Here is a question we often get from emails:
I own shares in an exchange traded fund. It is a PFIC. I have not made any elections for the shares. What happens if I sell it at a loss?
This post describes why the loss from the sale is most likely a capital loss.
What is a PFIC?
A passive foreign investment company (PFIC) is a special classification under US tax law. It applies to foreign corporations that meet at least 1 of 2 tests (IRC §1297(a)):
- Income test: At least 75% of the foreign corporation’s income is passive income or
- Asset test: At least 50% of the foreign corporation’s assets generate passive income or are held for generating passive income.
Foreign exchange traded funds (ETFs) are often PFICs, even if they are organized as a vehicle that might not be a corporation under foreign law.
Special tax rules apply to PFICs. These are deliberate difficult and punishing to discourage US persons from investing through foreign investment vehicles.
The ETF uses default rules under section 1291
There are 2 special elections a person can make for PFICs that change how the shareholder is taxed on the PFICs. These are the qualified electing fund (QEF) election and mark-to-market (MTM) election.
In our scenario, the reader has not made any elections. We therefore use the default rules under section 1291.
No specific rules about losses
If you take a look at section 1291, you will see detailed rules about how to calculate tax on distributions from a PFIC, and you see that gains are treated as excess distributions from a PFIC. Section 1291 does not mention losses.
We use normal rules for losses
The IRS has proposed regulations that address losses, and the proposition is short:
Unless otherwise provided under another provision of the Code, a loss realized on a disposition of a stock of a section 1291 fund is not recognized. Prop. Treas. Reg. §1.1291-3(a).
Note that this proposed regulation does not specify which section of the Code can be used to recognize losses. Thus, any section of the Code will do, not just the PFIC sections. The preamble to the proposed regulations confirm this result:
The general rules applicable to losses recognized on a disposition of stock apply to losses realized and recognized on the disposition of stock of a section 1291 fund. IL-656-87.
The proposed regulations merely attempt to say that the PFIC rules do not specifically allow recognition of loss in a transaction that normally does not permit recognition of loss–for example, if a domestic trust becomes a foreign trust, loss is not recognized. Reg. §1.684-1(a)(2). The proposed regulations make it clear that the PFIC rules do not provide for recognition of losses in these cases either.
For the sale of a ETC, we can rely on the basic rules about gains and losses: The entire loss from a disposition is recognized under section 1001. IRC §1001(c).
The loss is probably capital in nature
The PFIC rules do not specify whether the loss is ordinary or capital in nature. Thus, we use the general rules for losses recognized on the sale of stock. If our reader simply holds his ETF as a personal investment, then it probably is a capital asset. IRC §1221. Thus, the loss is a capital loss.
Summary
If you sell a PFIC at a loss, you can recognize the loss. The normal rules for determining whether the PFIC is a capital asset or not apply. In the case of a personal investment in a ETF, the loss is capital in nature.
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