Foreign National Tax Planning to Avoid PFIC Trap

As part of the Tax Reform Act of 1986, Congress enacted legislation on the taxation of a U.S. shareholder's interest in a passive foreign investment company (PFIC). To offset potential tax deferrals, the PFIC rules impose a punitive interest charge on U.S. shareholders of a foreign corporation that qualifies as a PFIC, for certain distributions by the PFIC and dispositions of PFIC stock.

When a shareholder receives an excess distribution, the PFIC regime allocates the stock's excess distributions ratably to each day in the taxpayer's PFIC stock holding period. The amounts allocated to the current year or any pre-PFIC years are included in the taxpayer's current-year gross income as ordinary income. Further, the "deferred tax amount" of the excess distribution allocated to prior PFIC years increases the current-year tax (Sec. 1291(a)). The deferred tax equals the tax imposed on the excess distribution allocated to the prior PFIC years, computed at the highest marginal rate in effect for the tax year in question, plus interest on such tax increase (Sec. 1291(c)).

While Congress originally enacted the PFIC regime to eliminate the tax-deferral advantage enjoyed by savvy U.S. investors who were investing in foreign (rather than domestic) investment funds, the PFIC regime can spring a trap on a different group of unsuspecting investors: foreign nationals. When a foreign citizen comes to the U.S. to work, he is commonly a shareholder in a foreign corporation. As a result, unsuspecting foreign nationals with no intention of deferring taxes may be subject to the PFIC regime and face harsh U.S. tax consequences. However, with the proper tax planning, foreign nationals who hold stock in a foreign corporation can avoid the harsh consequences of being caught in the PFIC trap.

Observation: Foreign nationals can be easily caught in the PFIC trap, as a PFIC might include something as common as a foreign mutual fund.

In tax planning, the importance of properly classifying a foreign corporation cannot be understated and this requires a particular analysis. Determining whether a corporation is a controlled foreign corporation (CFC) (by applying the laws defining CFCs (as found in Sec. 957)) is the first step. Determining whether the foreign corporation is a foreign personal holding company (FPHC) (as defined in Sec. 552) comes next. The IRS generally does not treat a foreign corporation that would otherwise be a PFIC as such if it were also a CFC. Additionally, the Service requires proper adjustments when PFIC and FPHC rules apply simultaneously.

If a foreign corporation is neither a CFC nor a FPHC, the next step is an evaluation to determine if it is a PFIC. A foreign corporation is a PFIC if (1) its income consists of at least 75% passive income or (2) if 50% or more of the corporation's assets produce passive income (Sec. 1297(a)). There are no minimum ownership requirements that subject a shareholder to the PFIC rules. The PFIC rules apply to any U.S. persons (e.g., resident aliens) who are shareholders in a PFIC (Sec. 1291(a)). However, two elections, when timely made, can free the taxpayer from the PFIC trap. A U.S. shareholder can make either the qualified electing fund (QEF) election or a mark-to-market election. These elections create an immediate income inclusion for the shareholder and eliminate the tax deferral.

Under the QEF method, shareholders able to obtain the necessary information from the PFIC may elect annual taxation on their pro rata share of the PFIC's ordinary earnings and capital gains. A taxpayer's pro rata share equals the amount that he would have received if, on each day of the QEF's tax year, the QEF had actually distributed to each of its shareholders a pro rata share of that day's ratable share of that year's ordinary earnings and net capital gains. To prevent double taxation, any subsequent actual distributions that a QEF makes from its previously taxed earnings and profits are tax-free to U.S. shareholders. Also, a U.S. shareholder's basis in the QEF's stock increases for any income inclusions and decreases for distributions of previously taxed income (Sec. 1293).

Observation: Generally, a taxpayer should make a QEF election if possible. However, obtaining the necessary information from the foreign corporation can prove difficult for most shareholders, especially minority shareholders. The inability to obtain this information often eliminates the taxpayer's ability to make a QEF election.

The mark-to-market election extends the current income inclusion method to PFIC shareholders unable or unwilling to make a QEF election. A shareholder can make this election only if the stock is marketable. If a shareholder makes a mark-to-market election, he must include in income the difference between the PFIC stock's fair market value (FMV) at the close of the tax year and his adjusted stock basis. The shareholder can deduct any excess of the PFIC stock's adjusted basis over its FMV at the close of the tax year. The net mark-to-market gains on the stock the shareholder included in income in prior years is not deductible. The shareholder must treat any income or loss recognized under the mark-to-market election as ordinary. Additionally, the income recognized under the mark-to-market election and decreased by the deductions allowed under the election increases a shareholder's adjusted basis in PFIC stock (Sec. 1296).

From Kyle A. Kauffman, J.D., Washington, DC