PFICs: some new twists to old rules.

The passive foreign investment company (PFIC) rules continue to pose significant problems for many U.S. taxpayers. Although Congress intended the PFIC rules to apply only to foreign passive investment funds, the wide scope of the rules permits their application to any foreign corporation, including controlled foreign corporations (CFCS) and foreign personal holding corporations (FPHCS) that otherwise meet the definition of a PFIC. The two examples discussed will illustrate the continuing need to address these rules. Example 1: U.S. parent corporation USP has a wholly owned subsidiary, FS, in a foreign country. FS is in the process of winding down its business All of FS's earnings and profits have been included in USP'S income under the subpart F rules, and thus have been taxed by the United States. In 1990, FS made a $10,000,000 distribution to USP. USP had not made a qualified electing fund (QEF) election under Sec. 1295 with respect to its interest in FS.

Under the general principles of subchapter C, the $1 0 million distribution constitutes a "return of capital." Without the PFIC rules, the distribution would result in n U.S. tax. However, under the PFIC rules, there is no concept of "earnings and profits." In computing an "excess distribution," the entire amount of the distribution (regardless of whether it is a dividend, return of capital or capital gain) is included. In Example 1, the entire $10 million distribution constituted an "excess distribution" under Sec. 1291(b). Such excess distribution is then allocated over USP'S holding period and subject to the deferred tax and interest charge provisions of Sec. 1291(c).

This situation clearly demonstrates the harsh results that arise when a foreign corporation meets the definition of a PFIC. Note that in this situation, a late QEF election is not available. Under Sec. 1295(b), a QEF election must generally be made on or before the due date (determined with regard to extensions) for filing the tax return. Sec. 1295(b) states that regulations may provide for an election to be made later than the due date, but this exception is limited to circumstances in which the taxpayer fails to make a timely election because the taxpayer reasonably believed that the company was not a PFIC. Note also that Sec. 1291(b)(3)(f) exempts previously taxed income under Sec. 959 from the definition of "excess distribution." However, this provision is not applicable to a return of capital distribution. Example 2: During 1989, a U.S. corporation acquired a minority interest in a U.S. partnership, P. P own shares in numerous foreign corporations meeting the definition of a PFIC. P's tax return for 1989 reflected substantial gain from the disposition of various PFIC interests. P has held these interests for approximately five years. No QEF election had been made by P or its partners.

The issue here is how the gain is treated under the PFIC rules. Since the U.S. corporation only invested in P in 1989, one would expect that all the gain is included on the corporation's tax return under Sec. 1291 as ordinary income. However, this is only partially true. Under the PFIC rules, the partner's share of gain from the disposition of the PFIC interests is allocated over the holding period. In this case, however, the holding period is that of the partnership. The result under Sec. 1291 is that the gain allocated to the 1987 and 1988 tax years (PFIC years) is subject to tax at 34% and is subject to the interest charge provided by Sec. 1291(c). This result is particularly harsh if the corporation is in a loss carryover position. Such losses are not available to offset the deferred tax amount (and interest charge) computed under Sec. 1291(c).

In this particular situation, the QEF election may have alleviated such a result. However, under Notice 88-125, the partnership, and not the partner, must make the QEF election. Since the U.S. corporation only holds a minority interest in the partnership, it is unlikely that the partnership would make the QEF election. Moreover, it is unlikely that the foreign corporations would be willing to share the information required to make a QEF election. The only practical answer may be for the U.S. corporation to sell its interest in the partnership. These examples illustrate the extremely harsh results that can occur when foreign corporations meet the definition of a PFIC. They also reaffirm the general notion that the QEF election should be made unless there is a sufficient reason not to make the election.