Avoiding the PFIC web when liquidating a non-QEF.

Within the context of the passive foreign investment company (PFIC) provisions, Secs. 1291-1298 may provide a surprise for the unsuspecting U.S. shareholder. Specifically, when a U.S. shareholder intends to liquidate a PFIC (primarily under Sec. 331), this intention should be clearly demonstrated by having the PFIC's board of directors pass a resolution to liquidate and filing a Form 966, Corporate Dissolution or Liquidation, within 30 days after the resolution. This is important; if the Service does not recognize the liquidation, the U.S. shareholder's return of capital could be taxed as ordinary income.

Mechanics of the PFIC Provisions

The purpose of the PFIC regime was to deal with what Congress perceived as abuses by U.S. investors in foreign mutual funds. These rules, however, apply to any foreign corporation that meets either the PFIC income or the asset test, regardless of the ownership percentage owned by such U.S. shareholder. In general, under the income test (Sec. 1297(a)(1)), a foreign corporation is a PFIC if 75% or more of its gross income for the tax year is passive income. Under the assets test, a foreign corporation is a PFIC if the average market value of its passive assets (i.e., assets used to generate passive income) during the tax year is 50% or more of the corporation's total assets. (A foreign corporation that is a controlled foreign corporation (CFC), as well as any other foreign corporation that so elects, measures the adjusted basis of its assets for the assets test, rather than their fair market value.)

Taxation of PFICs can become somewhat harsh, to say the least. The undistributed earnings of a PFIC whose shares are not marketable are subject to U.S. tax under one of two methods, each of which is directed at eliminating tax deferral benefits. First, if a U.S. shareholder obtains the necessary information, he may elect to be taxed currently on his pro rata share of the PFIC's earnings and profits (E&P); this is the qualified electing fund (QEF) method. A U.S. shareholder who fails to make a QEF election is taxed under special excess distribution provisions. Here, a U.S. shareholder is permitted to defer tax on the PFIC's undistributed income until he either disposes of the stock or the PFIC makes an excess distribution. If a shareholder disposes of the stock, the gain on the disposition will be taxed under the Sec. 1291(a)(1) excess distribution rules. If, on the other hand, a shareholder receives an excess distribution, the entire excess distribution will be taxable under Sec. 1291 (a)(1), without regard to either the PFIC's E&P or the amount of the shareholder's investment in it.

An excess distribution generally includes any gain realized on the disposition of PFIC stock and any actual distribution made, to the extent the total actual distributions received by the U.S. shareholder for the year exceed 125% of the average actual distributions received by him in the preceding three tax years (Sec. 1291(b)(2)(A)).

If a PFIC intends to liquidate, but fails to observe the necessary formalities for liquidation, a U.S. shareholder may become entangled in the PFIC web. Failure to observe the necessary formalities can result in the treatment of a return of capital as a part of a taxable excess distribution. This problem may be particularly acute when a shareholder does not control a PFIC, because he may not have the power to force the foreign corporation to observe the necessary U.S. formalities. If a PFIC is a CFC and a U.S. person owning the PFIC shares is a "U.S. shareholder" owning 10% or more of the CFC, Sec. 1297(e) will eliminate the problems discussed herein for years beginning after 1997, but not for earnings in prior PFIC periods.

Entanglement of the U.S. Shareholder

Example: Taxpayer R, his brother, D, and his son, S, owned a foreign corporation that, unbeknownst to them, qualified as a PFIC under the income test. Because they were unaware of the corporation's PFIC status, they failed to make a QEF election.

The PFIC was inactive for several years, earning only passive income subject to tax under subpart E R (who had acquired D's stock) and S, the only shareholders of the corporation, made a decision to liquidate the entity. This decision to liquidate was not formalized through a corporate resolution and no Form 966 was filed, even though the two shareholders agreed that a liquidation should occur. The PFIC made a liquidating distribution, but retained a small amount of funds for incidental expenses associated with a Sec. 331 liquidation.

The shareholders recognized gain on the PFIC liquidating distribution to the extent that the amount realized exceeded each of their adjusted bases. On audit, failing to recognize that a liquidation was in progress, the IRS attempted to treat the entire distribution, including the taxpayers' return of capital, as ordinary income under Sec. 1291(a)(1). Presumably, when the final liquidating distribution is made, this treatment will result in a large capital loss for the taxpayers.

Informal and Formal Liquidation

In the above example, the taxpayers' return of capital was taxed as an excess distribution, for two reasons. First, the IRS failed to recognize that a liquidation occurred, presumably because the taxpayers did not observe the liquidation formalities. Second, Sec. 1291, unlike the normal provisions of subchapter C, does not base taxation of a distribution on the amount of E&P, effectively resulting in the taxation of return of capital.

A status of liquidation exists when a corporation ceases to be a going concern and its activities are merely for the purpose of winding up its affairs, paying its debts and distributing any remaining balance to its shareholders (Regs. Sec. 1.332-2(c)). It is not material that a liquidating corporation does not have a formal resolution to liquidate or has not adopted a plan to dissolve (Kennemer, 96 F2d 177 (5th Cir. 1938)). The Tax Court, in Olmstead, TC Memo 1984-381, applied a three-prong test to make a factual determination of liquidation:

1. Whether there was manifest intention to liquidate;

2. Whether there was a continuing purpose to terminate corporate affairs and dissolve the corporation; and

3. Whether the corporation's activities were directed and confined to that purpose.

The liquidation of a taxpayer's non-QEF PFIC was subject to the provisions of Sec. 331, which provides that amounts received by a shareholder in complete liquidation of a corporation shall be treated as full payment in exchange for stock. Thus, a liquidation is effectively treated as a sale by a shareholder of his stock to a corporation. As a result, the shareholder computes gain or loss under Sec. 1001 (a), subtracting the adjusted basis of his stock from the amount realized. The gain is treated as ordinary income, which is then treated as if the amount of the gain were an excess divident.

Sec. 1291(a)(2) Controls under a Liquidation

Sec. 1291 (a) (1) treats distributions made by a PFIC quite differently from Sec. 1291(a)(2). Sec. 1291(a)(1) treats an excess distribution from a PFIC as income, including a return of capital. Conversely, Sec. 1291(a)(2) states that if a taxpayer disposes of stock in a PFIC, only the gain on the disposition is recognized and characterized as ordinary income. Prop. Regs. Sec. 1.1291-3(b) (1) defines "disposition" as "any transaction or event that constitutes an actual or deemed transfer of property for any purpose.... including (but not limited to) a sale, exchange, gift, or transfer at death, or an exchange pursuant to a liquidation." In the example, had the taxpayers formalized their intent to liquidate, only their gain would have been taxed under Sec. 1291 (a)(2). Because they did not take formal steps to ensure liquidation treatment, they may end up being taxed at ordinary income rates on the entire amount of the liquidating distribution (other than amounts previously taxed under the subpart F rules).

Conclusion

This situation could have been avoided through proactive planning. First of all, taxpayers should make QEF elections when they are appropriate and PFIC status is known. In this particular situation (and to the extent they could control the outcome), the taxpayers should have had the foreign entity's board of directors adopt a formal liquidation resolution. They also should have placed the Service on notice of the liquidation by filing Form 966 within 30 days after passage of the resolution to liquidate. While either of these courses of action (QEF election or formalization of the intent to liquidate) should have eliminated the dispute with the IRS, the fact remains that the excess distribution rules permit the Service to tax in full distributions that exceed E&P.

FROM HORACE A. JONES, JR., J.D., LL.M., AND JOSEPH MACH, CPA, J.D., LL.M., NEW YORK, NY