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New PFIC QEF election regulations encourage purging PFIC taint of a CFC/PFIC for 1997 tax year.

A calendar-year U.S. corporation owning stock of a foreign corporation that is both a controlled foreign corporation and a passive foreign investment company (CFC/PFIC) should consider taking action to make a timely election with its original 1997 income tax return to "purge" any "PFIC taint" from that CFC/PFIC under Sec. 1298(b)(1). By paying the U.S. tax resulting under the deemed sale election of Temp. Regs. Sec. 1.1297-3T(a) or the deemed dividend election of Temp. Regs. Sec. 1.1297-3T(c), and complying with the other requirements of Temp. Regs. Sec. 1.1297-3T(b) by the filing date for the original income tax return for 1997 (including any extensions of time to file), the U.S. corporation can reduce the amount of interest otherwise owing on untaxed PFIC earnings and can avoid the "once-a-PFIC-always-a-PFIC" rule of Sec. 1298(b)(1).

Under the once-a-PFIC-always-a-PFIC rule, once the stock of a foreign corporation held by a U.S. person is tainted with PFIC status, unless an appropriate qualified electing fund (QEF) election is made, such stock never loses that taint in the hands of the U.S. person, even if the foreign corporation ceases to have sufficient passive assets or income to be a PFIC within the meaning of Sec. 1297(a). A tainted foreign corporation that no longer meets the PFIC definition is referred to as a former PFIC"; a foreign corporation that has avoided the once-a-PFIC-always-a-PFIC taint by making a QEF election is known as a "pedigreed QEF."

A former PFIC can remove its taint if it makes a "purging" election under Sec. 1298(b)(1) to trigger income recognition as of the last day of the last tax year for which the company was a PFIC without regard to the once-a-PFIC-always-a-PFIC rule. The Taxpayer Relief Act of 1997 (TRA '97) gave new impetus for a U.S. person to make the election if he currently owns and has owned since before 1998, 10% or more of the voting stock of a foreign corporation that (1) is (and has been prior to 1998) both a CFC and a PFIC and (2) is not a pedigreed QEF, because the US. person did not make a QEF election for the first year in which the foreign corporation became a PFIC. The potential benefit of making the purging election stems from new Sec. 1297(e), which modifies the applicability of the PFIC rules to CFCs.

New PFIC QEF election regulations were published on Jan. 2, 1998 (TD 8750). The wording of the new regulations under Sec. 1298(b)(1) raises concerns about whether a taxpayer is allowed to make a purging election with respect to a CFC that, after Dec. 31, 1997, still meets the basic income or asset tests for PFIC status under Sec. 1297(a). The wording of the Sec. 1298(b)(1) regulations may be read as suggesting that the only foreign corporation for which the election can be made is one that no longer has enough passive income and assets to meet at least one of the tests to be treated as a PFIC under Sec. 1297(a). For example, new Temp. Regs. Sec. 1.1297-3T(c)(1) allows purging under Sec. 1298(b)(1) for a shareholder of a former PFIC that was a CFC "during its last taxable year as a PFIC under section 1296(a)." (See also old Temp. Regs. Sec. 1.1297-3T(a) (3); Regs. Sec. 1.1291-9(j)(2)(iv) (defining the term "former PFIC" by reference to the income and asset tests under Sec. 1296(a)); Regs. Secs. 1.1291-9(i)(2) and 1.1291-10(h).) If the CFC is still a PFIC under the income and assets tests of Sec. 1297(a), new Temp. Regs. Sec. 1.1297-3T(c)(1) provides no affirmation that the shareholder may purge by invoking Sec. 1298(b)(1).

It is possible, however, that the IRS will interpret the regulations to allow such a foreign corporation to be treated as a former PFIC due to its CFC status and the operation of Sec. 1297(e). In this case, U.S. shareholders will be able to purge under Sec. 1298(b)(1) as of the tax year of the PFIC that includes Dec. 31, 1997 (or at least sometime within the next 11 months) in the case of a CFC that would still be a PFIC after 1997 under the income and assets tests.

If so, a U.S. shareholder that seeks to purge under Sec. 1298(b)(1) the PFIC taint of its CFC/PFIC acquired before 1998, should give careful consideration to the procedures set forth in Temp. Regs. Sec. 1.1297-3T(b), which states that this election is to be made by filing an "amended return" There seems little reason, however, why the Service should not permit this election to be made, in the case of a foreign corporation covered by Sec. 1297(e), on an original return for the year of the U.S. shareholder that includes the last day of the foreign corporation's tax year that includes Dec. 31, 1997.

Finally, if the Sec. 1298(b)(1) election is not made on the original return, the US. shareholder should be aware that the Last date for making such an election on an amended return is three years after the due date (as extended) of the original return for the tax year of the US. shareholder that includes the last day of the foreign corporation's tax year that includes Dec. 31,1997.
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Title Annotation:passive foreign investment company, qualified electing fund, controlled foreign corporation
Author:Cohen, Harrison J.
Publication:The Tax Adviser
Date:Jun 1, 1998
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