Partnerships, PFICs and QEFs

Like much of the U.S. international tax regime, the passive foreign investment company (PFIC) provisions do not coordinate well with the subchapter K partnership rules. The qualified electing fund (QEF) rules and regulations offer one example of this coordination failure.

Background

The PFIC provisions were enacted as part of the Tax Reform Act of 1986 to combat Congress’s idea of improper offshore deferral of passive investment earnings. A PFIC is a foreign corporation that meets either a passive income or passive asset test; see Sec. 1297. The PFIC provisions prevent deferral through three tax regimes. The default tax regime under Sec. 1291 provides that U.S. persons owning PFIC stock—even one share—may be subject to tax at top marginal rates (without regard to the stockholder’s tax attributes, such as net operating losses), on certain distributions on, and dispositions of, PFIC stock; see Sec. 1291(a). Further, an interest charge is imposed on the amount of tax otherwise owed; see Sec. 1291(c). Even an indirect owner of PFIC stock (such as a partner in a partnership) can be subject to the regime; see Sec. 1298(a) and Prop. Regs. Sec. 1.1291-1(b)(8) and -2(f)(1).

A taxpayer may avoid the Sec. 1291 regime in one of two ways: (1) a mark-to-market election under Sec. 1296 or (2) a QEF election under Secs. 1293–1295. Under Sec. 1296, taxpayers holding PFIC stock regularly traded on a national securities market may include annually in gross income the excess of its fair market value (FMV) over adjusted basis (or, in certain circumstances, take a deduction if adjusted basis exceeds FMV). Under Secs. 1293–1295, taxpayers holding PFIC stock may elect to treat the PFIC as a QEF. Sec. 1293 requires every U.S. person who owns —or is treated as owning under the Sec. 1298(a) PFIC attribution rules —QEF stock at any time during such fund’s tax year, to include in gross income his or her pro-rata share of the PFIC’s ordinary earnings and net capital gain.

QEFs Owned Through Partnerships

QEF stock ownership through a partnership may have certain advantages.

Example 1: Two domestic corporations, A and B, form a 50/50 domestic partnership, USP. USP purchases 25% of a foreign corporation, Fsub, which is a PFIC.

As the first U.S. person in the chain of Fsub ownership, USP must make a QEF election; see Regs. Sec. 1.1295-1(d)(1). Under Regs. Sec. 1.1293-1(c)(1), USP takes into account its pro-rata share of the ordinary earnings and net capital gain attributable to the QEF shares it “holds.” Under this same rule, A and B account for their pro-rata shares of Fsub’s ordinary earnings and net capital gain according to the general rules for inclusions of partnership income (i.e., Secs. 702–704).

As A and B’s QEF inclusion appears governed by subchapter K and not Sec. 1293(a), the corporations have considerable flexibility to allocate the QEF inclusion in a manner that differs from their indirect share of such inclusion applying the Sec. 1298(a) attribution rules (subject to the substantial economic effect or partner’s interest in the partnership rules under Sec. 704(b)). Sec. 1298(a)(3) attributes PFIC stock through proportionate ownership of partnerships; an indirect ownership of a PFIC through a partnership generally does not insulate U.S. persons from taking their proportionate QEF inclusions into account. However, for no apparent substantive policy reason, the Sec. 1293 regulations allow U.S. persons holding QEFs through partnerships to do just that.

However, the QEF rules limit taxpayers’ ability to use partnerships and different tax years to defer unreasonably the applicable QEF inclusion. If the QEF income inclusion is not included in the gross income of either the passthrough entity or the interest holder within two years of the end of the PFIC’s tax year due to their nonconforming tax years, the IRS has the authority to invalidate any Sec. 1295 pass-through entity election for an interest holder or beneficiary; see Regs. Sec. 1.1295-1(i)(1)(ii).

QEF Taxation and Terminating Partnerships

Other issues arise in determining which partners receive a QEF inclusion when a U.S. partnership owning stock in a QEF is terminated under Sec. 708(b)(1)(B), because partners in the partnership sell 50% or more of their interests to new partners.

Example 2: Several U.S. individuals own a U.S. partnership for Federal income tax purposes, USP. USP owns 25% of a foreign corporation, FC, which is a PFIC; unrelated foreign persons own the rest of FC. USP has made a QEF election for FC; the election has been in effect for all of USP’s holding period in FC. On June 30, 2005, certain U.S. partners in USP collectively sell more than 50% of their interests to other U.S. individuals, thus triggering USP’s termination under Sec. 708(b)(1)(B).

If a partnership is terminated by the sale or exchange of an interest, the following is deemed to occur: the old partnership (USP) contributes all of its assets and liabilities to a new partnership (new USP) in exchange for an interest in the new partnership, and, immediately thereafter, the terminated partnership (USP) distributes interests in the new partnership to the purchasing partner and the other remaining partners in proportion to their respective interests in the terminated partnership in liquidation of it; see Regs. Sec. 1.708-1(b)(4). Thus, the holding period and character of USP’s assets in new USP’s hands are determined under the general rules applicable to property contributions to partnerships (i.e., the partnership gets a tacked holding period in the property deemed transferred under Sec. 1223(2)).

Effect on QEF election: Generally, elections made by a terminated partnership are not applicable to a reconstituted partnership. Under Regs. Sec. 1.1295-1(b)(3)(iii), however, the original QEF election will continue for the remaining partners, but will have to be remade for the new partners. How such a partial QEF election should be made under Sec. 1295 is left unexplained, as are the consequences if such election were not made. If there is no election, FC would seem to be a Sec. 1291 fund with respect to the new partners, but a QEF with respect to the remaining partners.

Allocating the inclusion: Further, how should the QEF inclusion from FC be allocated between the selling and new partners? Sec. 1293(a)(1) provides “every United States person” who owns QEF stock directly or through the Sec. 1298(a) PFIC attribution rules “at any time during the [QEF’s] taxable year” has to include in gross income an amount equaling his or her “pro-rata share” of the QEF’s ordinary earnings and long-term capital gains. The pro-rata share, under Sec. 1293(b), is the amount that would have been distributed with respect to the investor’s stock if, on each day during the QEF’s tax year, the QEF had distributed that day’s ratable share of its earnings and net capital gain to shareholders. Thus, if the selling partners had owned FC directly, they would have had a QEF inclusion for their pro-rata share of FC’s ordinary income and capital gain for the six months of the year when they were FC shareholders. The interposition of a domestic partnership between the selling partners and the FC should not change this result; hence, the selling partners and new partners ought to share in the QEF inclusion from FC on a pro-rata basis.

Sec. 1293(a)(2), however, provides that the inclusion under Sec. 1293(a)(1) is for the shareholder’s tax year in which, or with which, the QEF’s tax year ends. The partnership’s tax year ends on the date of its termination under Sec. 708(b)(1)(B); see Sec. 706(c)(1) and Regs. Sec. 1.708-1(b)(1)(iii). A partner includes a distributive share of partnership income on the return for his or her tax year in which, or within which, ends the partnership year during which the income was realized, in accordance with the partnership’s method of accounting under Sec. 706(a) and Regs. Sec. 1.706-1(a)(1). In Example 2 above, USP’s tax year ends on June 30; thus, the selling partners include in their income their share of the partnership’s income up to that date.

Under Sec. 1293(b) and Regs. Sec. 1.1293-1(c), however, the QEF inclusion from FC does not arise until FC’s year-end on December 31. At such time, however, new USP holds FC and tacks USP’s holding period for the year (and prior years). In such case, USP and the selling partners do not take into account the QEF inclusion; rather, new USP and the new partners take it into account under the plain language of Regs. Sec. 1.1293-1(c) and Sec. 1293(b). This result seems to find support in the preamble to those regulations, which states, a “domestic pass through entity takes the section 1293 inclusion into account in its return for the year in which or with which the PFIC’s taxable year ends…”; see the preamble to TD 8750 (12/31/97). (Emphasis added.)

Use of either the proration approach or new partner full-inclusion approach produces significantly different tax results for the selling and new partners. Under the proration approach, the selling partners take into account their allocable portion of USP’s QEF inclusion, increase their basis in the partnership under Sec. 705 and reduce their (presumably) capital gain from the sale of the partnership interests by the basis increase, under Sec. 741. The proration approach thus converts (in whole or in part) the selling partner’s capital gain into ordinary income (depending on the character of the QEF inclusion). The new partners include in income the QEF amount for the portion of the FC year during which they held FC, and increase their basis in the partnership by such amount under Sec. 705.

Under the new partner full-inclusion approach, the selling partners’ gain is all capital under Sec. 741, while the new partners have a QEF inclusion with respect to the FC income and gain for which they accounted in their purchase price (i.e., the pre-acquisition income and gain), and a corresponding basis increase for such inclusion. FC’s pre-acquisition earnings and profits are, thus, essentially taxed twice (once as capital gain to the selling partners and again as a QEF inclusion to the new partners). This double-taxation is eventually reversed when the new partners dispose of their interests, which is due to their double basis (for the purchase and for the QEF inclusion).

The proration rule is more consistent with the text and policy underpinnings of Sec. 1293(a). In allowing partners to alter the substantive result mandated by Sec. 1293(a) and changing key terms in the applicable substantive rules (i.e., using “held” instead of “owned” in describing the inclusion rule for partnerships), Regs. Sec. 1.1293-1(c) clouds the proper analysis and allows for multiple positions in the appropriate context.

Conclusion

While much of the U.S. international tax regime and the U.S. partnership rules are not coordinated, even the few attempts to coordinate raise more questions than they answer. This is particularly true of the QEF rules and regulations.

From Chris Bowers, J.D., and Jeffrey Cowan, J.D., LL.M., Washington, DC