In July of 2019, the U.S. Department of Treasury and the Internal Revenue Service (“IRS”) released proposed regulations regarding the tax treatment of investors that own stock in a passive foreign investment company (“PFIC”). More specifically, the newly proposed regulations provide guidance on the treatment of investments in foreign insurance corporations and address a number of rules relating to the definition of a PFIC.
The proposed regulations signal a response to some issues with the Tax Cuts and Jobs Act (“TCJA”) of 2017. Tax reform brought significant change to the realm of international income tax. While most of the change focuses on the new transition tax for specified foreign corporations and other provisions affecting United States multinational businesses, the TCJA also enacted adjustments regarding PFICs without a qualified electing fund (“QEF”) election.
Between the TCJA and the newly proposed regulations, the rules and definitions regarding PFICs are evolving. It is important to stay up-to-date with the latest changes and ensure that you demonstrate compliance with all tax laws concerning PFICs.
What is a PFIC?
One principle of the U.S. federal income tax policy is the taxation of citizens, domestic corporations, and domestic trusts based on their current worldwide income. Conversely, income from foreign subsidiaries of U.S.-based corporations is generally not subject to U.S. tax laws until it is repatriated to the United States.
Thus, in 1986 the IRS instituted rules governing PFICs in order to prevent U.S. taxpayers from deferring U.S. tax on passive investments or converting ordinary income to capital gains by effecting such investments though off-shore entities. The PFIC rules intend to eliminate the economic benefit of deferral with respect to all U.S. investors in a PFIC, not just those with significant ownership. Accordingly, the governing rules of PFICs have continued to grow notoriously broad and complex to discourage U.S. taxpayers from investing in a PFIC.
For many years, taxpayers relied on Notice 88-22 for guidance on the application of PFIC rules. The U.S. Treasury Department also proposed supplemental regulations in 2015 regarding the PFIC insurance exception. However, the regulations were never finalized and have been withdrawn in connection to the newly proposed rules.
A PFIC derives its name entirely from entity characteristics, regardless of the number of owners or owner traits. More specifically, PFICs are foreign-based corporations which satisfy one of two conditions:
- Based on the company’s income, at least 75% of the corporation’s gross income is “passive.” Income originating from investments is passive; however, income from the company’s regular business operations is not.
- Based on the company’s assets, at least 50% of the assets are investments, which yield passive income in the form of earned interest, dividends, rent, royalties, or capital gains.
Unlike controlled foreign corporations (“CFCs”), which require more than 50% ownership by U.S. shareholders, there are no ownership hurdles for PFICs. This means that a U.S. person could own less than 1% of a PFIC and still be subject to the PFIC taxation and reporting regimes. Ownership of PFIC stock may be direct or indirect through partnerships, S-Corps, trusts, and CFCs.
Latest Proposed Regulations
The most recently proposed regulations put forth by the IRS and Treasury Department include guidance on a number of PFIC topics. Those include: 1) the determination of ownership and attribution through partnerships; 2) the Income Test, 3) the Asset Test, 4) the look-through rule for 25%-owned corporations and certain domestic subsidiaries, 5) the change-of-business exception, and 6) the PFIC insurance exception.
While the rules do cover a variety of issues, there are still significant lingering questions and unresolved, longstanding PFIC concerns.
The determination of ownership and attribution through partnerships
The most notable piece of the proposed regulation is the “top-down” approach to determining PFIC ownership through a partnership. Essentially, the analysis starts at the U.S. person level and subsequently moves down to each entity in the ownership chain. The U.S. person will have a PFIC filing only when there is 50% or more ownership in the non-PFIC foreign corporation.
What is passive income?
General Passive Income
Essentially, there are three types of income: active, passive and portfolio. Passive income is earnings originating from a rental property, limited partnership or other enterprise in which the investor is not actively involved. In more colloquial terms, passive income is money regularly earned with little or no effort on the part of the person receiving it. Like active income, passive income is taxable. However, passive income does receive different treatment from the IRS.
Popular forms of passive income include: real estate, peer-to-peer (P2P) lending and dividend stocks.
In more technical terms, the IRS details two types of passive activities:
- Rentals, including both equipment and rental real estate, regardless of the level of participation
- Businesses in which the taxpayer does not materially participate on a regular, continuous, and substantial basis
PFIC-Specific Passive Income
When it comes to PFICs, IRC section 954(c) characterizes passive income as foreign personal holding company income. This generally includes interest, dividends, annuities, certain royalties and rents, as well as other investment income.
Are there any exceptions to PFIC qualifications?
Prior to the passage of the TCJA, passive income did not include any income originating from the active conduct of an insurance business. However, Congress expressed significant concern that hedge funds took advantage of the insurance company exception to invest in assets that yield passive income without notable risks. As a result, the IRS issued a notice in 2003 to warn of challenges to such arrangements.
Then in 2017 the newly signed TCJA effectively eliminated the “predominantly engaged in an insurance business” test for PFICs. In its place, the Act explains that passive income does not include any income derived from the active conduct of an insurance business by a qualifying insurance corporation (QIC). Without a legal QEF election, U.S. shareholders in these businesses are subject to the PFIC regulations.
In order to qualify as a QIC for the taxable year, the business must meet the following requirements:
- If it operated as a U.S. domestic corporation, it would be subject to tax under subchapter L.
- The “applicable insurance liabilities” reported on the corporation’s financial statements must comprise more than 25% of its total assets (or meet an alternative facts and circumstances test).
Applicable insurance liabilities include loss and loss adjustment expenses and reserves for life and health insurance risks.
The alternative facts and circumstances test permits a corporation that does not satisfy the 25% requirement to otherwise qualify for the insurance exception if:
- The business predominantly engages in insurance business.
- Applicable insurance liabilities comprise at least 10% of the total assets.
- Failure to meet the 25% test is solely due to run-off or ratings-related circumstances.
To fully utilize the insurance exception, the U.S. taxpayer – who otherwise faced PFIC consequences and owns stock in the insurance company – must make the election.
How does the IRS handle PFICs?
Investments classified as PFICs are subject to strict and complex tax guidelines instituted by the IRS in Sections 1291 through 1297 of the U.S. income tax code. The PFIC itself, as well as the shareholders, must keep precise records of all transactions related to the PFIC, such as the share cost basis, any dividends received, and undistributed income earned by the PFIC.
For example, with virtually any other marketable security or other asset, the IRS permits the person inheriting the shares to step up the cost basis for the shares to the fair market value at the time of inheritance. However, in the case of a PFIC, the IRS does not allow the step up in cost basis.
How does the US government tax a PFIC?
There are three methods of PFIC taxation: excess distribution, mark-to-market (“MTM”), and a qualified electing fund (“QEF”).
Any PFIC shareholder is subject to Sec. 1291 of the tax code by default. Sec. 1291 explains that U.S. taxpayers must allocate excess distributions and gains upon selling their PFIC shares pro rata to their entire holding period. The code defines an excess distribution as one that exceeds 125% of average distributions received in the three previous years of PFIC share ownership. In addition, all gains from the transaction are excessive distributions, thus leading to significant interest charges.
The government then treats all capital gains from the sale of PFIC shares as ordinary income for federal income tax purposes. As such, the government does not tax these capital gains at preferable long-term gain rates.
Due to the stringent PFIC regime, U.S. taxpayers typically defer taxes and accrue considerable interest charges on those deferred taxes. The interest charge on the deferred tax is compounded annually if there are excess distributions. Also, the taxpayer cannot recognize capital losses on the sale of PFIC shares. Ultimately, taxpayers end up paying substantially more tax than if they had recognized the PFIC income on an annual basis by making a mark-to-market election or by selecting QEF status.
If the U.S. taxpayer is an owner of a PFIC, absent of a QEF election, the IRS does not recognize the income nor subject it to tax unless the PFIC distributes it. However, when there are distributions, they are generally taxed as ordinary income at the highest marginal rate, regardless of the character of the income at the entity level.
Therefore, U.S. taxpayers try to avoid PFIC treatment.
Qualified Electing Fund (“QEF”)
The qualified electing fund tax regime operates parallel to the U.S. tax rules applied to domestic mutual funds. This allows domestic and foreign funds to receive similar tax treatment. QEF election income received from PFIC shares is subject to annual taxation. The election must be made in the first tax year following acquisition of the shares, and the first U.S. taxpayer in the ownership chain must make the QEF designation.
Per the tax laws, QEF election is only available if the PFIC provides U.S. taxpayers with an annual information statement describing their share of ordinary income, capital gains, and distributions made within the year of share ownership. To elect a QEF, the taxpayer must fill out Form 8621 (see below), and must reflect the information present in either the PFIC annual information statement, annual intermediary statement, or applicable combined statement for the year.
Notably, taxpayers prefer the QEF election and the annual PFIC income taxation. This allows them to avoid accrued interest charges on taxes from previous years.
Timely election is critical. If it is not done accordingly, the shareowner is subject to both QEF income inclusions throughout the holding period, as well as the excess distribution taxation method upon selling the shares in a gain.
Taxpayers intending to avoid the excess distribution regime, but do not qualify for QEF treatment, have the option to make a mark-to-market election. In order to qualify for MTM, the PFIC stock must be regularly trade on a qualified exchange and the taxpayer must make the election at the beginning of the first tax year in which they hold the PFIC stock. Once under MTM treatment, the owner of the PFIC shares must recognize as ordinary income annual increases in the market value of their PFIC shares. Additionally, annual decreases in share value are treated as ordinary losses to the extent of previously recognized gains (“unreversed inclusions”). Note, though, that any losses recognized upon the disposition of PFIC shares carry a capital loss label to the extent that they exceed unreversed inclusions.
What are the reporting requirements for PFICs?
Any U.S. taxpayer who owns shares in a PFIC must file IRS Form 8621. With the form, taxpayers report actual distributions and gains, as well as income and increases in QEF elections. The shareholder must attach the form to their U.S. income tax return. It may be necessary to complete the form even if the shareholder does not need to file an income tax return or other return for the year. For example, a taxpayer with no PFIC income but whose PFICs are worth more than $25,000 must file Form 8621 to report the PFICs.
How can Squar Milner help?
Admittedly, Form 8621 is lengthy and complicated. Even the IRS estimates the form, made up of four pages, requires approximately 40 hours to properly fill out.
Not properly identifying PFICs and not filing Form 8621 could result in penalties. In addition, not vetting ownership structures for PFICs could result in unexpected additional work and tax costs.
Finally, not being aware of potential PFICs during year-end planning meetings could result in missed opportunities to avoid transactions that trigger PFIC status or to make timely QEF elections to avoid the excess distribution tax and interest. Therefore, it is highly recommended to hire a tax professional to complete the form on your behalf.
That is where we come in. Squar Milner has the experienced, technically diligent tax professionals to guide you through the process. The firm is home to a highly skilled international tax practice, as well as other seasoned tax professionals at the ready.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.