Hi from Debra Rudd.

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PFIC deemed sale gains and Net Investment Income Tax

I received the following question from reader S after writing about the Net Investment Income Tax in the context of PFIC distributions:​

Along the same lines, if you were doing a deemed sale to remove the PFIC taint, would the gain from the sale still be subject to the NIIT? It’s not an actual sale as nothing was sold, but the taxpayer does get an uplift in basis for the deemed sale. I’m thinking it would be, but would appreciate your opinion.

I think S is right about this.

In today’s newsletter, I will first talk about what the Net Investment Income Tax is. Next, I will take a look at what the regulations say about how to apply the NIIT to PFIC gains, and lastly, I will try to answer S’s question about NIIT in the context of gains that arise from a deemed sale.

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 us ignore the term “Modified Adjusted Gross Income” and just assume that the NIIT does in fact apply in the scenario S is describing.

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.

How to apply NIIT to PFIC gains​

The Treasury wrote a rule for how to apply NIIT to gains from PFICs:

Gains treated as excess distributions under section 1291(a)(2) are included in determining net gain attributable to the disposition of property for purposes of section 1411(c)(1)(A)(iii) and § 1.1411-4(a)(1)(iii). Regs. §1.1411-10(c)(2)(i).

When you have a gain on the disposition of a PFIC, the entire gain is treated as an excess distribution according to section 1291(a)(2), which means the entire gain is included in your net gain from disposition of property for NIIT purposes.

It works the same way for gains on pretend sales

That is easy enough for a real sale where you exchange PFIC stock for money. What about gains from pretend sales?

There are at least a couple different situations in which a taxpayer will have to recognize gain from the pretend sale of a PFIC. One is the situation S mentioned, where you make a deemed sale as a purging election to remove the PFIC treatment. There are others, too.

In all deemed sale situations, you are pretending that you sold the PFIC and reporting the gain (if any) on the sale, but you receive no sale proceeds and you retain ownership of the PFIC stock.

For NIIT purposes, a gain from a deemed sale would work the same way that a gain from a real sale would. Look at the language of Regs. §1.1411-10(c)(2)(i): “Gains treated as excess distributions” are subject to NIIT.

Both gains from real sales and gains from deemed sales are treated as excess distributions. The regulations do not make any exception to the rule for deemed sales. We should infer that the gain from a deemed sale is subject to NIIT in the same way that a gain from a real sale is subject to NIIT.​

You get the basis adjustment, after all

When you make a deemed sale of a PFIC to purge the PFIC status, you get to adjust your basis in the PFIC up by the amount of the gain you report.​

Pretend you buy a PFIC for $10, make a deemed sale when it is worth $20, and then later sell it for $40. When you sell it for $40 you are reporting a $20 gain.​

Applying NIIT to the gain from the deemed sale is consistent with getting an increase in basis.​

What about losses on a deemed sale?

S did not ask about this, but it is an interesting question, so I will talk about it anyway. :)​

The NIIT rule for PFIC gains is relatively simple. The gain from any sale, real or pretend, is subject to NIIT.

​Losses from a deemed sale, however, are not always recognizable. For example, when you are making the deemed sale as part of a purging election, no losses are allowed. That means you do not report a loss on your tax return, and your basis in the PFIC stock does not adjust down for the deemed sale loss.

My guess would be that you would not include a PFIC loss in the NIIT computation when you do not get to recognize that loss and you do not get a basis adjustment for that loss.

In a situation where you have a loss on a deemed sale for purposes other than purging elections (for example, if you are a covered expatriate who has to pretend you are selling your worldwide assets), you do get to recognize the loss on the sale. Again, this is just a guess, but I would guess that in those situations you would get to include the loss in your NIIT computation.

Summary

Gains from the sale or deemed sale of a PFIC are always subject to NIIT.​

For losses, it is most likely the case that you have to look at the specific rule that governs whether you can recognize the loss or not — if yes, include it in your NIIT computation. If no, do not include it in your NIIT computation.

Thank you

Thank you for reading. I will see you in two weeks with another exciting edition of PFICs Only.

Oh, and… You would be crazy to rely on this as advice. So please, do yourself a favor and hire someone competent before making any life and/or tax decisions.​

Debra

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

This blog post describes a situation when there is an exception in the attribution rules so that one spouse is not considered the owner of the other spouse’s stock in a foreign corporation.

This can have real-world impact: what you assume is a controlled foreign corporation? It isn’t.

Facts

Husband is a U.S. citizen. Wife is not a U.S. citizen. Nor is Wife a resident of the United States.

Husband and Wife each own 50% of a foreign corporation’s stock. Let’s call it Foreign Corporation.

The 50% ownership could be because the shares are registered in the names of Husband and Wife. Or, community property rules could mandate that the shares are owned 50% each, no matter whose name appears on the stock certificate.

Question

Is Foreign Corporation a “controlled foreign corporation” if its stock is owned 50% by a U.S. citizen and 50% by the U.S. citizen’s nonresident alien spouse?

Answer

Foreign Corporation is not a controlled foreign corporation in that situation.

What’s a controlled foreign corporation?

A foreign corporation is a “controlled foreign corporation” if “U.S. shareholders” own more than 50% of the stock.

IRC §957(a) General rule. For purposes of this title, the term “controlled foreign corporation” means any foreign corporation if more than 50 percent of—

(1) the total combined voting power of all classes of stock of such corporation entitled to vote, or

(2) the total value of the stock of such corporation,

is owned (within the meaning of section 958(a)), or is considered as owned by applying the rules of ownership of section 958(b), by United States shareholders on any day during the taxable year of such foreign corporation.

Emphasis added.

More than 50% is not the same as exactly 50%. This is the crux of the argument that follows. I will demonstrate that Foreign Corporation has one U.S. shareholder who owns exactly 50% of its stock.

What’s a U.S. shareholder?

“U.S. shareholder” is a term of art, defined in the Internal Revenue Code. It does not mean a U.S. person who happens to own a share of stock.

Definition

A U.S. shareholder is someone who (1) owns 10% or more of a foreign corporation’s stock, and (2) is a U.S. resident or U.S. citizen.

IRC §951(b) United States shareholder defined. For purposes of this title, 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.

In this example, Husband is a U.S. shareholder because he meets both criteria:

• He is a U.S. citizen or resident, and
• He owns more than 10% of Foreign Corporation’s stock.

Wife is not a U.S. shareholder:

• She meets the ownership criteria with more than 10% ownership, but
• She is not a U.S. citizen or resident so Wife is not a U.S. shareholder.

Because Husband is the only U.S. shareholder and owns exactly 50% of its stock, Foreign Corporation is not a controlled foreign corporation.

But Phil, constructive ownership!

What about constructive ownership? Wife owns the other 50% of the stock. Attribution of stock ownership between spouses is an Article of Faith amongst tax professionals.

Not here.

Constructive Ownership for U.S. Shareholders

A U.S. citizen or resident will be a U.S. shareholder by owning stock in one or both of two different ways:

• Really, truly “owns” the stock within the meaning of IRC §958(a); or
• Let’s pretend. Is “considered as “owning” the stock within the meaning of IRC §958(b).

Just go read IRC §951(b), quoted above, to see how “owns” is defined.

Constructive Ownership for U.S. Shareholder Determinations

Let’s now see why Husband does not constructively own Wife’s stock of Foreign Corporation. The journey starts at IRC §958(b), travels to IRC §318(a)(1)(A), then returns to IRC §958(b)(1).

Constructive ownership rules consider a person (Husband in this case) to own the shares owned by someone to whom he is closely related. Husband and Wife are closely related.

IRC §958(b) tells us to use the default IRC §318(a) constructive ownership rules to determine whether an individual is a U.S. shareholder. These constructive ownership rules will help you decide how many shares a person owns, in the “let’s pretend” sense of the Internal Revenue Code.

IRC §958(b). For purposes of sections 951(b), 954(d)(3), 956(c)(2), and 957, section 318(a) (relating to constructive ownership of stock) shall apply to the extent that the effect is to treat any United States person as a United States shareholder within the meaning of section 951(b), to treat a person as a related person within the meaning of section 954(d)(3), to treat the stock of a domestic corporation as owned by a United States shareholder of the controlled foreign corporation for purposes of section 956(c)(2), or to treat a foreign corporation as a controlled foreign corporation under section 957, except that—

Emphasis added.

The next step of our journey, IRC §318(a), states:

IRC §318(a) General rule. For purposes of those provisions of this subchapter to which the rules contained in this section are expressly made applicable—

(1) Members of family

(A) In general. An individual shall be considered as owning the stock owned, directly or indirectly, by or for—

(i) his spouse (other than a spouse who is legally separated from the individual under a decree of divorce or separate maintenance), and

(ii) his children, grandchildren, and parents.

If you stopped here, you would treat Husband as constructively owning Wife’s 50% of the stock of Foreign Corporation. He would then own 100% of the stock of Foreign Corporation (50% directly and 50% constructively through his wife), and Foreign Corporation would be a controlled foreign corporation.

However, there is an important exception for precisely the question we are asking (“Is Foreign Corporation a ‘controlled foreign corporation’?”) and here our journey returns to IRC §958(b)(1).

IRC §958(b) Constructive ownership. For purposes of §951(b), §954(d)(3), §956(c)(2), and  §957, §318(a) (relating to constructive ownership of stock) shall apply to the extent that the effect is to treat any United States person as a United States shareholder within the meaning of section 951(b), to treat a person as a related person within the meaning of section 954(d)(3), to treat the stock of a domestic corporation as owned by a United States shareholder of the controlled foreign corporation for purposes of section 956(c)(2), or to treat a foreign corporation as a controlled foreign corporation under section 957, except that—>>

(1) In applying paragraph (1)(A) of section 318(a), stock owned by a nonresident alien individual (other than a foreign trust or foreign estate) shall not be considered as owned by a citizen or by a resident alien individual.

In easy language, IRC §958(b) tells you:

• Use the default rule for treating a U.S. person as the owner of stock in a foreign corporation that is owned by family members; BUT
• Not if the family member is a nonresident alien.

Conclusion: Not a Controlled Foreign Corporation

Let’s wrap it up.

In this example, Husband is not the constructive owner of the 50% of stock owned by Wife because Wife is a nonresident alien.

U.S. shareholders (one in this case, namely Husband) of Foreign Corporation collectively own precisely 50% of the stock of Foreign Corporation. To be a controlled foreign corporation, a corporation must have U.S. shareholders owning more than 50% of the stock.

Precisely 50% is not more than 50%.

Therefore, Foreign Corporation is not a controlled foreign corporation.

Note: this little excursion applies to any family attribution, not just between spouses.

The moral of this story is . . . when you do tax research, assume your first conclusion is wrong and that the Internal Revenue Code contains an exception to the rule on which you based your conclusion. Go hunting for it and look out, because there might be an exception to the exception.

The post Attribution Rules, Nonresident Alien Spouses, and Controlled Foreign Corporations appeared first on HodgenLaw PC – International Tax.