US Tax Compliance And Planning For US Executives, Entrepreneurs And Investors Living Outside The US: Part 10-B
This is the second part of the Tenth article in a series of articles on key US tax compliance and planning issues that should be considered by US executives, entrepreneurs and investors living outside the United States. The first article (Global Tax Weekly, Number 192, July 14th, 2016) provides an introduction to US taxation of Passive Foreign Investment Companies. This article addresses the applicable income tax regime, tax compliance challenges and strategies for addressing them.
The Three Alternative Tax Regimes For US Persons Who Are PFIC Shareholders
The excess distribution regime allows US tax deferral until dividends are received or the stock is sold, but may result in the imposition of a deferred tax and interest charge. The other two regimes must be elected and either tax undistributed Passive Foreign Investment Company (PFIC) income to the shareholders as it is earned by the foreign corporation (qualifying electing fund) or tax PFIC shareholders annually on appreciation or depreciation in the stock’s value during the year (mark-to-market).
Excess Distribution Regime
Under the excess distribution regime, a deferred tax and interest charge will apply any time a US person receives an excess distribution from the PFIC or recognizes a gain on selling all or a por-tion of the US person’s stock in the PFIC. An excess distribution is the amount by which:
(1) Distributions received by the US person from the PFIC during the taxable year exceed;
(2) 125 percent of the average of the distributions received by the shareholder over the preceding three years.
No distribution received in the stock in the year the stock is acquired by a US person can be an excess distribution.
If there is more than one distribution received during the year, the excess distribution for the year is prorated among the distributions, and the amount allocated to each distribution is treated as a separate excess distribution. This allocation is important because the excess distribution is pro-rated over the US person’s holding period of the stock through the date of distribution.
An excess distribution or gain on the disposition of PFIC stock is prorated, day by day, over the period from the date the stock was acquired to the date of the sale or distribution. The holding period is deemed to end the day of the distribution in computing the excess distribution.
Amounts allocated to years prior to 1987 and amounts allocated to years before the first year the foreign corporation became a PFIC are reallocated to the year of sale or distribution. Since the deferred tax and interest charge are inapplicable to amounts allocated to the year of distribution or disposition, the allocations to the current year for pre-1987 or pre-PFIC years has the effect of allowing deferral with respect to gain and excess distributions to these years.
Distributions that are not excess distributions or excess distributions allocated to the year of dis-tribution or sale of stock, are taxed at ordinary income tax rates. Distributions from a PFIC are not eligible for qualified dividend treatment.
Where there is an excess distribution:
(1) The excess distribution is allocated proportionally over the post-1986 years during which the US person held the stock;
(2) The amounts allocated to years prior to the current taxable year are taxed at the highest ordinary income tax rates in effect for those years; and
(3) The IRS collects interest as though the allocated excess distribution to each year had actually been taxed in the prior years and the US person had failed to pay the tax until the year in which the excess distribution or sale occurs.
Interest on the amount allocated to each prior tax year for an excess distribution begins on the due date of the tax return for the year to which the taxable amount is allocated, and ends with the return due date for the year of the excess distribution or sale. Extensions of filing due dates are ignored in the interest computation. Interest is computed based on the rates for underpayments of tax in effect during the interest accrual period.
For example, Uncle Sam’s holding period in a PFIC started in 2007. In 2016, he received a dis-tribution of USD225. The three-year average of distributions for 2013-2015 is USD100. For purposes of determining the excess distribution, 125 percent of USD100 is USD125. Therefore, USD125 of the distribution is not an excess distribution. The USD100 that is an excess distri-bution is evenly allocated to each year of the holding period (to make the example easier, based on years in the holding period and not days), or USD10 to each year. For years 2007-2012 the USD10 allocated to each year is taxed at 35 percent. For years 2013-2015 the USD10 allocated to each year is taxed at 39.6 percent. In addition, an interest charge is added to the deferred tax due for each year. For non-excess distributions of USD125 and excess distributions allocated to the year of distribution of USD 10, these amounts will be subject to tax at the US person’s ordinary income tax rate for the year.
There are rules to coordinate and allocate foreign tax credits between the excess distribution and remainder of the distribution. If the excess distribution accounts for 50 percent of the distribution from the corporation, then 50 percent of the foreign tax credits are allocated to the excess distribution. Foreign tax credits allocated to the excess distribution are then divided among the years of the US person’s holding period for the PFIC stock in the same proportions as the excess distribution. Taxes that are allocated to the year of distribution are creditable for the current year to the extent allowed under the normal rules. Foreign taxes that are assigned to each prior year in the US person’s holding period reduce the deferred tax on the portion of the excess distribution allocated to that year. The deferred tax cannot be offset by any other foreign income taxes.
It is important to note taxation under the excess distribution rules is not limited by earnings and profits of the foreign corporation. This means distributions of a US person’s capital contribution to the foreign corporation is subject to the excess distribution regime. If the corporation were a US corporation or was not subject to PFIC rules or other special rules, once a shareholder receives a distribution in excess of the corporation’s earnings and profits, the shareholder receives the remainder of the distribution tax free to the extent of his or her capital contribution or remaining basis in the stock. Under the PFIC rules, the return of capital contributions that are included under the excess distribution rules are subject to taxation. This is important because typically the capital invested was already taxed in the US when earned, it is really a second tax on the previously earned income and not a tax on new income on the capital invested in the PFIC.
For example, a US person invested USD100 in a foreign corporation that is a PFIC in 2007, and in 2016 receives a distribution of USD80. During the period 2007-2016 there are USD40 of earnings and profits attributable to the US person’s interest in the foreign corporation. The US person has received no prior distributions from the foreign corporation. Since there were no prior distributions, all USD80 of the distribution in 2016 is an excess distribution and allocated over the holding period. This includes the USD40 that would be treated as a return of capital and not taxed under the normal dividend rules.
The excess distribution regime can produce punitive tax outcomes. With longer holding periods, the deferred tax and interest charge could approximately equal the total distribution or gain on the sale of the stock. In addition, under the excess distribution rules, the capital invested into the PFIC could be subject to the deferred tax and interest charge. Due to the required calculations and allocating excess distributions to multiple years, the tax accounting can be complex and significantly increase the tax preparation and compliance costs to the US person.
Qualifying Electing Fund Regime
An alternative method is for the US person to elect to have the PFIC taxed as a qualifying electing fund (QEF). Under the QEF election, US persons are taxed annually on their proportional share of corporate earnings. The QEF income for each year is split between its ordinary earnings (earnings and profits reduced by net capital gain) and its net capital gain (excess of net long-term capital gain over net short-term capital loss, but not more than earnings and profits).
Under the QEF election, US persons include their share of ordinary earnings and net capital gain prorated among the days of the year, and the amount for each day is deemed distributed on that day. US persons who make a QEF election include in gross income the amounts deemed distributed apportioned to the stock directly owned and stock owned indirectly through foreign entities. The US person’s share of ordinary earnings is taxed at ordinary income tax rates and share of net capital gains is taxed at long-term capital gains rates.
If the US person is a US corporation and owns at least 10 percent of the QEF’s stock, the US person is allowed a foreign tax credit for portions of the QEF’s foreign income taxes.
Since the QEF election requires US persons to be subject to tax on income whether or not it is distributed to them, and they may not be able to compel a distribution to pay the resulting tax, they may be allowed to defer payment of the tax on undistributed QEF earnings. If deferral is allowed, interest is charged on the deferred tax amount. The deferral, which is elective, applies to the tax liability attributed to undistributed PFIC earnings, which is the amount of the US person’s tax for the year that equals the tax that would have been imposed if the QEF inclusion had been restricted to the amounts distributed by the QEF to the US person during the year.
When the election to defer the tax is made by the US person, the time for payment of the tax is ex-tended until the deferred earnings are distributed, the US person sells some of the stock, or the foreign corporation ceases to be a QEF. Distributions in future years are deemed to be made first from current earnings and then from accumulated earnings in order of time, starting from the most recently accumulated earnings. When there is a deferral election, distributions first reduce deferral of current tax, rather than terminating deferral of tax for earlier years, unless the distributions exceed current earnings.
Distributions from a QEF are tax free to the US person to the extent made from earnings and profits taxed under the QEF pass-through regime. In order to avoid double taxation and track previously taxed earnings and profits, the US person’s stock basis is increased by the amounts taxed to the US person and is reduced by tax-free distributions.’ If the US person is an indirect owner of the QEF stock, the basis adjustments occur to the property that causes the US person to be an indirect owner. The deferral of payment of tax election does not affect the US person’s basis adjustments because the election only defers payment of the tax on QEF inclusions and does not delay the time when they are brought into the US person’s gross income.
It is important to note that the excess distribution regime will also apply if the QEF election is not made in the first year the US person acquired the PFIC stock. The US person has the opportunity to make an additional election that avoids the application of the deferred tax and interest charge under the excess distribution rules. If the US person makes this election, gain or loss is computed as though the stock had been sold on the first day of the first QEF year for an amount equal to its fair market value. Any resulting gain is subject to the deferred tax and interest charge, and the US person’s stock basis is stepped up to the stock’s fair market value. The US person can make this election whether the constructive sale results in a gain or a loss; however, the US person cannot recognize the loss. If there is a loss, the benefit to the US shareholder is the PFIC taint is removed (as discussed in Article 10-A, the PFIC rules would taint all gain as ordinary income and add an interest charge), and there is no cost because the stock basis is unaffected when there is a loss.
The QEF election is made by the US person who owns stock of the foreign corporation. If a US person owns interest in more than one PFIC, the QEF election is separate for each foreign corpo-ration. The QEF election can be made in any tax year, but once made, the QEF election applies to all subsequent years until revoked with IRS consent.
The foreign corporation must supply sufficient information so US persons can properly report their share of the pro rata income for each year and the IRS can administer the QEF rules. The foreign corporation must provide a US person, who makes a QEF election, a PFIC Annual Information Statement. The PFIC Annual Information Statement specifies:
(1) The foreign corporation’s taxable year;
(2) The US person’s ratable share of the foreign corporation’s ordinary income and net capital gain for the year and the amounts distributed to the US person during the year; and
(3) A statement that the US person may inspect and copy the PFIC’s books to the extent necessary to establish that ordinary earnings and net capital gain have been computed in accordance with US tax rules.
The IRS has the authority to terminate the QEF election if the PFIC does not satisfy the PFIC Annual Information Statement requirements.
The QEF election requires the US person to recognize their pro rata share of the foreign corporation’s ordinary earnings and net capital gain whether or not a distribution is received. Thus, there is no deferral of tax. This can create a liquidity problem since the US person is paying tax on income that he or she has not received. Also, the QEF election requires the foreign corporation to provide a detailed PFIC Annual Information Statement under US tax rules. The cost of QEF reporting is usually significant. Also, there is the real possibility that the foreign corporation will not agree to provide the PFIC Annual Information Statement or open its books to inspection by the US person.
The benefit of the QEF election is the avoidance of the deferred tax and interest charge. Also, certain types of income will be taxed at preferred long-term capital gains rates. The gain on the sale of the foreign corporation’s stock can also be taxed at long-term capital gains rates. The capital contribution of the US person of the foreign corporation should be returned tax free to the US person in one form or another, if proper US tax accounting records are kept.
The final alternate reporting regime for PFICs is the mark-to-market election. Under the mark-to-market election, the US person will annually recognize income or loss equal to the difference between the stock’s fair market value at year-end and the US person’s adjusted basis in the stock.
For the mark-to-market election to be an option, the PFIC stock must be marketable. PFIC stock is considered marketable if it is regularly traded on a qualified exchange. A qualified exchange for this purpose is a national securities exchange registered with the US Securities and Exchange Commission, the national market system established under § 11A of the Securities Act, or a foreign securities exchange meeting certain requirements. Marketable PFIC stock, where such an election is in effect, is referred to as § 1296 Stock.
A US person who elects the mark-to-market tax treatment must annually report as ordinary in-come any amount by which the fair market value of the § 1296 stock at year-end exceeds the US person’s stock basis. If the value of the stock is less than the US person’s stock basis at year-end, the US person can recognize the ordinary loss to the extent of unreversed inclusions with respect to the stock. Unreversed inclusions equal the sum of the inclusions for prior years, less any losses allowed in prior years.’ Based on this limitation, losses can never exceed income inclusions under the mark-to-market election.
On the sale of stock for which a US person made a mark-to-market election, gains are taxed at ordinary income tax rates, and if there is a loss, the loss is deductible as an ordinary loss to the extent it does not exceed the unreversed inclusions.
If a US person makes a mark-to-market election after the year in which the US person acquires the PFIC stock, the excess distribution rules apply to distributions with respect to the stock and dispositions of the stock during the year of election and to the mark-to-market rules for income earned during the year of election.’ The purpose of the coordination rule is to preclude the US person from avoiding the deferred tax and interest charge with amounts attributable to the periods prior to the election.
The US person elects the mark-to-market election by the due date (including extensions) of the US person’s US income tax return for the year the election is to be effective. The election only applies to a single PFIC, and US persons can separately make or not make a mark-to-market elec-tion for each PFIC they own.
For purposes of the mark-to-market rules, an individual who became a US citizen or resident dur-ing a taxable year takes an adjusted basis in the PFIC stock equal to the greater of the stock’s fair market value or adjusted basis on the first day of the year. This rule can be a particular benefit for a new US citizen or resident as tax on pre-immigration appreciation in the stock can be avoided.
The mark-to-market election is easier to report than the excess distribution rules or QEF election rules, so where available, the mark-to-market election should result in a reduced cost of compliance. The mark-to-market election is limited to marketable PFIC stock, so it is not always an option. Any gain recognized under the mark-to-market election is taxed as ordinary income. Therefore, un-like under the QEF election, there is no opportunity for recognition at reduced capital gains rates. Under the mark-to-market election, the US person can recognize losses, but the loss recognition is limited to the aggregate prior year income inclusion less prior year loss reductions. This means the loss recognized on the PFIC stock can never exceed the aggregate gain previously recognized.
Other Considerations For The Three Regimes
A US person who is a PFIC shareholder is required to file an annual report. For now, a US per-son who owns PFIC stock complies with their reporting requirements by filing Form 8621. There are different reporting rules depending on whether the PFIC stock is being taxed under the excess distribution, QEF election, or mark-to-market rules.
All three PFIC tax regimes are unfavorable compared to the normal reporting rules. It is more of a matter of reducing compliance costs and negative tax consequences as much as possible.
The deferred tax and interest charge imposed under the excess distribution regime typically make it the worst of the three options, especially the longer the holding period and larger the excess distributions. A typical problem is that a US person does not realize that they have invested in a PFIC. For example, as in the US, mutual funds are common investments in other countries. Especially for US citizens living abroad, it would not be obvious that investing in a mutual fund in their country of residence amounts to investing in a PFIC. Also, US persons, through inheritance or other estate planning transfers from family members who are not US persons, are likely to own interest in family corporations that are PFICs. As a result of the lack of knowledge of US persons or advisors as to what is or is not a PFIC, the issue is often not caught for several years after the US person has held the PFIC stock.
In this situation, the default rule is the PFIC stock is subject to the excess distribution tax regime. A QEF or mark-to-market election can be made going forward, but for prior years the tax returns often have to be amended both to file Form 8621 and to properly report distributions under the excess distribution regime. One opportunity to deal with excess distributions, to the extent possible, is to control the distributions from the PFIC so there are no excess distributions for the year. There is an excess distribution only to the extent that the distributions for the year exceed 125 percent of the average distributions for the prior three years. Under this strategy, the distribution from the PFIC would be equal to or less than 125 percent of the prior three-year average. Also, if the US person was looking to increase the annual distributions, setting the distribution each year to 125 percent of the prior three-year average would increase the amount allowed to be distributed each year without being subject to the deferred tax and interest charge. This strategy is easier to implement with a closely held family corporation than a publicly traded foreign investment fund.
When the issue of the PFIC is realized in the initial year, it is possible for the US person to Check-the-Box and elect for the foreign corporation to be taxed as a partnership or disregarded entity for purposes of US taxation. This election is allowed for all entities that are not per se corporations under Treasury Regulations § 301.7701-2(b)(8). If an election is made to have the foreign cor-poration taxed as a partnership for purposes of US taxation, there will be no deferral of taxation. The US person would recognize his or her pro rata share of income. However, the gain that is recognized can be taxed at preferred rates and the US person can recognize losses.
The Check-the-Box rules are particularly useful for US private equity firms who form ventures with foreign investors. These ventures often involve large chains and multiple layers of subsidiary corporations. If the US private equity firm does not have enough ownership interest to meet the 25 percent look-through rule, then as can often be found in these structures, there are subsidiary foreign holding companies holding only stock of a lower level foreign operating corporation, making the upper level foreign holding company a PFIC. The Check-the-Box rules allow an easy alternative to avoid PFIC treatment and allow losses to flow upwards, especially in early years of the venture.
The PFIC rules are complex. The three different tax regimes for a PFIC are typically unfavorable to US persons either due to the tax rules or complexity of reporting. To the extent possible, it is usually advisable to avoid PFIC treatment.« US Tax Compliance And Planning For US Executives, Entrepreneurs And Investors Living Outside The US: Part 10-A US Companies Expanding Into Foreign Markets – Legal And Tax Considerations »