Adverse consequences to U.S. shareholders of PFICs.

A passive foreign investment company (PFIC) is any foreign company for which (1) 75% of its annual gross income is passive or (2) 50% of the average value of its assets produces passive income. (Controlled foreign corporations (CFCs) must measure their assets by adjusted basis, rather than by value.) Companies with high-value intangibles, such as high technology companies, and others, such as service or manufacturing companies, with large amounts of cash and other investments compared to active assets, can be PFICs. The adjusted basis measurement of assets imposed on CFCs can have dramatic effects in turning an active company into a PFIC, A PFIC's income is not taxed until distributed, but the tax consequences for a PFIC's U.S. shareholders can be harsh: 1. An excess distribution (defined in relation to past distributions) is taxable, even if it exceeds the PFIC's earnings and profits and would not otherwise be a taxable dividend. 2. Excess distributions are allocated to all years the PFIC stock has been held. Amounts allocated to years before they are actually received are taxed at the highest statutory rate for each year, regardless of the shareholder's actual tax bracket during those years. (However, amounts allocated to pre-1987 years are grouped with the current allocation and are taxed at current year rates.) All capital gain from a disposition of PFIC stock is deemed to be an excess distribution. 3. To the extent an excess distribution is allocated to earlier post-1986 years, the tax imposed on it is deemed to have been "deferred," and interest is charged as if it had been due to those earlier years. Foreign tax credits are extremely limited when attributable to an excess distribution. 4. Tax-free exchanges and reorganizations involving PFIC stock are generally not allowed. Proposed regulations would permit them only if PFIC stock, is exchange for other PFIC stock, or if the PFIC is transferred to another U.S. owner who would be subject to tax in an amount equal to that which the transferor would have had to pay. The PFIC rules treat such transfers as gifts and transfers by death as taxable exchanges. 5. Capital gain benefits are denied on sales or exchanges of PFIC stock. 6. The IRS may tax capital gain in PFIC stock held at death.

An excess distribution is one greater than 125% of the prior three-year average distributions. Gain from selling PFIC stock is spread evenly to all years in which the shareholder owned the stock.

The effect of the interest charge (point #3) intensifies as more post-1986 years are added to the holding period. If the shareholder received an excess distribution in 1990, but owned the stock since Jan. 1, 1971, the interest charge would not have a dramatic impact. Sixteen of the 20 years to which the excess distribution would be allocated occurred before the effective date of the PFIC rules (the pre-1987 years), and the distribution would be taxed as if it had been distributed in the current year. However, if the stock was bought on Jan. 1, 1987, all of the excess distribution would be allocated to the period from 1987 to 1990, and the deferred tax and interest would be computed for each year.

To avoid the adverse tax consequences of excess distributions (points #1-3), a shareholder may elect to have the PFIC treated as a qualified electing fund (QEF) under Sec. 1295. This election treats the PFIC in a manner similar to a mutual fund. The PFIC's income and capital gain flow through pro rata to its shareholders and are taxed currently. (The Service presently intends to suspend this election and allow deferral for years in which the corporation fails the PFIC tests.)

A QEF election does not cure the other consequences (points #4-6 and treatment of gain as an excess distribution), however, unless it is in effect for all post-1986 years that the foreign company is a PFIC. Thus, a liquidation or reorganization of a company would still generate gain treated as an excess distribution. To correct this, the shareholder can elect to treat his PFIC stock as "sold" on the day of the QEF election. This deemed sale creates gain that is treated as an excess distribution and taxed, with interest charged. Another, often less harsh, election is available for U.S. shareholders of CFCs that are PFICs.

Because the tax cost of dismantling a PFIC or invoking the deemed sale election increases the longer the stock is owned after 1986, PFIC shareholders may want to take corrective action as soon as possible to minimize the potential interest charge exposure. See the examples on page 143 illustrating PFIC tax calculations.