Passive foreign investment companies.

U.S. shareholders of passive foreign investment companies (PFICs) face interest charges on the "deferred" tax on a PFIC's earnings and appreciation. This harsh treatment applies to share-holders of operating companies as well as investors in offshore funds. The PFIC rules contain many potential pitfalls requiring careful monitoring of foreign companies. (For instance, see the Tax Clinic item, "PFICs: Some New Twists to Old Rules," TTA, June 1992, at 362.)

Definition and background

A PFIC is any foreign corporation that meets either of the following tests under Sec. 1296(a):

*Passive income is 75% or more of gross income.

*The value of assets (including cash) that produce or could produce passive income is 50% or more of total assets.

Passive income generally means foreign personal holding company income (as defined in Sec. 954(c)), such as dividends, interest, rent and royalties. However, dividends and interest from "same-country" related corporations, rents and royalties on "same country" property from related corporations, and active business rents and royalties from unrelated persons are not passive income (Temp. Regs. Sec. 1.954-2T(b)(3), (4) and (5)).

There is no minimum U.S. ownership required for a PFIC. Indeed, a foreign corporation can be a PFIC without having any U.S. shareholders, although there is no practical effect until there are U.S. shareholders. If a U.S. person purchases shares in a foreign corporation that is a PFIC and retains those shares while the corporation continues to be a PFIC, the corporation will be a PFIC as to that shareholder. Once a corporation becomes a PFIC with respect to a shareholder, it will continue to be a PFIC with respect to that shareholder until either of two elections purges the PFIC taint (Sec. 1297)(b)(1)).

Effects of PFIC status

The PFIC rules have no direct impact on foreign corporations; they affect only U.S. shareholders.

A PFIC's shareholders must pay an interests charge on "excess distributions" relating to income earned by the PFIC for post-1986 years. An "excess distribution" is the gain on any disposition of shares plus that portion of any distribution exceeding 125% of the average distributions for the three preceding tax years. Distributions include any money or property distributed to a share-holder in respect of his stock and cover both taxable and many types of otherwise nontaxable transactions. Thus, the principal effect of PFIC status is to change the timing of income recognition and to impose an interest charge on the deemed tax deferral arising in prior years.

Avoiding the interest charge

The PFIC interest charge is imposed on the tax deferred on excess distributions. There are only three ways to avoid this charge: (1) avoid PFIC status or excess distributions; (2) elect treatment as a qualifying electing fund (QEF); or (3) pay foreign taxes at the PFIC level at rates equal or exceeding the shareholder's top marginal U.S. rate, thus offsetting the PFIC tax with the foreign tax credit.

A PFIC shareholder may elect under Sec. 1295 to treat the PFIC as a QEF and currently includes his pro rata share of the PFIC's realized earnings and gains in the shareholder's income in years for which the PFIC test is met. The QEF election removes the interest charge if the election applies to every PFIC year.

However, if the election is missed the first year, the interest charge will apply for that year unless a deemed sale (market to market) election is made. This election purges the PFIC taint by recognizing gain, and paying tax and interest under the PFIC rules, as though the shares were sold at fair market value (FMV) on the first day of the PFIC's tax year for which the shareholder also makes a QEF election.

An alternative election is available for shareholders of controlled foreign corporations (CFCs). The shareholder may purge the PFIC taint by including in income as a dividend (treated as an excess distribution) his pro rata share of the corporation's post-1986 earnings and profits. This dividend is ratably allocated only to post-1986 days. It also is treated as a distribution under Sec. 1248(a) for determining previously taxed amounts under Sec. 959(e) (Sec. 1291(d)(2)(B)(iii)). Further, deemed paid foreign tax credits are available as with other excess distributions (Sec. 1291(g)). This election does not require the immediate recognition of a CFC's unrealized appreciation and could be of great benefit to shareholders of a CFC with low earnings but substantial unrealized appreciation.

The QEF election and the related purging elections must be made by the extended due date of the shareholder's tax return. They cannot be made on an amended return after the date. However, a later QEF election may be allowed by future regulations if a taxpayer reasonably believed that the corporation was not a PFIC (Sec. 1295(b)).

PFIC pitfalls

The complexity of the PFIC provisions creates many problems for taxpayers and practitioners. For instance, the gross income test is based on gross income, not gross receipts. Gross income is sales plus other income less cost of sales. This test can lead to PFIC status for a foreign manufacturing or sales subsidiary. If cost of sales exceeds sales revenue, the foreign corporation will be a PFIC if it has any passive income.

Missed elections: If a company suddenly become a PFIC, it is imperative to make the QEF election to avoid the deferred tax interest charge. Further, the QEF and related purging elections must be made by the extended due date of the shareholder's return; no provisions currently exists for later election. Thus, an error in preparing a tax return in which PFIC status was not detected and a QEF election was not made may not be corrected.

Pro rata allocation: Excess distributions and gain from selling PFIC stock are automatically considered earned pro rata. The actual pattern of earnings or appreciation is ignored. This can result in distortions if there has been no tax deferral under regular tax principles, but only unrealized appreciation - even if all this appreciation occurred at the end of the holding period.

Gain recognition: PFIC rules require that gain generally is recognized in nonrecognition transactions; see Sec. 1291(f) and Prop. Regs. Sec. 1.1291-3. However, Prop. Regs. Sec. 1.1291-6 provides a few exceptions.

Inadvertent disposition: Pledging shares of a PFIC as security for a loan is considered a disposition at the date of pledge. The consideration is the lesser of the stock's FMV or the unpaid principal of the obligation secured by the stock, with the gain treated as an excess distribution (Prop. Regs. Sec. 1.1291-3(d)).

In contrasts, pledges or guarantees of CFC stock are taken into account at year-end (Regs. Sec. 1.956-1(d) and -2(c). In the case of PFICs, once documents are in place, tax will be imposed. since there is no second chance, bankers must be educated before closing a loan.

FSCs as PFICs: A foreign sales corporation (FSC) that generates primarily rental income is also a PFIC under current law. To obtain FSC benefits, this income must be derived from export property used by the lessee outside the United States; see Secs. 923(b) and 924(a)(2).

Newly proposed HR 13 would exempt FSCs from PFIC status. However, the exemption would only apply prospectively. Consequently, existing PFIC/FSCs will continue to be PFICs until purged. See HR 13, Section 402, adding proposed Secs. 1296(b)(1)(D) and 1297(d)(4).

Foreign currency distributions: The determination of whether there has been an excess distribution is normally made in U.S. dollars. However, Prop. Regs.

Sec. 1.1291-2(d)(4)(ii) provides that if all distributions are in a foreign currency, the determination is made in that currency. If this currency is subject to inflation exceeding 11% a year, level distributions may cause excess distributions. If possible, some distributions should be made in nonlocal currency.

Annualization: If the taxpayer does not hold the PFIC stock during the entire tax year, distributions received during the year may be annualized under future regulations to determine the excess portion (Sec. 1291(b)(3)(C)). This could result in serious distortions if a shareholder disposes of his stock early in the year after receiving an annual distribution. Start-up rules: Sec. 1297(b)(2) exempts corporations from PFIC status in a start-up year, This is a potential trap, since "year" is only the first tax year, not the first 12 months, that the corporations has gross income. To qualify, a corporation must not be a PFIC in either of the next two tax years.

Example: A calendar-year foreign corporation is formed Dec. 1, 1993 and has $100 of interest income for its first tax period beginning Dec. 1 and ending Dec. 31, 1993. This short period is a "tax year" (Sec. 441(b)(3)). Therefore, this corporation would have a mere one-month grace period for avoiding PFIC status under the "start-up" exception.

Conclusions

These pitfalls are only a few of the many possible problems faced by shareholders of potential PFICs. As part of tax planning analysis, taxpayers and their advisers should review PFIC exposure for all foreign companies with the U.S. shareholders. For both actual and potential PFICs, possible issues should be discussed, excess distributions avoided and distributions planned to reduce PFIC consequences. Errors in applying PFIC rules can be costly, since many cannot be subsequently corrected