PFIC deferred tax amount: timing is everything.

Taxpayers familiar with the passive foreign investment company (PFIC) provisions are all too aware of just how onerous those rules can be. Shareholders of a foreign corporation that is a PFIC during part, but not all, of the shareholder's holding period should be especially wary of how the PFIC provisions apply to them.

Background

The PFIC provisions were enacted as part of the Tax Reform Act of 1986 (TRA '86) to combat what Congress determined was improper offshore deferral of passive investment earnings. Although PFICs are generally thought of as foreign corporations primarily used as passive investment vehicles, unpleasant PFIC consequences can apply to active companies, too.

Tests: Characterizing a foreign corporation as a PFIC turns on satisfying, under Sec. 1297(a), either a passive income or passive asset test for any tax year. For the Sec. 1297(a)(1) income test, 75% or more of a foreign corporation's gross income for a tax year must consist of passive income, which generally means "foreign personal holding company (FPHC) income," defined in Sec. 954(c). According to the Sec. 1297(a)(2) asset test, at least 50% of the foreign corporation's assets (based on either value or, in certain circumstances, adjusted tax basis) held during the tax year must be passive (i.e., produce (or reasonably expected to produce) passive income); see Notice 88-22. Under the so-called "once a PFIC, always a PFIC" rule of Sec. 1298(b)(1), stock is generally treated as stock in PFIC if, at any time during the taxpayer's holding period, the foreign corporation was a PFIC, even if it no longer satisfies either the income or asset test.

Anti-deferral rules: PFIC shareholders are subject to a near punitive anti-deferral regime under Sec. 1291 for certain events as to their PFIC stock. Unlike other anti-deferral regimes (e.g., controlled foreign corporation (CFC) or FPHC provisions), Sec. 1291 consequences do not depend on a corporation's earnings. In general, under Sec. 1291(a)(1), "excess distributions" (according to Sec. 1291(b), any distribution from a PFIC that exceeds 125% of the average distributions for the last three years and gains from PFIC stock dispositions) in respect of stock in a PFIC are subject to tax at top marginal rates, plus an interest change.

The PFIC penalty works as follows. First, under Sec. 1291(a)(1)(A), an excess distribution in respect of stock in a PFIC is "allocated ratably to each day in the taxpayer's holding period for the stock." Sec. 1291(a)(1) (B) provides that amounts allocated to the current year or any period in the taxpayer's holding period before the foreign corporation became a PFIC (but after 1986) (pre-PFIC years) are included as ordinary income (not capital gain) in the taxpayer's gross income for the current year. Thus, such amounts may be off set by current-year tax attributes, such as losses. By contrast, amounts allocated under Sec. 1291(a)(1)(A) to years other than the current year or pre-PFIC years are subject to tax at the highest applicable rate, without offset for losses or other tax attributes pursuant to the "deferred tax amount" calculation discussed below; see Sec. 1291(a)(1)(C) and (c)(2).

Amounts allocated to PFIC years and, ostensibly, post-PFIC years, form the base of the "deferred tax amount," which is the sum of the "aggregate increases in taxes," plus the "aggregate amount of interest" (Sec. 1291(c)(1)(A) and (B)). Under Sec. 1291(c)(2), the aggregate increases in taxes are amounts allocated to PFIC years under Sec. 1291(a)(1)(A) (without offset), multiplied by the highest individual or corporate rate (whichever applies) in effect for each year to which an amount is allocated, and the aggregate interest amount is an interest charge imposed on each year's aggregate increase in tax, starting on the hypothetical due date for that tax year and ending on the due date for the tax year of the distribution or disposition; see Sec. 1291(c)(3).

Elections: A taxpayer may generally avoid the Sec. 1291 regime by one of two alternative elections: the (1) qualified electing fund (QEF) election or (2) mark-to-market election; see Secs. 1291(d), 1293 and 1296. If a shareholder makes a QEF election, it generally includes in income each year its pro-rata share of the PFIC's ordinary earnings and net capital gain. Shareholders owning marketable PFIC stock may make a Sec. 1296 mark-to-market election to include annually in gross income the excess of the PFIC stock's fair market value over its adjusted basis (or, in certain cases, a deduction if the stock value declines). Further, a PFIC/CFC overlap elimination rule was added in 1997, which generally provides that a foreign corporation is not treated with respect to a shareholder as a PFIC during the portion of the shareholder's holding period when the corporation was a CFC and the shareholder was a U.S. shareholder; see Set:. 1297(e)(1) and (2).

Tax Computation for Non-PFIC Years

Provided a taxpayer has not made a QEF or mark-to-market election, taxation under the PFIC regime hinges on the allocation of an "excess distribution" (which, despite the name, includes gain from the disposition of stock in a PFIC) to the taxpayer's holding period for such stock.

Example 1: A U.S. citizen (USP) has held 10% of the stock in a foreign corporation (FC1) since the latter's incorporation in 1995. From 1995-2000, FC1 was not a PFIC. Since 2000, FC1 has been a PFIC. At no time was it a CFC. USP did not make a QEF or mark to-market election. At the end of 2004, USP disposes of 5% of FC1's stock, realizing a $100 gain.

The entire gain is an excess distribution; see Sec. 1291 (a)(2). Based on the dally allocation requirement in Sec. 1291(a)(1)(A), $10 would be allocated to each year from 1995-2004. Under Sec. 1291(a)(1)(B)(ii), the $50 of gain allocated to the years when FC1 was not a PFIC (i.e., 1995-1999) would be included in USP's gross income as ordinary income in 2004, together with $10 of gain allocated to 2004. The remaining $40 of gain allocated under Sec. 1291(a)(1)(A) to the years when FC1 was a PFIC, other than the year of disposition (i.e., 2000-2003), would be subject to the deferred tax and interest charge. USP's tax would be increased by the deferred tax amount, calculated by multiplying the $10 allocated to each year from 2000-2003 (without any offsets) by the highest individual rate in effect for those years plus an interest charge; see Sec. 1291(c). Subjecting amounts allocated to PFIC years to the tax and interest charge appears consistent with the PFIC regime's anti-deferral purpose.

Example 2: The facts are the same as in Example 1, except that FC1 was a PFIC from 1995-1999. However, since 2000, it has not been a PFIC. At the end of 2004, USP disposes of 5% of FC1's stock, resulting in a $100 gain.

Under the "once a PFIC, always a PFIC" rule, FC1's stock is still "stock in a PFIC" in 2004, even though FC1 has not been a PFIC since 1999. Thus, as in Example 1, the entire gain on the stock sale is an excess distribution, allocated to each day in USP's holding period under Sec. 1291(a)(1)(A), or $10 to each year from 1995-2004. Because USP's FC1 stock is still "stock in a [PFIC]," Sec. 1291(c)(2) subjects the gain allocated to all years of USP's holding period (other than 2004) to the onerous deferred tax amount calculation. Thus, the deferred tax amount includes amounts allocated to both PFIC and non-PFIC years, solely because PFIC status arose sooner, rather than later, in USP's holding period.

The result in Example 2 seems unwarranted. In both examples, USP has held stock for 10 years and FC1 was a PFIC for only four years. Yet, in Example 2, $90 (more than double the $40 amount of Example 1) is subject to the deferred tax amount. Sec. 1291 (a)(1)(B)(ii) includes as ordinary income (not capital gain) to the current year only amounts allocated to a taxpayer's holding period "before the 1st day of the 1st taxable year of the company which begins after December 31, 1986, and for which it was a passive foreign investment company ...[.]" (Emphasis added.) This provision provides no exception for subsequent non-PFIC years.

Perhaps even more surprisingly, the allocation to post-PFIC years appears to result even if the foreign, corporation is a CFC in those post-PFIC years and the shareholder includes subpart F income in its taxable income each year. The PFIC/CFC overlap elimination rule of Sec. 1297(e) does not turn off the "once a PFIC, always a PFIC" rule or otherwise exclude the CFC holding period from the deferred tax calculation. Thus, in both examples, even if USP were a U.S. shareholder and FC1 became a CFC in 2001, USP would still be required to allocate any excess distribution amount to years in which FC1 was a CFC. Such allocation undermines, in part, the benefits of the PFIC/CFC overlap rule, but is a direct consequence of applying the plain language of Sec. 1291(a) and (c).

Other Authorities

The TRA '86 legislative history, however, seems to suggest that subjecting excess distributions to the deferred tax amount when an entity becomes a PFIC sooner rather than later may not have been Congress' unambiguous intent. For example, the Conference Report describes the U.S. tax due for excess PFIC stock distributions and dispositions as the sum of:

(1) U.S. tax computed using the highest rate of U.S. tax for the investor (without regard to other income or expenses the investor may have) on income attributed to prior years, plus (2) interest imposed on the deferred tax, plus (3) U.S. tax on the gain attributed to the year of disposition (or year of receipt) and to years in which the foreign corporation was not a PFIC (for which no interest is due). (Emphasis added.)

The Report seems to call into doubt Example 2's conclusion that a deferred tax amount would be calculated for 1995-2003 for the periods in which FC1 was not a PFIC.

Moreover, the TRA '86 Blue Book description of the PFIC rules also appears inconsistent with the statute's language; it provides that U.S. tax due in the disposition year includes, inter alia, "U.S. tax on the income attributable to the year of disposition (or year of receipt) and to the years in which the foreign corporation was not a PFIC that precede the year of disposition (for which no interest is due)." (Emphasis added.) This description again seems to suggest that no interest should be due for any non-PFIC years, regardless of whether those years follow a PFIC year.

Conclusion

Subjecting excess distribution amounts allocable to PFIC years to the tax and interest charge is clearly consistent with the PFIC regime's anti-deferral aim. Treating such amounts allocated to non-PFIC years as ordinary income also appears consistent with PFIC legislation purposes. However, the unusual interplay of the PFIC provisions subjects amounts allocated to non-PFIC years, when a foreign corporation was a PFIC at any time in the shareholder's holding period, to the deferred tax amount calculation.

David Madden, J.D., LL.M.

Principal

Washington National Tax Service

KPMG LLP 

Washington, DC

FROM CHRIS BOWERS, J.D., ROBERT LAUDEMAN, J.D., LL.M., AND JEFFREY COWAN, J.D., LL.M.,WASHINGTON, DC