the PFIC rules, even if you become a United States shareholder, and the corporation becomes a CFC. Reg. §1.1297-3(a). This is known as the PFIC taint.

The only way to stop applying the PFIC rules is to make a purging election. Reg. §1.1297-3. Debra covered the transition from PFIC to CFC rules in depth in a series of 3 posts.

Here is the short version: To make a purging election, the United States shareholder must either (1) recognize his share of the CFC’s earnings and profits under a deemed dividend election or (2) recognize gain from the shares under a deemed sale election. The deemed dividend or deemed sale election is taxed under PFIC rules, so it can create high tax liability.

Returning to our previous example: Suppose you have a foreign corporation with 2 series of shares. Shareholder 1 owns all series 1 shares, and shareholder 2 owns all series 2 shares. Both are US citizens. Series 1 has voting power but no right to profits or liquidation proceeds. Series 2 has no voting power but has all rights to profits or liquidation proceeds.

This corporation always has been a CFC, because there is 1 US citizen who owned all voting power of the corporation.

Shareholder 1 always has been a United States shareholder of a CFC, so he operates under the CFC rules but not the PFIC rules. Shareholder 2, however, was not a United States shareholder before 2018, because he held no voting power. He became a United States shareholder in 2018. He treated the shares as PFIC shares during his holding period.

Both the CFC rules and PFIC rules apply to shareholder 2 starting 2018. He needs to make a purging election to stop the PFIC rules from applying.

The post Tax Law Changes Made a CFC-PFIC Overlap Easier appeared first on HodgenLaw PC – International Tax.

The Tax Cuts and Jobs Act completely rewrote Section 965 to force a one-time repatriation of deferred earnings and profits in foreign corporations. It forces income recognition in the 2017 tax year, so there is not a lot of time to figure this one out!

Rufus Rhoades will give a one-hour free workshop on March 23, 2018 at 9:00 am Pacific Time. Register here; it’s free.

I call this a workshop because the intention is for Rufus to talk a bit about the new law, then we will open it up for questions and input. Some of you out there are smart about Section 965, so please share with us. We can all pool our collective ignorance to become individually brighter.

Along those lines, it is important to bring in as many resources and perspectives as possible. I learn from reading what others write, and listening to what they say.

Here are some links I have collected from Out There on the Interwebs. I have omitted anything that requires a subscription.

If you know of other good Section 965 discussions, please tell me so I can update this page. Email = phil “at” hodgen.com.

Section 965 Itself

• 26 USC § 965.  From the Cornell website.

What the IRS is Saying

• The Generic IRS Tax Reform Web Page. Start here first for anything the IRS is publishing about the Tax Cuts and Jobs Act.
• Questions and Answers about Reporting Related to Section 965 on 2017 Tax Returns. Self-explanatory. FAQ format.
• Notice 2018-7. (PDF). The first guidance from the IRS on Section 965.
• Notice 2018-13. (PDF). “Additional Guidance Under Section 965 and Guidance Under Sections 863 and 6038 in Connection with the Repeal of Section 958(b)(4)”.
• Rev. Proc. 2018-17. (PDF). Guidance on changing your accounting period when faced with Section 965.

Section 965 and California Taxation

• Preliminary Report on Specific Provisions of the Federal Tax Cuts and Jobs Act. (PDF). Published by the Franchise Tax Board, you can find the discussion of Section 965 in pages 16-21.

Analysis by PowerPoint

You learn from slides? Here you go.

• The Tax Cuts and Jobs Act: A Conference with the Government and Private Sector to Discuss the Legislation. (PDF). Slides from a conference cosponsored by Tax Analysts and Bloomberg. The international tax discussions start at page 65 of this 381-page behemoth.
• Understanding the Tax Cuts and Jobs Act. (PDF). This is a large PowerPoint deck from from Venable. The Section 965 discussion is at pages 42-45.

Shorter Pieces

Here are better-than-average overviews, or deep dives on a particular slice of Section 965.

• Tax Cuts and Job Act News. A curated web page from the International Tax Policy Forum with links to articles they like about the new tax law. Good if you have subscriptions to the publications they link to.
• Code §965: Individuals Recognizing the Deemed Repatriation in 2017 vs. 2018. Andrew Mitchel discusses the timing of Section 965 income recognition for human taxpayers.
• Tax Cuts and Jobs Act significantly affects US private companies with outbound investments. Ernst & Young has a summary web page with brief discussions of the new law. Of particular interest is the relatively short section under the heading Application of Transition Tax to US individuals and trusts, their pass-through entities and closely-held C corporations.
• Tax Cuts and Jobs Act: The Toll Charge to Move into the New Quasi-Territorial Regime. This well-written longer piece walks you through how Section 965 works. It is comprehensive but dives a bit deeper when it is needs to.
• News Analysis: How Some Taxpayers Got Cut Out of the Tax Cuts and Jobs Act. From a real journalist. Not 100% a Section 965 discussion, but useful to add context. This article discusses how some taxpayers are harmed by the new tax law: individuals owning foreign corporations, foreign pass-through businesses, etc. Includes a brief discussion of Section 965.
• Tax Reform: The International Provisions (Part 1)-Section 965 Deemed Repatriation Tax. Shorter writeup, distinguished by a very nice flow chart that walks you through Section 965 analysis, step-by-step.
• Repatriation of Foreign-Sourced Accumulated Earnings in Transitioning to a Participation Exemption System for Reporting Foreign Sourced Dividens Under the Tax Cuts and Jobs Act of 2017. Another short-ish but comprehensive enough-ish introduction to Section 965.
• Overview of the Major International Tax Provisions Of the Tax Cuts and Jobs Act. (PDF). This is a useful list of the international tax provisions of the Tax Cuts and Jobs Act, courtesy of Gutter Chaves Josepher Rubin Forman Fleisher Miller P.A.. It includes a discussion of Section 965, of course.
• IRS Notice 2018-13: How it Affects Your Toll Tax Model. Translates Govspeak to English and tells you what Notice 2018-13 says.
• Talking Toll Tax: Calculation and Provision Considerations for the New Year.  (PDF).  An overview of Section 965.  Touches on GAAP issues and SEC guidance.
• Repatriation “Toll Tax”.  A well-written introductory overview of new Section 965 from Rödl and Partner.
• Tax reform: IRS clarifies repatriation transition tax, other international aspects.  Another discussion of Notice 2018-13.
• Impact of the Tax Cuts and Jobs Act on U.S. Investors in Foreign Corporations.  (PDF).  An overview article from Ruchelman P.L.L.C. Discussion of Section 965 starts on page 6.
• The Toll-Charge Playbook:  A Step-by-Step Example. (PDF) From Alvarez & Marsal.

The post Upcoming Section 965 Workshop and a Collection of Links appeared first on HodgenLaw PC – International Tax.

Hello from Debra Rudd.

You are receiving this email because you are signed up for our “PFICs Only” newsletter, delivered directly to your electronic mailbox every other Thursday at 6:00 am Pacific time. To stop receiving this message, scroll down to the bottom and click “unsubscribe”. If you are interested in receiving more of these types of communications, check out our other mailing lists at hodgen.com/lists.

CalCPA International Tax Conference — November 6

Tomorrow, November 6, I will be speaking at the CalCPA International Tax Conference, a full-day event dedicated to practitioners who work with individuals whose tax situations cross the US border — either US persons living and working abroad, or foreigners coming to the US to work or make investments. The topic for my presentation will be “Taking the Pain out of PFICs: A Survey of Purging Elections”.

Please attend the conference if you can. It is a wonderful resource for those of us who work in international tax (and 8 hours of CPE credit for having attended. Imagine that: You can learn something AND get CPE credit!)

International Tax Lunch — November 13

If you cannot attend the conference but still would like to hear my presentation, I will be speaking on the same topic at our monthly International Tax Lunch, scheduled for Friday, November 13 at 12:00 noon Pacific time at our office in Pasadena, California. Everyone is welcome to attend, either in person at our office or via dial-in, and attendance is free. (And if you attend in person at our office, we’ll buy you lunch.)

If you want to attend in person, register here.
Click the big green button that says "register in the upper right corner.

If you want to call in, register here.
Click the big green button that says "register in the upper right corner.

A broad overview of purging elections

The topic I will be covering in these presentations is PFIC purging elections. I have talked about them from time to time in this newsletter, and the presentation will tie together the various elections available, who can make them, when they can be made, and how to make the elections on the tax forms.

It is intended more as a broad overview than as an in-depth study. One thing I have learned from Phil about writing and delivering presentations: If you have an hour to talk, you can go broad, or you can go deep, but you cannot do both. At some point in the future I would like to do more detailed studies of the individual elections available. For now, I have created what I think is a helpful guide to understanding how, when, and whether to utilize each of the various elections.

Purging elections mean paying tax

At one point several years ago, I remember the international tax scene being all atwitter about PFIC purging elections. I would hear questions such as: How do we make purging elections? What about late purging elections??? If only we could make purging elections, everything would be better for our clients!

What you are doing when you make a purging election is solving a timing issue. You are deciding to pay a certain amount of tax now instead of an uncertain amount of tax in the future. You are making a bet that things will get better (your PFIC will generate more income and/or increase in value) rather than worse (your PFIC will lose money and you will sell it at a loss).

What I mean about solving a timing issue is this: Under any purging election that exists, you will be making a pretend sale or recognizing a pretend distribution under the IRC §1291 excess distribution rules. That means tax at ordinary rates on a portion of the income, tax at maximum rates on the remainder of the income, and all of the maximum-rate income tax is also subject to a daily compounded interest charge that goes back to the beginning of your holding period.

So when you make a purging election, it is generally because you expect the value of your PFIC to increase, or for it to be paying out increasingly large distributions in future years, and you want to improve the tax results for those eventualities. If you expect to receive smaller distributions, or if you expect the value of the PFIC to decrease, it actually may make sense to not make a purging election and allow it to remain a PFIC, because the tax you pay now by making the purging election could easily exceed the tax you would instead pay later when you sell or receive distributions from your diminished-in-value PFIC.

Practical considerations should be at the front of our minds when solving problems for our clients: Is a purging election really the right move? Between tax and professional fees, does it make financial sense?

Hope to see you there

I hope to see you either at the CalCPA International Tax Conference on November 6, or our monthly International Tax Lunch on November 13. Please say “hi” if you attend!

Debra

The post Upcoming presentations and purging elections appeared first on HodgenLaw PC – International Tax.

Hi from Debra Rudd.

You are receiving this email because you are signed up for our “PFICs Only” newsletter, delivered to your electronic mailbox every other Thursday at 6:00 am Pacific time. To stop receiving these emails, scroll to the bottom of this message and click “unsubscribe”. To see what other newsletters we offer, go to hodgen.com/lists.

Taxation of distributions from PFICs in multi-tiered structures

For this week’s newsletter I will discuss the following scenario:

You, a US citizen, and your friend, a non-US person, form a foreign corporation in 2005. You each own 50% of it. Let’s call your corporation Investment Corp.

In 2005, Investment Corp forms a 100% owned subsidiary called Holding Corp. Holding Corp in turn purchases 100% of the shares of an active business called Manufacturing Corp.

Holding Corp sells Manufacturing Corp in 2013. Two years after the sale, Holding Corp distributes the proceeds from the sale to Investment Corp. Investment Corp then uses the money to make other investments.

You never received a distribution from Investment Corp, but you would like to know if any of these events create a US tax liability for you.

The answer is “yes”. Even though you did not receive any money from any of these transactions, there will be tax to pay. And it will be a somewhat painful tax. Let’s take a look at why.

Multi-tiered structure analysis in general — the blueprint

The way we tend to approach these types of situations is by asking the following questions:

1. Did you actually receive any money from any foreign corporation you own directly? If you did, it could be a taxable distribution.

2. Is the foreign corporation you own directly a “controlled foreign corporation”? If so, there may be tax that arises from that company’s earnings even if nothing is distributed to you. This happens when the company has a type of income called “Subpart F” income.

3. Is the top level corporation (Investment Corp) a PFIC by virtue of the IRC §1297(c) look through rules? If so, you will be subject to the PFIC rules for that entity.

4. Do you own enough of the top level corporation that the PFIC attribution rules under IRC §1298(a) would apply to you? If you do, and if any of the underlying companies are PFICs, there may be tax that arises from any distributions made from an indirectly held company to its parent, or from the sale of an indirectly held company by its parent, even if you never receive a dollar of the distribution or proceeds.

Multi-tiered structure analysis for this particular scenario

Let’s look at the questions one by one as they apply to our fact pattern:

1. No money was received, so no tax

Investment Corp did not distribute anything to its shareholders – no dividends, no return of capital. Therefore, no tax liability will arise as a result of a distribution from Investment Corp.

2. Investment Corp is not a controlled foreign corporation

A controlled foreign corporation is a foreign corporation where more than 50% of its value or voting power is owned by “US shareholders”. IRC §957(a). A “US shareholder” is defined under IRC §951(b) to be a United States person who owns 10% or more of the voting power of a foreign corporation.

You are a US shareholder of Investment Corp, because you are a United States person, and you own 10% or more of its voting power – you own 50% of its voting stock.

Investment Corp is not a controlled foreign corporation, however, because you are its only US shareholder, and you only own 50% its stock. You would need to ownmore than 50% for Investment Corp to be a controlled foreign corporation.

Because Investment Corp is not a controlled foreign corporation, you do not need to be concerned with Subpart F income. By definition Subpart F income only occurs when there is a controlled foreign corporation.

3. Investment Corp is not a PFIC

Investment Corp owns nothing but 100% of Holding Corp, and Holding Corp owns nothing but 100% of Manufacturing Corp. I will assume that Manufacturing Corp is not a PFIC by virtue of the income test or asset test of IRC §1297(a).

IRC §1297(c) states:

If a foreign corporation owns (directly or indirectly) at least 25 percent (by value) of the stock of another corporation, for purposes of determining whether such foreign corporation is a passive foreign investment company, such foreign corporation shall be treated as if it—

(1) held its proportionate share of the assets of such other corporation, and

(2) received directly its proportionate share of the income of such other corporation.

Because of this look through rule, Holding Corp is attributed all the assets and income of Manufacturing Corp (and it has no other assets or income of its own). Investment Corp is in turn attributed all the assets and income of Holding Corp (and it has no other assets or income of its own).

Manufacturing Corp is not a PFIC, so Holding Corp is not a PFIC. Holding Corp is not a PFIC, so Investment Corp is not a PFIC.

4. Tax liability arises from the PFIC attribution rule

We have already established that Investment Corp, Holding Corp, and Manufacturing Corp are not PFICs. But what happens when Holding Corp sells Manufacturing Corp in 2013? Because its only asset at that point is cash, and because cash is a passive asset for purposes of the asset test, Holding Corp will surely satisfy the asset test under IRC §1297(a) and become a PFIC.

As the owner of Investment Corp, you may think you do not need to worry about that. After all, you do not own the PFIC stock directly. You own the stock of a company (Investment Corp) that owns the stock of a PFIC (Holding Corp).

The PFIC attribution rule of IRC §1298(a)(2) says that you are treated as owning directly the stock of any PFIC that you hold indirectly through another corporation, if you own 50% or more of the stock of that other corporation.

You own 50% of the stock of Investment Corp, so IRC §1298(b)(2) applies to you and you are treated as owning directly the stock of its subsidiaries.

Holding Corp becomes a PFIC after the sale of Manufacturing Corp. When it finally distributes the proceeds of the sale to Investment Corp two years later, that distribution is taxable to you under the PFIC rules as if you had owned the stock directly and received the distribution yourself because of the IRC §1298 attribution rule. This is true even though Investment Corp never distributed any money to you and used the funds to invest in other businesses.

Assuming no elections were ever made for Holding Corp, the cash distribution from Holding Corp to Investment Corp will be taxed under the excess distribution rules of IRC §1291, the default tax treatment for PFICs.

The excess distribution rules require an allocation of the distribution over the entire holding period, an application of maximum tax rates and an interest charge to the prior years’ allocated distributions, and an application of ordinary tax rates for the current year’s allocated distribution.

Because you have to go back to 2005 for the beginning of the holding period, the total PFIC tax you pay will be quite high once you factor in the interest charges.

Change of business exception does not apply

Those of you who are very, very familiar with the PFIC rules may be wondering at this point about the “change of business” exception: Under IRC §1298(b)(3), a corporation that becomes a PFIC because it sold an active business and now has a lot of cash and little else will not be treated as a PFIC.

That rule only applies if the corporation is not a PFIC for either of the two years after the year for which the change in business exception is being claimed. IRC §1298(b)(3)(C). I chose to write the fact pattern for our discussion such that the cash is held within Holding Corp for two years so that Holding Corp does not benefit from the change of business exception and is a PFIC. I did this to illustrate some of the issues that I frequently see in these types of structures.

How to restructure your foreign holding structure

In many cases, this type of holding structure is necessary for business purposes. So how would the US investor avoid the PFIC problem without having to immediately distribute profits from Holding Corp?

Regulation section 301.7701-3 allows a foreign corporation that is not a “per se” corporation listed under section 301.7701-2(b)(8) to elect tax treatment between a flow through entity and a corporation. By making the flow through election, Holding Corp becomes a disregarded entity under US tax law, because its sole owner is Investment Corp. Only entities taxed as corporations can be PFICs. Holding Corp, if it makes the disregarded entity election, can hold onto its cash for as long as it wishes to without becoming a PFIC.

There will be US filing requirements for the disregarded entity (think Form 8858), but there will be no PFIC tax to pay.

Summary

The PFIC look through and attribution rules of IRC §§1297(c) and 1298(a) can create situations where, in multi-tiered structures, the ultimate human owners of those structures may be paying tax on transactions that happen several layers down in the holding structure.

The human owner never receives any money from these transactions, as long as the top level corporation is not sold and does not make any distributions to the owner, but has a tax liability to pay nonetheless. Under the excess distribution rules, it could be quite a hefty tax.

If you have this kind of structure, or if you are planning to set one up, you will need to plan carefully to avoid getting caught in these traps.

Thanks

Thanks for reading. This stuff is really, really complicated, so you should seek some competent professional advice if you’re facing these types of questions — this newsletter is not advice to you. I am, however, happy to talk about PFICs with you if you’d like. Just hit “reply” to this message.

Debra

The post Taxation of distributions from PFICs in multi-tiered structures appeared first on HodgenLaw PC – International Tax.

Hello again from Phil Hodgen, and Happy 2016.

Work here

We are hiring.

You can see the job listings at hodgen.com/jobs. One admin/office manager, one accountant. That’s what’s on the plate at the moment.

But there will be more job listings to come in the next few months.

International Tax Lunch – Today

You are getting this at 6:00 a.m. Pacific time. At noon (Pacific time) today, our International Tax Lunch series for 2016 will kick off. I will be talking about the foreign earned income exclusion and Form 2555. Quick. Go to hodgen.com/lists and sign up so you can get the last-minute email with the conference call dial-in information.

Or just hit “Reply” and email me. We will make sure you get the announcement email so you can call in.

Also. If you want to come to our new offices in Pasadena, we would love to see you. Email me (just hit “Reply” and send me an email) and we will get your lunch request. (Yes, we will feed you!)

Foreign Life Insurance and Americans Abroad

Martha Myron in Bermuda sent me an email with a topic suggestion. It is a good one. This is a tax problem that happens a lot, seems boring (therefore not a tax problem), and yet can make a mess for Americans abroad.

Life insurance. Specifically, life insurance issued by non-U.S. insurance companies. Here is Martha’s suggestion:

USCITS / US green card holders / US tax persons abroad being sold foreign life insurance. You do not have to told the serious misconceptions here, and the hurdles that these individuals have no idea they are going to have to cope with. A recent scenario – the foreign life insurance salesman (selling whole life or variable, of course) told the dual citizen with the US that it was just fine because the individual was earning less than 90,000 under the exemption. Foreign salesperson is not a US CPA / EA or US international tax attorney and actually has never been exposed to any US tax. This might be a topic to add to your PFIC series.

The Problems With Foreign Life Insurance

I am not going to write the Encyclopedia of Foreign Life Insurance, but here are the risks that an American Abroad faces when purchasing a life insurance policy.

Excise Tax

There is an excise tax to pay every time you pay a premium on a foreign life insurance policy, annuity, or sickness and accident insurance.

• 1% of Premium Paid. A U.S. person who buys such a policy is taxed. The tax is 1% of the premium paid.
• Form 720. You are required to file Form 720 to report the premium payment and remit your excise tax.
• Resource. Look at the IRS audit technique webpage for a good overview.

Form 8938

Life insurance and annuity policies with cash value are reportable on this form. They are “specified foreign financial accounts”.

FinCen Form 114

The Dreaded FBAR. Life insurance policies are reportable here, too. 31 CFR § 1010.350(c)(3)(ii).

The PFIC Risk

There is another risk entirely. This is, I think, the risk that Martha pointed out.

In some circumstances, you might have been sold a financial product that is called an “insurance policy”, but from the point of view of the U.S. tax system, it is not an insurance product at all.

If this is the case, you are treated (by the U.S. tax system) as owning an investment account full of assets. That “insurance policy” you bought will contain assets of various types, some of which are almost certainly mutual funds. Foreign mutual funds. These are Passive Foreign Investment Companies, or PFICs. This means:

• You have to file Form 8621 to report all of the mutual funds held as part of the investment account in that insurance policy.
• If, during the time the life insurance policy is active and you are alive, the insurance company buys and sells mutual funds, you will have actual taxable sales under the excess distribution rules.
• When you die, your estate will be treated as having sold the PFICs inside the “insurance policy” for fair market value, again triggering tax under the excess distribution rules.

Estate tax

Worse yet, the death benefit when you die could be taxable.

If this is not an “insurance policy” under the definitions in the Internal Revenue Code, then you have an asset that will be subject to estate tax. The account is just an investment account with stuff in it. When you die it owns the death benefit from the insurance policy. That could be a big number — big enough to cause estate tax problems.

Your heirs, instead of receiving cash tax-free (from the U.S. tax system, that is), will face the possibility of filing Form 706 for you, and paying an estate tax.

Cool

A couple of weeks ago, an unexpected email hit my inbox. A newsletter, it said, would be starting up again after a two-year hiatus.

Read this — an excerpt from the first issue of this revived newsletter. It recounts one of Simo Hayha‘s kills as a WWII sniper in the Finnish Army.

Simo Hayha exhales, his breath showing in the cold air. He shifts his posture, placing as much of his weight as he can against the hard tissue of his body. The small muscles twitch; bone does not twitch.

He looks through the iron sights of his Model 28-30 rifle, closes his left eye, and then re-opens it for depth perception. The Soviet officer is perfectly in the rifle’s trajectory.

The marksmanship instructors always said that the best shot is the one that surprises you. You must pull the trigger so slowly it’s almost a surprise when the gun flares to life. Simo applies gently pressure, unnoticeably tensing the pad of index finger on the trigger, touching it as if he were carefully applying medicine to a young child’s gums, a child that had been crying from new teeth coming in.

The loud crack of the rifle flaring to life shocks Simo, he’s surprised and flinches, but the flinch doesn’t matter – the lead slug has had its gunpowder activated and has already left the rifled barrel.

The bullet’s trajectory is pinpoint-perfect. In milli-seconds, it will strike the invading officer in his breast, near his heart, severing flesh and tendon. The young Russian will crumple sideways into the snow, immediately enter shock, and be on the brink of death before his comrades reach him.

But, wait!

The bullet has not yet struck the Soviet; freeze this landscape in your mind. Simo Hayha is mid-flinch at the surprise of the rifle roaring to life; the young officer is milling about on the cold land, oblivious to the fact that his life is nearing conclusion; the bullet hangs in mid-air, its trajectory set; this scene has almost entirely played out, but not yet; it’s not over yet, we’re at a moment frozen in time.

Who could stop reading at that point?

Here is what I find compelling about the newsletter:

• It is extremely well written. This is not a one-off event. Read anything he has written and you will see the same care and intentionality.
• It contains simple suggestions that you can understand and actually, y’know, do. These things can you make your life better.
• The only way to read the newsletters (at the moment at least) is to sign up. You cannot go to the website and read prior episodes. This is intensely interesting to me as a marketing strategy — that an author would deliberately make it harder for people to find him and his work.

Go to The Strategic Review and sign up. Highly recommended. The author is Sebastian Marshall.

Logging Out

That’s it for this Friday. See you in a couple of weeks.

Remember, this newsletter is not legal advice and you’d be a damn fool to use this newsletter to make tax or legal or life decisions. Go hire someone competent.

Phil.

The post Foreign life insurance and Americans abroad appeared first on HodgenLaw PC – International Tax.

Hey from Debra Rudd.

You are receiving this message because you are signed up for our “PFICs Only” mailing list, delivered to your electronic mailbox every other Thursday at 6:00 am Pacific time. If you would like to stop receiving this newsletter, just scroll to the bottom of this email and click “unsubscribe”. To see what other newsletters we offer, go to hodgen.com/newsletters.

Work here

We are hiring.

You can see the job listings at hodgen.com/jobs. One admin/office manager, one accountant. We will also be posting a listing for an attorney soon.

For the accountant position, you might be straight out of school or you might have done your tour through the Big 4 or somewhere else and are disillusioned. You want to do international tax work that interests you — instead of junk that some senior partner thinks you should do. And you want a life.

If this sounds like you, please take a look at the listing and consider applying.

PFIC held by a domestic partnership stops being a PFIC

This week’s topic is inspired by a number of questions I received while delivering a speech on PFIC purging elections at the CalCPA International Tax Conference in San Francisco on November 06, 2015:

Jill is a US citizen who purchases an interest in a domestic publicly traded partnership in 2014. The partnership invests in various domestic and foreign companies. On Jill’s 2014 K-1, one of those foreign companies is shown as a PFIC with QEF income information provided. On her 2015 K-1, the company that was shown as a PFIC in 2014 has a note stating that it is no longer a PFIC, and no QEF income information is provided. What does Jill need to do on her 2015 US income tax return?

In today’s newsletter, I will discuss how the QEF election works when a PFIC is held through a domestic pass through entity. Then I will take a look at the rules for reporting income from a QEF that ceases to meet the PFIC definition.

First, a refresher on QEFs

A qualified electing fund (QEF) is a PFIC for which a valid QEF election has been made. Under the QEF rules, a PFIC is taxed similarly to a partnership, meaning that income retains its character (capital gains are taxed as capital gains) and is passed through to the shareholder for current inclusion in income.

You will pay less tax under the QEF rules than you will pay under the punitive Mark to Market rules of IRC §1296 or the extremely punitive excess distribution rules of IRC §1291. You will want to make the QEF election if you can because it has the best tax result for a PFIC.

Partnership makes the QEF election

For PFICs held through pass through entities, the QEF election is generally made by the first US person in the chain of ownership. Regs. §1.1295-1(d)(2).

For a PFIC that is owned by a domestic partnership, an interest in which is owned by a US citizen, the first US person in the ownership chain is the domestic partnership. The domestic partnership makes the QEF election. Regs. §1.1295-1(d)(2)(i)(A).

QEF election only valid if made by partnership

Under Regs. §1.1295-1(b)(3)(iv)(A), the QEF election is only valid for the partners if the election is made by the partnership:

Stock of a PFIC held through a pass through entity will be treated as stock of a pedigreed QEF with respect to an interest holder or beneficiary only if—

(A) In the case of PFIC stock acquired…and held by a domestic pass through entity, the pass through entity makes the section 1295 election…

Note that the QEF election is in effect “only if” the partnership makes the election. Jill cannot herself decide whether to make the QEF election — that is decided at the partnership level.

When she receives the 2014 K-1 from the partnership which provides QEF income information, Jill can assume that the partnership has correctly made a valid QEF election for the PFIC and that she must report it on her tax return as QEF income as directed by the K-1.

If it stops being a PFIC, no QEF income inclusion

PFIC status for a corporation is determined by applying the income test and asset test under IRC §1297(a): if 50% or more of its assets are passive, or if 75% or more of its income is passive, then it is a PFIC.

According to Regs. §1.1295-1(c)(2)(ii), a shareholder of a QEF that ceases to meet either one the two tests does not include income under the QEF rules on her tax return.

That is Jill’s answer: the K-1 states that the company is no longer a PFIC, so she does not have to report income under the QEF rules for that company. When preparing her 2015 tax return, she can assume that any includable income from the former QEF (if there is any) is reflected elsewhere on the K-1.

“Once a PFIC, always a PFIC” rule does not apply

In general, if a company is a PFIC in any year, it continues to be taxed as a PFIC in all future years, regardless of whether it meets the income test or the asset test in those future years. The only way that PFIC status can be terminated is by making a purging election to remove the PFIC status. IRC §1298(b)(1). This is known as the “once a PFIC, always a PFIC” rule.

However, there is an exception for QEFs in that paragraph:

Stock held by a taxpayer shall be treated as stock in a passive foreign investment company if, at any time during the holding period of the taxpayer with respect to such stock, such corporation (or any predecessor) was a passive foreign investment company which was not a qualified electing fund. IRC §1298(b)(1).

In this scenario, Jill’s PFIC is a qualified electing fund, because the partnership made the QEF election, and Jill is bound by that election.

The “once a PFIC, always a PFIC” rule does not apply to Jill, and she can rely on the regulation that states there is no QEF income inclusion when a QEF ceases to meet the PFIC rules. That result is automatic: she does not need to make a purging election.

If it meets the PFIC definition again, the QEF election applies again

Under Regs. §1.1295-1(c)(2)(ii), if a QEF that ceases to meet the PFIC definition begins to qualify as a PFIC once again in a future year, the QEF election remains in effect and the shareholder is subject to the QEF rules for that future year (unless the election is somehow terminated or invalidated).

If Jill’s PFIC held through the partnership meets the income test or the asset test in some future year (and if the PFIC provides the partnership with the necessary QEF income information), the K-1 will once again reflect the QEF income information she needs to report on her US tax return.

What if the PFIC just disappears from the K-1?

In Jill’s situation, she received a K-1 which explicitly stated that a PFIC which was previously taxed under the QEF rules no longer qualifies as a PFIC. But what if the PFIC just disappears from the K-1? As several CalCPA International Tax Conference attendees pointed out, that is sometimes the case.

In that situation, I’m not sure what the answer is. It could be that the PFIC was sold by the partnership, or it could be that, like in Jill’s situation, the PFIC ceased to meet the PFIC definition. Or, it could be a third scenario: the partnership left an important note off the K-1 in error.

Personally, I would look at the K-1 for clues: does it include notes about other PFICs held in the same partnership, saying that they did not qualify as PFICs in that year? If so, perhaps the PFIC that disappeared without a note was sold. Does it include notes about other PFICs that were sold? If so, perhaps the PFIC that disappeared without a note ceased to be a PFIC in that year.

You may need to contact the partnership for additional information if you cannot determine what happened by process of elimination (I, for one, wouldn’t take anything for granted). Maybe if many people contact the partnership requesting clarification, the partnership will begin to provide better detail on its K-1s in future years.

Thank you

As always, thank you for reading. This is not tax advice to you, and you cannot rely on it as advice. I skipped over a lot of nuances for the sake of brevity and clarity. If you need help, hire a professional.

See you in two weeks.

Debra

The post PFIC held by a domestic partnership stops being a PFIC appeared first on HodgenLaw PC – International Tax.

Hello from Debra Rudd.

You are receiving this email because you are signed up for our bi-weekly “PFICs Only” newsletter, delivered to your electronic mailbox every other Thursday at 6:00am Pacific time. To stop receiving this newsletter, scroll to the bottom of this email and click “unsubscribe”. On the other hand, if you would like to see the other newsletters that we offer, go to hodgen.com/newsletters.

Is a late MTM election under the inbound immigrant rules possible?

This week’s topic comes from a question I received a while ago from an anonymous reader:

Does an immigrant to the US get to apply the basis step up/transition rule if they did not do a MTM election in their first year of US residence? Can we do it 2 years later?

The answer is “no”, but you can still make the mark-to-market election if you first make a pretend sale under the excess distribution rules. Because the immigrant has not been a US person very long, the actual tax result under the excess distribution rules may not be that bad, relatively speaking, and this could be a viable option.

In today’s newsletter, I will explain why a person new to the US may not use the inbound immigrant transition rule if they do not do it in the first year of US person status. I will then briefly describe the coordination rule for persons making the MTM election after operating under the excess distribution rules. Finally, I will use a specific example to show why the tax results of making the MTM election in the second year of US person status may be a viable option.

Inbound immigrant transition rule only for first year of US status

Our reader (let’s call him A) is referring to a special rule in the Code for inbound foreigners who own PFICs and who want to make a MTM election in the year in which they become US persons. This rule provides for a step-up in basis to fair market value at the beginning of the first year he is a US person (if that market value is greater than his adjusted basis in the PFIC) for the purposes of making the MTM election. IRC §1296(l).

The inbound immigrant transition rule is only available in the year that a person becomes a US person.

If the MTM election is not made in the first year of US person status, then the US immigrant is operating under the excess distribution rules of IRC §1291 for that year. IRC §1291 is the default treatment for PFICs when no elections have been made.

There is no provision for making a retroactive MTM election under the inbound immigrant transition rule.

A cannot make the MTM election under the transition rule two years after becoming a US person.

A can use the “coordination with section 1291” rule

Any person who is operating under the excess distribution rules can transition to the MTM election, assuming that their PFIC meets the marketable stock requirements of IRC §1296(e) and they are otherwise permitted to do so under the Code and regulations. Let’s assume that A owns marketable PFIC stock and is otherwise permitted to make the MTM election.

Under IRC §1296(j), coordination with section 1291 for first year of election, when A makes the MTM election in the second year of US person status, he is subject to a special set of rules that include gain recognition under the excess distribution rules:

• The entire first year of the MTM election, any distributions or actual sales are taxed under the excess distribution rules, not the MTM rules;
• At the end of the first year of the MTM election, A must make a pretend sale and recognize the gain under the excess distribution rules; and
• A does not get to operate under the MTM rules until the second year of his MTM election.

For a more detailed explanation of how this works, see a blog post I wrote last year on that topic.

Tax results under the “coordination with section 1291” rule

Let’s use the following scenario to determine the tax results if A makes the MTM election under the coordination rule of IRC §1296(j) in the second year of US person status:

A, a nonresident, purchases a foreign mutual fund which qualifies as a PFIC on January 1, 2008. A never makes any subsequent purchases or sales, and never receives any distributions from the fund.

A becomes a US resident under the substantial presence test in 2014, so the first day of A’s US person status is January 1, 2014.

A fails to make the MTM election under the inbound immigrant transition rule for 2014.

A decides to make the MTM election under the coordination with section 1291 rule for 2015.

A computes his gain on the deemed sale as of December 31, 2015 to be $1,000.

I will assume that readers are familiar with the excess distribution rules while going through the calculations. For those not familiar, go here for a primer in excess distributions.

Step 1: Allocate the gain over the holding period

The holding period is 8 years exactly, starting on January 1, 2008 and ending on December 31, 2015. Ignoring the extra day in leap years, A can allocate $125 of gain to each of the 8 years ($125 x 8 = $1,000).

Step 2: Separate holding period into pre-PFIC, prior years’ PFIC, and current year periods

Now we must separate the gains into three periods: the pre-PFIC period, the prior years’ PFIC period, and the current year.

The pre-PFIC period includes all the time that A was a nonresident of the US, according to Prop. Regs. §1.1291-1(b)(1)(i):

A corporation will not be treated as a PFIC with respect to a shareholder for those days included in the shareholder’s holding period before the shareholder became a United States person within the meaning of section 7701(a)(30).

Therefore, the amounts allocated to each period are as follows:

• Pre-PFIC period: From January 1, 2008 to December 31, 2013 (6 years). 6 x $125 = $750.
• Prior years’ PFIC period: From January 1, 2014 to December 31, 2014 (1 year). 1 x $125 = $125.
• Current year: From January 1, 2015 to December 31, 2015 (1 year). 1 x $125 = $125.

Step 3: Determine ordinary income

Under the excess distribution rules, the amounts allocated to the pre-PFIC period and the current year are ordinary income. That means in this example A has $875 of ordinary income.

Step 4: Calculate tax and interest on prior years’ PFIC income

$125 of the gain is allocated to the prior years’ PFIC period. Tax is computed on that amount at the maximum tax rate for the year. For 2014 that is 39.6%.

A’s tax on the amount allocated to 2014 is $125 x 39.6% = $49.50.

A must compute interest on the tax he calculated as if it was an underpayment of tax due on the tax return due date of the tax year to which the tax was allocated, and the interest runs through the due date of the tax return on which he is reporting the excess distribution. IRC §1291(c)(3).

For A, that means he computes interest on $49.50 of tax from April 15, 2015 to April 15, 2016. I calculated the interest to be $1.51.

Recap of tax results for A

To recap, if A makes the MTM election under the coordination with section 1291 rules in his second year of US person status, and computes his gain to be $1,000, the tax he will face will be the following:

• Ordinary income of $875, assuming a tax rate of 30% = $262.50
• PFIC tax and interest on amount allocated to prior years’ PFIC period = $49.50 + $1.51 = $51.01
• Total tax as a result of the election = $262.50 + $51.01 = $313.51

Some comments on this strategy

Note that, had A been able to make the MTM election under the inbound immigrant transition rule, the entire gain would have been ordinary income (and according to my calculations that means $13.51 less tax to pay, assuming a gain of $1,000).

Of course, he would have been able to use a stepped-up basis under the inbound immigrant transition rule, so the gain would have been smaller than the $1,000 we are dealing with here, and the tax savings could have been quite a bit more than $13.51.

However, I would like to point out that the interest charges only apply to one year of A’s holding period when using the method I described here, so he will at least not be subject to years upon years of accumulated interest.

While it is not the best tax result he could have had, it may be worth it to make the MTM election under the coordination with section 1291 rules if he plans to continue to hold the fund for a significant period of time and plans to continue to be a US person. In the long run, the MTM election will be better for him than the default PFIC treatment.

He can consider the extra tax he pays by failing to make the MTM election in the first year the “oops” tax. I personally pay an “oops” tax somewhat frequently in life because I am human and I make mistakes.

Thank you

As always, thank you for reading this week’s edition of PFICs Only. I hope that you found something useful in it, but please do not rely on this as legal or tax advice (and hire a professional if you need help).

See you in two weeks.

Debra

The post Is a late MTM election under the inbound immigrant rules possible? appeared first on HodgenLaw PC – International Tax.

Hello from Debra Rudd.

You are receiving this email because you are signed up for our PFICs Only newsletter, delivered to your electronic mailbox every other Thursday at 6:00 am Pacific time. To stop receiving these emails, scroll to the bottom and click “unsubscribe”. To see what other newsletters we offer, go to hodgen.com/newsletters.

Applying the look through rules to figure out if you have a PFIC

This week I will take a look at the following anonymous question I received:

I have shares in a foreign family holding company which buys shares in various foreign businesses. I am not sure if it is a PFIC. What information do I need to ask for to figure out if it is a PFIC?

In today’s newsletter, I will discuss how to apply the PFIC look through rules in conjunction with the PFIC definition to determine whether the family holding company is a PFIC or not.

Some assumptions about Holding Co

I am going to call it “Holding Co” rather than “the family holding company” because, well, I like proper nouns.

I will assume Holding Co is taxed as a corporation under US tax law. If it is not taxed as a corporation, it cannot be a PFIC.

I will further assume that Holding Co has bought shares in two businesses: Business A, of which it owns 10% of the shares, and Business B, of which it owns 40% of the shares. I will assume both businesses are taxed as corporations under US tax law.

I will assume that neither Business A nor Business B paid out any dividends to its shareholders.

Lastly, I will assume that our reader is the only US person owner of Holding Co, and I will assume that she owns less than 10% of the shares of Holding Co so that no Form 5471 filing requirements will be triggered.

PFIC Definition

A foreign corporation is a passive foreign investment company, or PFIC, if it meets either the income test or the asset test.

The income test says that if 75% or more of its income is passive, then it is a PFIC. IRC §1297(a)(1).

The asset test says that if 50% or more of its assets are passive, then it is a PFIC. IRC §1297(a)(2).

This rule applies no matter what type of entity you are analyzing as it is classified under local law (whether mutual fund, unit trust, hedge fund, startup company, etc.), as long as it is a foreign entity that is taxed as a corporation under US law.

There is nothing particularly mysterious about it. It requires an understanding of what counts as “passive” income and assets, an income statement, a balance sheet, and an Excel sheet or a calculator and some scratch paper.

Look through rule for subsidiaries

Some complication could arise, however, when the entity you are analyzing makes investments in other entities.

If the company owns 25% or more of the stock of another corporation, then that company is treated as receiving its proportional share of the income and owning its proportional share of the assets of that other corporation. IRC §1297(c). This is known as the PFIC look through rule.

The effect of the PFIC look through rule is that a parent company will be attributed its proportional share of the assets and income of its 25% or more subsidiaries when applying the PFIC definition.

In other words, when a company has a 25% or more interest in a subsidiary, you apply the look through rule first before applying the income and asset tests to determine if it is a PFIC.

A company that would not otherwise meet the income test or the asset test, and therefore would not qualify as a PFIC, could end up being a PFIC because of this rule. Conversely, a company that would in itself be a PFIC and owns shares in an active business could end up not being a PFIC because of this rule.

The look through rule only applies to Business B

In our example, Holding Co owns 10% of Business A, so it does not meet the minimum requirement for taking Business A’s income and assets into the calculation. Holding Co must own 25% or more of the shares of the subsidiary company for the rule to be in effect.

However, Holding Co does meet the minimum requirement for taking Business B’s income and assets into the calculation for Holding Co’s PFIC status, owning 40% of Business B’s stock.

Applying the PFIC tests to Holding Co

To determine if Holding Co is a PFIC, you need to have the financial statements of Holding Co, and because you have to apply the look through rule to Business B, you also need to have the financial statements of Business B.

When you are applying the PFIC tests, you will need to separate passive income from non-passive income, and passive assets from non-passive assets. You will do this to the income statement and balance sheet for both Holding Co and Business B. (For brevity I am assuming readers are familiar with what are considered passive assets and passive income for the purposes of these tests).

Then you apply the proportional interest that Holding Co has in Business B. Holding Co owns 40% of Business B, so multiply all the numbers from Business B by 40%.

The income test

Add together the passive income from Holding Co and 40% of the passive income from Business B that you just calculated. That gives you Holding Co’s passive income for purposes of the income test.

Add together the non-passive income from Holding Co and 40% of the non-passive income from Business B that you just calculated. That gives you Holding Co’s non-passive income for purposes of the income test.

Compute the total income by adding the results of the last two steps. Then figure out whether passive income makes up 75% or more of the total.

If so, you can stop now. It is a PFIC. Remember that you only need to meet one of the two tests for it to be a PFIC.

If Holding Co does not meet the income test, go on to see if it satisfies the asset test.

The asset test

Add together the passive assets from Holding Co and 40% of the passive assets from Business B that you just calculated. That gives you Holding Co’s passive assets for purposes of the asset test.

Add together the non-passive assets from Holding Co and 40% of the non-passive assets from Business B that you just calculated. That gives you Holding Co’s non-passive assets for purposes of the asset test.

Compute the total assets by adding the results of the last two steps. Then figure out whether passive assets make up 50% or more of the total.

If so, you have a PFIC.

If not, and if it did not meet the income test, Holding Co is not a PFIC for the year you are looking at.

A brief aside about the asset test

One thing that should not go without mention is that cash is considered a passive asset for the asset test.

Additionally, you must look at the fair market value of assets when computing the value for PFIC determination purposes. Some financial statements show fixed assets and intangibles brought to fair market value each year, but some do not.

Furthermore, intangibles such as goodwill, trade secrets, patents, and copyrights are sometimes not shown on the balance sheet at all when they are developed internally.

It may not be as simple as merely looking at a balance sheet: where a company has an unrecorded non-passive intangible, or where assets are not brought to market value on the balance sheet, it could mean the difference between “PFIC” and “not a PFIC”. For example, a company with a large cash balance and an even larger unrecorded non-passive intangible could appear to be a PFIC when you look at the balance sheet but may in reality not be a PFIC.

If you are aware of these issues when applying the asset test, and if you have some basic information about how the financials were prepared and whether the company has any intrinsic value that may not be reflected on the balance sheet, you will be much more likely to arrive at the correct answer.

Once a PFIC, always a PFIC

It is not sufficient to perform the income test and asset test calculations for only one year. You must do it for each year that you own Holding Co to be sure it is not a PFIC.

According to IRC §1298(b)(1), if a company was a PFIC previously in your holding period, it continues to be taxed as a PFIC for you now and in the future. This is known as the “Once a PFIC, always a PFIC” rule.

That means that if you bought shares in Holding Co in 2008, for instance, and you just recently learned about PFICs, you should do the calculations described above for each year of your holding period.

If it qualified as a PFIC for you in the past, it will continue to qualify as a PFIC in the current year, even if it does not meet the income test or the asset test for the current year.

You may have the option of making a purging election if it was a PFIC in the past but no longer meets the PFIC definition, and the purging election may even be available retroactively, but that is a topic for another time.

The calculations can get complicated

Applying the look through rule over a period of multiple years for multiple subsidiaries can be a lot of work. It can be even more work where the company regularly buys and sells shares in the subsidiaries and there is a great deal of change within the structure.

The most difficult aspect of it can be staying methodical and staying organized. It may be helpful to create an organization chart of the structure at each year end with notes about all the transactions you need to be aware of and possibly report, and by doing so you can isolate the issues and approach them one by one.

Based on the information I have, it sounds like Holding Co probably does not have a lot of activity and the level of complication that goes with it; I am waiving this flag of caution only because I have seen similar structures that do and it can be very difficult to figure out what is a PFIC and what is not.

My guess is that Holding Co is not a PFIC

If Business B is an active operating business, chances are that it has mostly non-passive income and assets, which will all be attributed to Holding Co via the look through rule.

Holding Co itself probably does not have a lot of assets other than Business A and Business B and some cash, and probably does not receive a lot of income.

I would guess that the total non-passive income attributed from Business B is probably enough to prevent Holding Co from meeting the income test, and I would also guess that the total non-passive assets attributed from Business B are enough to prevent Holding Co from meeting the asset test.

These are just guesses, of course – it is necessary to do the math and figure out the answer.

Thank you

Thank you, as always, for reading. Please send me any PFIC questions you have by clicking “reply” to this message.

Obligatory disclaimer: Do not rely on this newsletter as legal or tax advice. Hire a professional if you need help.

See you in two weeks.

Debra

The post Applying the look through rules to figure out if you have PFIC appeared first on HodgenLaw PC – International Tax.

Hello from Debra Rudd.

You are receiving this email because you are signed up for our PFICs Only newsletter, delivered to your electronic mailbox every other Thursday at 6:00 am Pacific time. To stop receiving these emails, scroll to the bottom and click “unsubscribe”. To see what other newsletters we offer, go to hodgen.com/newsletters.

How do losses affect MTM basis and gain recognition?

This week’s question comes from reader G (lightly edited):

I bought mutual funds in 2015. I plan to make a mark-to-market election. At the end of 2015 they were down. As an example on one there was a loss of $800 (it wasn’t sold) and I stated the FMV on Dec 31 as $14,500, down from $15,300 adjusted basis. 2 questions:

1. At the end of 2016 what do I show as my basis in the fund? $15,300 (its purchase price) or $14,500 (its fair market value at end of 2015)?
2.  In the future if it increases, and say at the end of 2016 the FMV will be $15,500, what is my gain? Is it $1,000 ($15,500 – $14,500) or $200 ($15,500 – $15,300)?

To answer these questions, I will first need to take a look at how loss recognition works for mark-to-market (MTM) PFICs. Then I will talk about how loss recognition affects the basis of a MTM PFIC.

What is a PFIC?

A passive foreign investment company is a foreign corporation that meets either the income test or the asset test of IRC §1297(a):

If 75% or more of its income is passive, or if 50% or more of its assets are passive, it is a PFIC.

Foreign mutual funds and other similar investments often end up being PFICs. This is because they are often configured in such a way that they will be foreign corporations under US tax law (even if they are not organized as corporations under foreign law), and because usually all of their income is passive.

If it is classified as a foreign corporation under US tax law, and it meets the income test or asset test, it is a PFIC.

G is assuming that his mutual funds are PFICs, and he is probably correct.

How are PFICs taxed?

There are three ways that PFICs are taxed:

• Under the default treatment, distributions and dispositions are taxed under the extremely punitive excess distribution rules: Returns of capital can be swept in as taxable receipts. Taxable receipts are subject to a mix of ordinary and maximum tax rates. And there are daily compounded interest charges on top of that.
• Under the MTM election, annual increases in value are taxed as ordinary gains.
• Under the QEF election, income is passed through to the shareholder as either capital gain or ordinary income.

If you have a PFIC, you will want to make either the MTM or QEF election if you can, because the default treatment means very high taxes to pay.

MTM election generally

The MTM election can only be made for what the Code calls “marketable stock”. There are some specific requirements for what qualifies as marketable stock, but basically it is stock that is traded on an exchange. I will assume that G’s PFICs are marketable stock and qualify for the MTM election.

When you make the MTM election, you must pretend to sell the stock at the end of every year for its fair market value and pay tax on any gain that arises in the pretend sale. The gain is taxed as ordinary income.

Losses and “unreversed inclusions”

For each MTM PFIC, you must keep a record of a running balance that the Code refers to as “unreversed inclusions”. The unreversed inclusions for any PFIC can never be less than zero.

Each time you report a gain from the annual pretend sale of your PFIC under the MTM rules, the unreversed inclusions for that PFIC are increased by the amount of the gain you report.

If you claim a loss on that PFIC from the annual pretend sale of your PFIC, you decrease unreversed inclusions for that PFIC by the amount of the loss you claim on your tax return. But because the unreversed inclusions can never be less than zero, you cannot claim losses in excess of the unreversed inclusions available. You also cannot use unreversed inclusions from a different PFIC.

To put it a different way, you can deduct losses on the annual pretend sale of your PFIC only up to the total amount of prior gains you reported for that PFIC (decreased by losses you were able to claim for that PFIC).

Losses you take on PFICs subject to the MTM rules are ordinary losses. You deduct the MTM losses against ordinary income.

Example: Losses in excess of unreversed inclusions

What happens if you do the pretend sale and you have a loss that exceeds your unreversed inclusions? This is best answered with an example.

Let’s say that you have a MTM loss of $2,000, but you only have $1,000 in unreversed inclusions. You are only permitted to show a $1,000 loss on your tax return, the amount of your unreversed inclusions. You adjust your basis in the PFIC down by $1,000. You also adjust your unreversed inclusions down by $1,000 so that they are now $0, and there are no further MTM losses you can take.

If, in a subsequent year, there is another $500 gain, you would pay tax on that gain and unreversed inclusions would once again increase by $500. A loss in a later year would be deductible up to the $500 unreversed inclusions amount.

G’s example

This brings us to G’s example. He describes a situation where he purchases a PFIC for $15,300 in 2015. The value of the PFIC is $14,500 at the end of 2015. This is a decrease of $800.

G must pretend he is selling the PFIC at the end of 2015. Under the normal tax rules, the sale of this stock would create a capital loss of $800.

Under the MTM rules, you have to first ask “do I have any unreversed inclusions that I can use?”. Only if you have unreversed inclusions can you take the loss.

In G’s example, there are no unreversed inclusions, because he has never previously had a MTM gain for this PFIC.

G does not get to recognize the loss for 2015.

This brings us to G’s first question.

Question 1

G’s first question is what his basis in the PFIC is at the end of 2016. Assuming he has made no sales or purchases during calendar year 2016, he will be looking at year end 2015 to determine his basis for year end 2016.

As a general principle, gain or loss recognition and basis move together. In other words, if you pay tax on a gain associated with an asset, you would expect that your basis in that asset will be increased by the amount of the gain you report. If you deduct a loss associated with an asset, you would expect that your basis in that asset will be decreased by the amount of the loss you report.

Because he could not deduct his loss at the end of 2015, his basis in the PFIC did not decrease.

G’s basis in the PFIC at the end of 2016 is still $15,300, his original purchase price.

Question 2

G’s gain at the end of 2016 is $15,500 (fair market value) – $15,300 (basis) = $200.

Why not recognize the entire $1,000 increase from fair market value at the end of 2015 to fair market value at the end of 2016? Because his basis never adjusted down with the decrease in value that took place in 2015, because the loss was not claimed.

G’s basis going into 2017 is his original cost basis of $15,300 plus the 2016 gain recognized of $200, or $15,500.

Losses upon sale with no unreversed inclusions

Suppose that on December 31, 2015, instead of doing a pretend sale under the MTM rules, G actually sells his PFIC. He would receive $14,500, its fair market value on the date of the sale.

His adjusted basis, or purchase price, is $15,300. He has a loss of $800.

Under the unreversed inclusion rules for pretend MTM sales, G would not get to recognize the loss.

But for losses that arise from real sales, you get a small break: you can deduct the loss under the rules that would normally apply to such assets in the absence of the PFIC rules if there are no unreversed inclusions. In other words, G would get a capital loss.

This is the difference between real and imaginary sales under the MTM rules when you have a loss: unreversed inclusions principles apply for the imaginary annual MTM sales; (mostly) normal tax principles apply for the real sales.

G would get to recognize a short term capital loss of $800 for 2015 if he were to sell the PFIC at the end of the year.

Losses upon sale with unreversed inclusions available

If you do have unreversed inclusions available when you sell your PFIC stock at a loss, you get to claim some or all of the loss against ordinary income, depending on how much unreversed inclusions you have available.

Just for fun, suppose that G has held the MTM fund for a several years and has total unreversed inclusions of $100. He sells it for a loss of $250.

G can claim an ordinary loss of $100, the amount of his unreversed inclusions in the PFIC. He can claim a long term capital loss of $150, the amount of loss upon sale in excess of unreversed inclusions.

Summary

The MTM rules require a pretend sale of your PFIC at the end of every year. The taxation of MTM funds can essentially be reduced to five bullet points:

• MTM gains are taxed at ordinary tax rates.
• MTM losses (up to available unreversed inclusions) are deducted against ordinary income. MTM losses in excess of unreversed inclusions are not deducted.
• Basis adjusts up for gains you pay tax on and down for losses you deduct.
• Gains upon sale of a MTM fund are taxed at ordinary tax rates.
• Losses upon sale of a MTM fund are deducted against ordinary income (up to available unreversed inclusions) and any loss in excess of unreversed inclusions is taxed as a capital loss.

Send your PFIC questions now

There are tax deadlines approaching, and we all have questions we need answered: those little bothersome queries you just don’t know the answers to that wake you from a dead sleep at 4 am.

Send me your PFIC-related questions and I may feature your question in a newsletter and provide a detailed response. Just hit “reply” to this email and your response will be sent directly to me.

Thank you

Thank you for reading. You may not rely on this publication as advice. Hire a professional if you need help.

Debra

The post How do losses affect MTM basis and gain recognition? appeared first on HodgenLaw PC – International Tax.

​Hi from Debra Rudd.

You are receiving this email because you are signed up for our PFICs Only newsletter, delivered to your electronic mailbox every other Thursday at 6:00 am Pacific time. To stop receiving these emails, scroll to the bottom and click “unsubscribe”. To see what other newsletters we offer, go to hodgen.com/newsletters.

PFIC distributions and Net Investment Income Tax

​Today I’m going to talk about a question I’ve received from a few different people. This particular version of the question comes from reader X:

Does the Net Investment Income Tax apply to the entire distribution I receive from my PFIC? Since some of the distribution is not included in income, I have heard many people say that a portion of the distribution should not be subject to the Net Investment Income Tax. Do you know how this works?

X’s question can be answered by addressing the following three separate questions:​

1. What is the Net Investment Income Tax?
2. How are PFIC distributions taxed, and what does X mean when he says a portion of the PFIC distribution is not included in income?
3. How does the IRS apply the Net Investment Income Tax to PFIC distributions?​​

What is the Net Investment Income Tax?

The Net Investment Income Tax, or NIIT, became effective in January 2013 as part of the Affordable Care Act. It applies to taxpayers with Modified Adjusted Gross Income high enough to trigger the requirement (and there are different thresholds for different filer types). For our purposes, let’s ignore the term “Modified Adjusted Gross Income” and just assume that the NIIT does in fact apply to X.

​NIIT is a 3.8% tax that is applied to your net investment income in addition to any other income tax that applies.

​“Net investment income” means income items like interest, dividends, capital gains, rental and royalty income (and etc.), minus certain deductions.

​The IRS has a web page that describes how this works in a little more detail.

​The question X wants to answer is: How does the NIIT get applied to PFIC distributions?

How PFIC distributions are taxed​

First, let us examine what X means when he says that a portion of the PFIC distribution is not included in income, which requires a basic understanding of how PFIC distributions are taxed.

​I will assume that X has not made any PFIC elections, so he is operating under the default excess distribution rules of IRC §1291.

​When you receive a distribution from a PFIC, and your PFIC is taxed under the default rules, the very first thing you do is ignore the usual rule under IRC §301 that says that your distribution is either a dividend, a return of capital, or a capital gain (or some combination of those)

​Instead, you must figure out: What portion of the distribution is an “excess distribution” under IRC §1291?

​The amount you calculate to be the excess distribution is subject to a particularly harsh set of rules with very high tax rates and interest charges; the remainder of the distribution follows the normal rules of section 301.

Excess distributions: what are they?

​I am not going to go into detail about how to calculate excess distributions in this post. If you would like to read about that, visit a previous post that dealt with that topic in detail.

​For our purposes, just assume that of the total distribution X received, some portion of it is excess distribution and some portion of it is non-excess distribution.

​The non-excess portion of the distribution is subject to the normal section 301 rule: it is either dividend, return of capital, or capital gain. The excess portion of the distribution is taxed in a special way.

Excess distributions: how are they taxed?

Once you have computed your excess distribution, you have to allocate the excess distribution over each day of your holding period, ending with the date of the distribution.

You then assign each day to one of the following periods, and add up the amount of excess distribution allocated to each period. The amounts allocated to each period are taxed as follows:​

• Pre-PFIC period: ordinary tax rates.
• Prior years PFIC period: maximum individual tax rate for each year in the period plus a daily compounded interest charge.
• Current year: ordinary tax rates.

The important piece of information to take away from this is that your excess distribution is allocated to different time periods, and the amounts allocated to those different time periods are taxed in different ways.​

Excess distributions: amounts “not included in income”​

The excess distribution allocated to the prior years’ PFIC period is subject to a special tax and interest calculation.

That special calculation involves dividing the amount allocated to the prior years’ PFIC period up by tax year, applying maximum individual tax rates to the amount allocated to each year, and applying an interest charge to the tax computed for each year.

Because X is computing the tax and interest directly on the prior years’ PFIC period, those changes do not get included in his income on his tax return. Instead, it is added directly into the tax X pays on page 2 of his Form 1040.

The amount allocated to the current year, however, is included in income, and X pays tax on it at his marginal rate.

X’s question was whether the NIIT applies to the amount allocated to the prior years’ PFIC period, because that amount is not included in income.

This is not an unreasonable question. After all, section 1411 (the Code section that imposes NIIT) specifically defines net investment income to be the sum of certain types of gross income and net gain.

NIIT on PFIC distributions​

The Treasury Regulations say something different, however.

​For purposes of computing NIIT, ignore all of the computations just discussed for the PFIC distribution. You still do those computations, and the PFIC is still taxed the way I described above, but that doesn’t matter for NIIT.​

Instead, the NIIT is applied to amounts that constitute dividends under IRC §316. Regs. §§1.1411-4(a)(1)(i) and 1.1411-10(c)(1)(ii).

IRC §316 says that a distribution is a dividend if it is paid out of current or accumulated E&P.

X simply has to look at the total distribution he received for the year and determine whether any or all of the distribution was paid from current or accumulated E&P. If the answer is “yes”, that amount is a dividend for NIIT purposes and must be included in the NIIT calculation.

If any portion of the dividend for NIIT purposes is not included in income and therefore does not auto-populate on Form 8960 (where NIIT is calculated) in the software he is using, X should use line 6 of Form 8960 to make an adjustment so that NIIT will be computed correctly.​

The NIIT regulations do not make any special provisions for the portion of an excess distribution that is not included in income, which tells us that Congress did not intend for us to be able to exclude a portion of the distribution from NIIT based on the theory that its tax was computed outside the normal tax rules.

Indeed, the Form 8960 Instructions indicate that if there is an amount that was not included in your taxable income from a PFIC but should be subject to NIIT, then you are responsible for making the manual adjustment so that NIIT does include the correct amount.

Recap: NIIT for PFIC distributions​

When determining whether NIIT applies to your PFIC distribution, ignore all the PFIC computations you are required to do for Form 8621. You still do those computations, and you still file Form 8621 and pay the tax and interest, but that does not determine the NIIT you pay.

Simply look at whether the entire distribution or any portion of it constitutes a distribution from current or accumulated E&P and would be taxed as a dividend if not for the PFIC rules; if so, that amount is subject to NIIT.​

Thank you

As always, thank you for reading. You absolutely should not rely on this as advice; make sure to hire a professional if you need help.​

Debra

The post PFIC distributions and Net Investment Income Tax appeared first on HodgenLaw PC – International Tax.