private client services the complex universe...
TRANSCRIPT
28 | WeiserMazars Ledger
PRIVATE CLIENT SERVICES
THE COMPLEX UNIVERSE OF PASSIVE FOREIGN INVESTMENT COMPANIES By Richard Tannenbaum and Mark Tadros
THE PASSAGE OF THE FOREIGN ACCOUNT TAX COMPLIANCE ACT (FATCA) IN 2010
SIGNALED A RENEWED FOCUS BY THE INTERNAL REVENUE SERVICE (IRS) ON NON-
COMPLIANCE OF U.S. TAXPAYERS WITH OWNERSHIP OF FOREIGN ACCOUNTS AND ASSETS.
AS PART OF AN INITIATIVE TO ENCOURAGE TAXPAYERS WITH UNDECLARED FOREIGN
ASSETS TO COME FORWARD, THE IRS CONTINUED AND EXPANDED ON THE ORIGINAL 2009
OFFSHORE VOLUNTARY DISCLOSURE PROGRAM (OVDP).
October 2016 | 29
The current program offers protection from criminal
penalties and a reduction in civil penalties as an incentive
for taxpayers to disclose foreign assets when they file past-
due or amended tax returns and pay the taxes, interest and
penalties on unreported income.
Commonly held foreign assets include interests in foreign
mutual funds and foreign exchange-traded funds (ETFs).
Most taxpayers are unaware that such funds are treated
differently, and more harshly, than U.S. mutual funds or
domestic ETFs. A foreign mutual fund or ETF is generally
considered to be a Passive Foreign Investment Company
(PFIC), which subjects the taxpayer to severe tax and
reporting requirements. As part of the voluntary disclosure
program, the IRS provides relief for taxpayers failing to make
timely elections through an alternative method for reporting
PFICs. This article discusses the tax treatment of PFICs and
the various elections available.
background
The current taxation of PFICs was established as part of the
Tax Reform Act of 1986. Prior to this, taxpayers were able
to defer taxes, without consequence, on income earned in
their PFICs provided the income was undistributed. Today,
undistributed earnings still remain untaxed under the default
rules; however the taxation upon distribution no longer
comes without consequence. The PFIC provisions enacted
were originally designed to bring foreign funds in line with
U.S. funds. As written, they are decisively punitive to non-U.S.
investments.
WhaT is a pfic?The Internal Revenue Code (IRC) defines a PFIC as a foreign
corporation that meets one of the following:
1. Seventy-five percent or more of the corporation’s gross
income for its taxable year is passive income (Income
Test); or
2. At least fifty percent of the assets held by the foreign
corporation are assets that produce passive income,
or are held for the production of passive income (Asset
Test).
In this regard, the term “passive income” is defined as any
income that would be considered foreign personal holding
company income as defined in Internal Revenue Code
Section 954(c). This generally includes interest, dividends,
capital gains from the sale of stock, royalties, and rental
income (unless part of an active trade or business).
Assets producing passive income, such as cash, which
can yield interest, and securities, which can issue interest,
dividends or capital gains, would be included in the Asset
Test under this meaning.
There are certain exceptions to the above rules for
corporations engaged in banking or insurance, and for U.S.
shareholders of a controlled foreign corporation. Further
discussion of these exceptions is beyond the scope of this
article.
reporTing and TaxaTion
Taxpayers who hold an interest in a foreign company that
meets the definition of a PFIC may also need to file a Form
8621 as part of their U.S. income tax return. There are three
methods that may be used to compute the tax applicable to
PFICs:
1. Section 1291 Fund (“Code” Method)
This is the default taxation method.
Under the code method, shareholders are subject to
tax when they receive a distribution. Any part that is
deemed to be an “excess distribution” will then be
subject to special reporting requirements. A distribution
received in a tax year that is greater than 125 percent
of the average distributions received during the three
preceding tax years, or if fewer than three years, the
amount of years in the holding period before the current
tax year, is considered to be an excess distribution.
Additionally, 100 percent of any gain from the disposition
of a PFIC will be considered an excess distribution taxed
as ordinary income. Any loss from disposition will be a
capital loss in the year of disposition. A pure example of
“Today, undistributed earnings still remain untaxed under the default rules; however the taxation upon distribution
no longer comes without consequence.”
30 | WeiserMazars Ledger
PRIVATE CLIENT SERVICES
this is when a taxpayer sells shares or units in the PFIC.
Excess distributions are considered to be earned evenly
throughout a shareholder’s entire holding period. The
portion of the distribution deemed to be earned in
the current tax year is taxed as ordinary income. The
portion deemed to be earned in prior years is subject to
a separate tax and interest charge. This portion is taxed
at the highest marginal individual income tax rate in
effect for each taxable year, regardless of the taxpayer’s
level of income, plus an interest charge beginning on
the original due date for each prior year. For example,
an individual paying a 10 percent tax rate on all other
income would still be charged the highest tax rate of
39.6 percent as of January 1, 2013. Taxpayers may avoid
the punitive, complicated, and burdensome nature of a
section 1291 fund by electing to be taxed under one of
the other two alternatives.
2. Mark-to-Market Election (MTM)
The second method is to make a mark-to-market
election as described in section 1296 of the IRC. This
option is only available if the PFIC is a marketable stock.
For purposes of this election, the term “marketable
stock” is generally considered to be any stock, mutual
fund, or ETF that is regularly traded on a U.S. or foreign
securities exchange.
By making this election, a shareholder marks each
PFIC stock to its year-end market value and reports the
increase as ordinary income. Essentially, a taxpayer is
choosing to be taxed currently on any unrealized gains.
In the case of any unrealized losses, a taxpayer can
recognize an ordinary loss, but only to the extent that
there have been gains previously recognized, which is
called “unreversed inclusions”; thus a taxpayer cannot
use the mark-to-market election to mark a stock below
its original cost. The gains and losses recognized will
determine the taxpayer’s adjusted tax basis in the stock.
Upon disposition, the gain or loss will be recognized as
the difference between the proceeds and the adjusted
basis.
3. Qualifying Electing Fund (QEF) Election
The third option available to taxpayers is to make a QEF
election. Under this method, a taxpayer will annually
report his or her share of earnings and net capital gain
of the PFIC. The earnings will be taxed as ordinary
income, while the net capital gains will be taxed as long-
term capital gains. The income reported will increase
the adjusted tax basis and, upon disposition of the stock,
the taxpayer will recognize a capital gain or capital loss.
While this election is generally more favorable in terms
of taxes, it is more restrictive than the others. In order to
be considered a QEF, a foreign corporation must agree
to allow the IRS access to their books and records;
additionally, the foreign corporation must also supply
statements for each U.S. shareholder stating their share
of earnings and gains. This can be a heavy request for
a non-US company. Generally, only large funds with a
substantial amount of U.S.-
based investors agree to
these reporting requirements.
coordinaTion WiTh The ovdpTaxpayers entering into the
OVDP must file eight years
of past-due or amended
tax returns and Reports of
Foreign Bank and Financial
Accounts (FBARs) to disclose
their foreign assets. They also must pay taxes, penalties,
and interest on any unreported income. In order to utilize
an MTM or QEF election, the election must have been made
with a timely filed return. As a result, these elections are not
available under the OVDP. For those filing under the OVDP the
IRS offers an alternative MTM method as a resolution.
Alternative MTM Method
Under the alternative MTM method, a taxpayer will calculate
the amount of gains and losses in the same manner as the
MTM method discussed earlier. When electing this method
though, the taxpayer applies this methodology to every PFIC
held during the voluntary disclosure period. The initial MTM
computation will begin the first year of the OVDP period,
meaning all unrealized gains in pre-OVDP years will also be
included in this marked-to-market amount. However, unlike
“UNDER THE ALTERNATIVE MTM METHOD, A TAXPAYER WILL CALCULATE THE AMOUNT OF GAINS AND LOSSES IN THE SAME MANNER AS THE MTM METHOD DISCUSSED EARLIER. WHEN ELECTING THIS METHOD THOUGH, THE TAXPAYER APPLIES THIS METHODOLOGY TO EVERY PFIC HELD DURING THE VOLUNTARY DISCLOSURE PERIOD.”
October 2016 | 31
the regular MTM method, these gains are not reported as
ordinary income on the tax return. Instead, the alternative
MTM method states that Regular and Alternative Minimum
Tax are computed without regard to any MTM gain, MTM
loss, or gain on disposition. A tax rate of 20 percent is
applied to the MTM gain and reported on the tax return
as other taxes. There is also a charge of seven percent on
the calculated tax in the initial year. MTM losses are still
limited to the extent of previously recognized gains, with
the benefit limited to the same rate of 20 percent. The 20
percent rate also applies to gains on the disposition of the
PFIC stock. Losses on dispositions in excess of previously
recognized gains are reported as capital losses in the
year of disposition. At the end of the program, taxpayers
who choose the alternative resolution will be required
to continue using the regular MTM method on any PFIC
investments that were part of the disclosure and continue
to be held. Also, unreversed MTM gains remaining with
these investments are considered to be zero meaning the
taxpayer can no longer take MTM losses against these
amounts.
Generally, using the alternative MTM method is more
beneficial to a majority of taxpayers. It allows taxpayers
who failed to make timely elections to utilize the simpler
MTM method and avoid being taxed at maximum rates
along with an interest charge. Of course, there are
instances in which the alternative MTM method may not
be the best option. Taxpayers who did not dispose of or
receive distributions from their PFIC investments, and
taxpayers who disposed of PFIC investments at a loss are
two examples of situations that call for a further analysis.
concLusion
The concept of a PFIC is extremely complicated and can
result in expensive consequences if not handled properly.
Taxpayers need to be aware of the investments being made
in their foreign as well as domestic portfolios. They should
also understand the options and potential tax burdens they
assume when holding PFICs. Making timely elections is
crucial. For taxpayers who choose to enter into voluntary
disclosure, the alternative MTM method can provide a
simpler and more beneficial path back into compliance.
richard is a parTner in our neW York pracTice. he can be reached aT 212.375.6545 or [email protected].
Mark is a Manager in our neW York pracTice. he can be reached aT 212.375.6830 or [email protected].
“Generally, using the alternative MTM method is more beneficial to a majority of taxpayers. It allows taxpayers
who failed to make timely elections to utilize the simpler MTM method and avoid being taxed at maximum rates
along with an interest charge. .”