Check-the-Box Elections (cont.)

PFIC Considerations
For Foreign Investors With U.S. Beneficiaries
STEP Presentation
April 24, 2013
Dina Kapur Sanna, Esq. and Stephen Ziobrowski, Esq.
© 2013 Day Pitney LLP
 Passive Foreign Investment Company (PFIC)
rules are triggered in a typical NRA structure
when investments are consolidated in a holding
company or foreign funds are part of the
investment portfolio, and one or more
beneficiaries are U.S. persons
 While NRA is alive and treated as the owner of
the PFIC, there is no problem, but on his death,
indirect ownership rules may apply to treat U.S.
beneficiaries as owners of PFICs
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What is a PFIC
 A PFIC is a foreign entity that is treated as a
corporation for U.S. tax purposes and generates
primarily passive investment income, or holds
primarily passive assets
 Passive income is defined by reference to
foreign personal holding company income,
which includes investment income such as
dividends, interest and gains
 No minimum threshold of U.S. ownership or
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What is a PFIC (cont.)
A foreign entity is classified as a corporation
under Treasury regulations if one of the
following is true:
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It is a “per se” corporation
It elected to be treated as a corporation by filing
Form 8832 with the IRS
It did not make an election and under the law where
the entity is formed, no shareholder or member has
personal liability for the debts or obligations of the
What is a PFIC (cont.)
 A foreign entity that is classified as a corporation
for U.S. tax purposes will be a PFIC if 75% or
more of its gross income for the taxable year is
passive income, or 50% or more of the average
percentage of its assets are held for the
production of passive income
 There is a 25% subsidiary look-through rule
 If a foreign corporation is both a PFIC and CFC,
the PFIC rules take precedence with respect to a
10% U.S. shareholder
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Ownership of PFIC through an Estate or
 Stock owned directly or indirectly by or for an
estate or trust is considered as being owned
“proportionately” by the U.S. beneficiaries
 Prop. Regs. apply facts and circumstances test
to determine “proportionality” but reserve on
substantive guidance
 TAM 200733024: absence of final or temporary
regulations do not prevent PFIC rules from
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What is a PFIC (cont.)
Is the company
organized under
U.S. law?
Is the company treated as a
corporation for U.S. tax
purposes as a result of
a. per se corporation rule
b. default classification
c. check the box election?
Is either of the following true:
a. 75% of the company’s gross income
is passive income; or
b. 50% or more of the company’s
assets are held for the production of
passive income?
(After applying “look through” rule)
*If this question is answered yes, then the U.S.
shareholder is taxed under the Controlled Foreign
Corporation (“CFC”) rules
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Are both of the following true?
1. U.S. persons own more
than 50% of the stock (by
vote or value) and
2. The U.S. shareholder owns
10% or more of the voting
as a
as a
Ownership of PFIC through an Estate or
Trust (cont.)
 TAM 200733024: IRS applied facts and
circumstances to tax U.S. beneficiaries of
discretionary trust on indirect PFIC disposition
resulting from liquidation of PFIC into trust in that
year (year 1), rather than when liquidation
proceeds distributed to them (year 2)
 Analysis based on settlor’s intention to provide
separate shares of equal proportion for all
beneficiaries and trustee’s pattern of equal
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Ownership of PFIC through an Estate or
Trust (cont.)
 Indirect ownership despite the fact that U.S.
beneficiaries had no role in creating the trust
and could not control distributions
 IRS: intent is not a factor. PFIC regime applies if
there is a perceived advantage of tax-deferral
achieved by investing through a foreign holding
company, regardless of whether investment
through that holding company was explicitly
created for that purpose
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Ownership of PFIC through an Estate or
Trust (cont.)
 Pattern of past distributions seems to be most
relevant fact for a discretionary trust, but the
analysis falls short in many respects:
 What if there are no distributions?
 When do distributions rise to the level of a “pattern”?
 Do distributions have to be of a minimum value to be
 Is there a risk that fall-back rules of intestacy could
apply where there are no such distributions?
 No guidance on how to reconcile with Subchapter J
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Taxation Under the Excess Distribution
 In absence of QEF election or mark-to-market
election, taxable event occurs on “excess
 Excess distribution is amount by which actual
distributions with respect to PFIC stock exceed
125% of the average of the prior 3 years (or if
shorter, taxpayer’s holding period in PFIC stock)
 Importantly, entire gain realized on disposition of
PFIC stock is treated as an excess distribution
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Taxation Under the Excess Distribution
Regime (cont.)
 Excess distribution allocated ratably over U.S.
shareholder’s holding period
 Portions allocated to current year and pre-PFIC years
are taxed as ordinary income
 Portions allocated to PFIC years are taxed at highest
marginal rate of U.S. shareholder in effect for that year
and draw an interest charge (sum of tax and interest is
“deferred tax amount”)
 Deferred tax amount cannot be offset by losses or
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Elections Under PFIC Regime
QEF Election
 A U.S. shareholder can make a “Qualified
Electing Fund” (“QEF”) election with respect to a
 If the QEF election is made, the U.S.
shareholder includes his allocable share of the
PFIC’s ordinary income and capital gains in
income currently
 There is a separate election which can be made
to defer payment of tax on undistributed income
of a QEF
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QEF Elections (cont.)
 The character of the PFIC’s income as ordinary
income or capital gain passes through to a
shareholder who makes the QEF election
 The election is made by the first U.S.
shareholder in the chain of ownership
 In the case of a foreign nongrantor trust, the
U.S. beneficiary of the trust makes the election
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QEF Elections (cont.)
 The election is made on a shareholder by
shareholder basis
 A PFIC, therefore, may be a QEF with respect to
some U.S. shareholders but not with respect to
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QEF Elections (cont.)
 The QEF election must be made by the due date
of the U.S. shareholder’s tax return for the first
year in which it is to be effective
 If the QEF election is made effective as of the
first day of the first year of the U.S.
shareholder’s holding period, then the PFIC is a
“pedigreed QEF”
 A “pedigreed QEF” is not subject to the PFIC
default regime as long as the QEF election is
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QEF Elections (cont.)
 If a QEF election is made effective after the first
day of the first year of the U.S. shareholder’s
holding period, the QEF is an “unpedigreed
 An “unpedigreed QEF” is subject to the PFIC
default rules (i.e., tax on “excess distributions”)
on a sale or liquidation of the stock
 This result stems from the “once a PFIC, always
a PFIC” rule and is called the “PFIC taint”
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QEF Elections (cont.)
 Late QEF elections are permitted only in very
narrow circumstances
 In general, a U.S. shareholder seeking to make
a late QEF election must demonstrate that he
possessed a reasonable belief as of the original
due date of the late election that the foreign
corporation was not a PFIC
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QEF Elections (cont.)
 If it is not possible to make a late QEF election,
the U.S. shareholder should consider making a
purging election (to remove the PFIC “taint”) and
combining that election with a QEF election
going forward
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QEF Elections (cont.)
 A QEF election may only be made if the PFIC is
willing to compute its income and gain in
accordance with U.S. tax rules and furnish the
information annually that the U.S. shareholder
needs to comply with the QEF election
 Many foreign investment funds are unable or
unwilling to comply with this requirement
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Elections Under the PFIC Regime
Check-the-Box Elections
 Foreign entities which are not “per se”
corporations are eligible to elect to be taxed in
the U.S. as fiscally transparent entities
 A foreign entity which has elected to be fiscally
transparent is not a PFIC
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Check-the-Box Elections
 A check-the-box election can be made
retroactively up to 75 days after the date it is to
become effective
 Rev. Proc. 2009-41 permits late check-the-box
elections for up to 3 years and 75 days after the
requested effective date of the election
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Check-the-Box Elections (cont.)
 A late check-the-box election may be permitted
 the foreign entity failed to obtain its requested
classification as of the date of its formation or as of
the date its classification became relevant for U.S. tax
purposes only because Form 8832 was not timely
filed; and
 the foreign entity has not filed a federal tax return for
the first year of the requested election because the
due date for that return has not passed; or
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Check-the-Box Elections (cont.)
 the foreign entity has filed federal tax returns
consistent with the requested classification and no
inconsistent federal tax returns have been filed
 if the foreign entity is not required to file federal tax
returns, then each “affected person” who is required
to file a federal tax return has filed federal tax returns
consistent with the election, and no inconsistent tax
returns have been filed
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Check-the-Box Elections (cont.)
 The eligible entity has “reasonable cause” for its
failure to make the entity classification election
on time; and
 3 years and 75 days from the requested
effective date of the election have not passed
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Check-the-Box Elections (cont.)
 As a practical matter, the IRS has been very
willing to accept late check-the-box elections
made before the first federal tax returns would
be due for the first year of the election
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Check-the-Box Elections (cont.)
 A check-the-box election must be made by the
foreign entity, not the U.S. shareholders
 The check-the-box election affects all
shareholders, not just the U.S. shareholder who
makes the election
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Check-the-Box Elections (cont.)
 For these reasons, a check-the-box election may
not be available with respect to most PFICs
 If PFICs are held in a foreign holding company,
though, a check-the-box election should be
considered for the foreign holding company
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Check-the-Box Elections (cont.)
 A retroactive check-the-box election for the
holding company may achieve a basis step-up in
the stock of PFICs held by the holding company,
with no U.S. tax
 This would minimize PFIC gain subject to tax
under the default regime on a subsequent sale
or liquidation of the PFIC stock
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Elections Under the PFIC Regime
Purging Elections
 There are a number of “purging elections”
available to remove “PFIC taint”
 The most useful of these elections is the
“deemed sale” election
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Deemed Sale Election
 The deemed sale election can only be made if
the U.S. shareholder also makes a QEF election
 If the deemed sale election is made, the U.S.
shareholder is treated as having sold the PFIC
stock as of the first date of the QEF election
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Deemed Sale Election (cont.)
 Gain resulting from the deemed sale election is
taxed under the default regime, i.e., as ordinary
income with an interest charge
 The U.S. shareholder obtains a new basis in the
PFIC stock (unless the deemed sale results in a
loss) and he begins a new holding period in the
 The PFIC is a “pedigreed QEF” after the
deemed sale and QEF election, and the “PFIC
taint” has been expunged
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Deemed Sale Election (cont.)
 The deemed sale election should be considered
if the U.S. shareholder has a small or modest
built-in gain (or loss) on the PFIC stock and the
shareholder can establish the market value of
the PFIC stock
 If the built-in gain is very large, the U.S.
shareholder may have to consider an actual sale
of the stock, to have the funds to pay the tax
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Elections Under the PFIC Regime
Market-to-Market Election
 A U.S. shareholder may make a “mark-tomarket” election with respect to marketable PFIC
 If the election is made, the U.S. shareholder
includes in income the annual increase in value
of the PFIC stock at the end of each year
 Any increase in value is treated as ordinary
income. A decrease in value may be deducted
as a loss, to the extent of previous inclusions
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Mark-to-Market Election
 The mark-to-market election is generally
available only for PFIC stock which is regularly
traded on a qualified stock exchange
 As a practical matter, this requirement greatly
limits the utility of the election
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Direct PFIC Holding
 Assume a nonresident alien invests $1,000,000 in stock
of a PFIC in 2002
 He holds the stock in his own name or in a revocable
trust which allows him to direct payments of income
 The PFIC stock grows 5% a year. The nonresident alien
dies in 2013 and the stock is liquidated for $1,710,340
 There is no “excess distribution” because the basis of
the PFIC stock was stepped up to fair market value at
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Examples (cont.)
Indirect PFIC Holding
 Assume the same facts except that the PFIC is
held through a foreign corporation which is itself
 If the stock in the holding company is liquidated
shortly after the nonresident alien’s death in
2013, U.S. beneficiaries of his estate will be
taxable on their “proportionate shares” of
$710,340 of PFIC gain
 The amount taxable will be taxed as ordinary
income, with an interest charge
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Strategies for Dealing with Indirect
 QEF election
 Due by the due date of the U.S. beneficiary’s 2012 tax return
 Deemed Sale Election, combined with a QEF election
 Check-the-Box Election for the Holding Company
 Could be retroactive to a date before the nonresident alien’s
 But first be sure there are no U.S. situs assets (e.g., stock of
U.S. corporations) held by the holding company. Otherwise, a
check-the-box election could trigger U.S. estate tax
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Advance Planning
 Investing in PFICs which are targeted to U.S.
investors and will accommodate QEF election or
mark-to-market elections
 Avoiding foreign fund of funds, which trigger
indirect disposition of lower-tier fund when toptier fund is sold
 Avoiding funds which have liquidity restrictions
and do not permit regular redemptions
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Advance Planning
 Holding PFICs individually or directly by trust
and drafting trust to permit a date-of-death basis
step up
 Segregating PFICs in a “checkable entity” which
can check the box to be disregarded
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