Editor: Anthony S. Bakale, CPA, M. Tax.
Foreign Income & Taxpayers
As the workforce becomes more mobile, many non-U.S. citizens who become U.S. residents for work reasons have to deal with not only cultural adjustments but also the unanticipated workings of the passive foreign investment company (PFIC) tax regime.
For example, U.K. citizens may have investments in U.K. unit trusts, which for U.K. tax purposes are very similar to U.S. mutual funds. But as soon as they attain resident alien status in the United States and become subject to the full extent of U.S. tax laws, these funds become subject to the PFIC tax regime. However, these individuals often have no idea that they have fallen afoul of the PFIC tax regime—that is, until they sell their U.K. unit trust shares and think they have a capital gain taxable at a top long-term rate of 15%.
Then their tax adviser has to break the news that they have been ensnared by the PFIC rules. The gain on the sale of the shares is treated as an excess distribution under Sec. 1291(a)(2) and is taxed under the rules for excess distributions in Sec. 1291(a)(1). This item examines what this means and how the sale of U.K. unit trust shares or other PFIC stock is taxed for U.S. tax purposes.
Example 1: B, who is a U.K. citizen, bought 100 shares of a U.K. unit trust on Jan. 1, 2006. He became a U.S. resident alien on July 1, 2009, and sold the shares on April 30, 2012. His total holding period is 2,311 days. The 100 shares cost £10 each, and he sold them for £20 each. What are the U.S. tax consequences of the sale?
The issues to consider are:
- Can B step up the basis in his stock to fair market value (FMV) as of the date he became a U.S. resident alien, which would then become its cost basis? No. Rev. Rul. 55-62 provides that no step-up in basis is permitted to the FMV of the asset as of the date that U.S. residency starts. The revenue ruling provides that the taxpayer is taxable on both pre-residency and post-residency gain in the United States when a taxable event occurs, e.g., a sale or exchange.
- At what exchange rate is the original cost of the shares translated? For U.S. tax purposes, the exchange rate on the date of purchase is used (see Rev. Ruls. 54-105 and 78-281), i.e., $1.7234:£1 (midpoint rate on Jan. 1, 2006, per this online translator). So B’s 100 shares cost $1,723.
- At what exchange rate is the sale price of the shares translated? As with the cost part of the calculation, the exchange rate on the date of the disposal is used, i.e., $1.6259:£1. So B’s 100 shares were disposed of for $3,252 (100 shares × £20 × 1.6259).
Therefore, the total gain on the sale of B’s 100 shares in the U.K. unit trust is $1,529.
Now the question becomes whether all this gain is taxed as an excess distribution as if the unit trust shares were PFIC stock from the date of acquisition. Under the excess distribution rules, once the excess distribution gain has been determined, it is allocated ratably to all the days in the investor’s holding period, in this case, Jan. 1, 2006, to April 30, 2012. However, this can result in an allocation to three distinct periods: (1) the pre-PFIC period—the period that the investor held the stock before it became a PFIC stock; (2) the current-year period—the days in the investor’s tax year when the excess distribution occurred, i.e., Jan. 1, 2012, to April 30, 2012; and (3) the prior-year PFIC period—the days in the investor’s prior tax periods during which the foreign corporation was a PFIC.
So the issue then becomes how to split the excess distribution gain among these three periods. Based on the fact that B’s unit trust shares under U.S. law would have been PFIC shares from the date of acquisition, it would appear that all the PFIC gain, except for the amount allocated to 2012, would be prior-year PFIC period and subject to the highest rate of tax and an interest charge for each year the gain is allocated.
However, Regs. Sec. 1.1291-9(j)(1) provides that
a corporation will not be treated as a PFIC with respect to a shareholder for those days included in the shareholder’s holding period when the shareholder . . . was not a United States person within the meaning of section 7701(a)(30).
Since B did not become a U.S. resident until July 1, 2009, the excess distribution gain allocated to Jan. 1, 2006, to June 30, 2009, is pre-PFIC period, and the gain allocated to July 1, 2009, to Dec. 31, 2011, is prior-year PFIC period.
So how is the gain taxed? Per Sec. 1291(a)(1) and Prop. Regs. Sec. 1.1291-2(e)(2):
- The pre-PFIC period gain—$845 ($1,529 × [1,277 ÷ 2,311 days])—and current-year period gain—$80 ($1,529 × [121 ÷ 2,311 days])—are taxed as ordinary income on B’s 2012 U.S. tax return. Even though B’s stock may have otherwise qualified for the 15% dividend tax rate, the stock is a PFIC security that is not eligible for the 15% rate. Therefore, this income is taxed at whatever B’s marginal tax rate is for 2012.
- The prior-year PFIC period gain—$604 ($1,529 × [914 ÷ 2,311 days])—is further allocated to the specific tax year in which it was deemed earned, i.e., 2009—$122; 2010—$241; and 2011—$241. B is then subjected to the highest rate of tax on these gains, irrespective of his actual marginal rate of tax during that year. Once the tax has been determined, it is subject to an interest charge.
In summary, B was unaware of the PFIC rules, so what he thought was a capital gain subject to 15% federal tax resulted in a much greater tax burden. This is normally a big shock to non-U.S. citizens holding PFIC stock who become U.S. resident aliens subject to U.S. income taxes on worldwide income. A practitioner who advises a taxpayer before he or she becomes a U.S. resident can warn of the PFIC pitfalls and help the taxpayer plan accordingly. The taxpayer may decide to sell the PFIC stock before becoming a U.S. resident and invest in a vehicle that is not subject to these rules and thus mitigate the U.S. tax burden.
Anthony Bakale is with Cohen & Co., Ltd., Baker Tilly International, Cleveland.
For additional information about these items, contact Mr. Bakale at 216-579-1040 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly International.