Due to the increased prevalence of foreign mutual funds, tax practitioners should be familiar with the related reporting requirements. Patrick J. McCormick authored the below article in the September issue of Practical Tax Strategies, a national tax journal published by Thomson Reuters (and distributed electronically through RIA Checkpoint). The following article has been republished with permission from Practical Tax Strategies.
Rapid globalization has led to a marked increase in the number of U.S. residents and citizens with offshore holdings. These assets can be accumulated by U.S. persons through various methods, such as by inheriting assets overseas, being born in another country then coming to the U.S., or from working overseas. In recent years, offshore reporting has become an area of increased emphasis for the IRS. Specifically, significant publicity has been given to FinCen Report 114 (formerly Form TD F 90-22.1), more commonly referred to as the FBAR. The FBAR must be filed when there is a reportable interest in foreign financial accounts, and when the aggregated value of such accounts exceeds $10,000. Interests in certain foreign financial assets must also be reported on Form 8938, Statement of Specific Foreign Financial Assets (filed with an individual’s tax return—the FBAR is filed separately from the tax return, and currently maintains a separate filing deadline). Form 8938 mirrors the FBAR in many ways (with some distinctions between the two forms).
Although the FBAR and (to a somewhat lesser extent) Form 8938 have received great publicity in recent years, other forms exist for reporting foreign interests that require attention. One such form is Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. This form must be filed by taxpayers who hold interests in passive foreign investment companies (PFICs). The scope of what is considered a PFIC is covered herein; of importance is that the term encompasses several assets that can be held by individual taxpayers. The most prominent of these assets is foreign mutual funds, which are common among taxpayers with foreign interests. Familiarity with the reporting requirements related to foreign mutual funds (and PFICs generally) is vital, given both the prevalence of foreign mutual funds among taxpayers and the onerous reporting requirements and tax ramifications associated with the same.
The threshold question for whether PFIC reporting requirements exist for a particular taxpayer is whether an offshore interest held by the taxpayer is classified as a PFIC. Generally, a foreign corporation is classified as a PFIC pursuant to Section 1297 if it meets either an income test or an asset test. Under the income test, 75% or more of a corporation’s gross income for its tax year must be passive income. Passive income is generally defined by Section 1297(b) to include any income that is of a kind that would be foreign personal holding company income. The definition of foreign personal holding company income is provided by Section 954(c), and normally encompasses income sources such as dividends, interest, royalties, rents, and annuities. Under the asset test, at least 50% of the average percentage of assets held by the foreign corporation during the tax year must be assets that produce passive income or that are held for the production of passive income. When determining PFIC status using the asset test, a foreign corporation may use adjusted basis if: (1) the corporation is not publicly traded for the tax year, and (2) the corporation is (i) a controlled foreign corporation within the meaning of Section 957, or (ii) makes an election to use adjusted basis.
Types of reportable assets
Under the Service’s interpretation of the above rules, the scope of what constitutes a PFIC is substantial. Ownership shares of a foreign corporation can create PFIC reporting requirements if the foreign corporation is classified as a PFIC. Reporting requirements can also occur in unanticipated circumstances, however; one such set of circumstances is in the context of foreign mutual funds. These funds normally make investments and generate passive income (with the fund’s assets being held for the production of passive income). Based on this, foreign mutual funds are generally classified as PFICs.
Other foreign assets can also be classified as PFICs depending on the facts involved. Foreign pensions may be PFICs—many pensions will offer investment options for participants, with the funds in which these investments are made qualifying as PFICs. Investment in mutual funds through atypical methods, such as through life insurance policies, can also be problematic and can necessitate PFIC reporting requirements.
Exceptions to general PFIC reporting requirements may exist based on the availability and applicability of income tax treaties with the country in which the PFIC originates. Treaties are maintained by the U.S. with several countries (such as Canada and many Western European nations). The applicability of each treaty to PFIC reporting depends on the specific facts presented by the client.
The default rules for taxation of PFICs are provided in Section 1291, and cause significant consternation among taxpayers holding such interests. Under the default rules, when a taxpayer receives an excess distribution (defined as the part of the distribution received in the current year that is greater than 125% of the average distributions received in respect to such stock by the shareholder during the three preceding tax years or, if shorter, the portion of the shareholder’s holding period before the current tax year) in respect of stock in a PFIC: (1) the amount of the excess distribution shall be allocated ratably to each day in the taxpayer’s holding period for the stock; (2) the taxpayer’s gross income for the current year with respect to the distribution shall include (as ordinary income) only the amounts allocable to the current year or any period in the taxpayer’s holding period before the first day of the first tax year of the company which begins after 12/31/86 and for which it was a PFIC; and (3) the tax imposed for the current year will be increased by the deferred tax amount (defined as an amount equal to the sum of: (a) the aggregate increases in taxes plus (b) the aggregate amount of interest on such increases in tax). When a taxpayer disposes of stock in a PFIC, the above rules apply to any gain recognized on such disposition in the same manner as if the gain were an excess distribution.
Under the default PFIC rules, holders of PFICs are subject to tax on any excess distribution or disposition at the top marginal tax rates for individual taxpayers, plus interest amounts calculated based on the taxpayer’s holding period. Worse, all reportable gains from a PFIC are classified as ordinary income—even ones that would be classified as capital gains if they were shares in non-PFICs (i.e., American mutual funds). Additionally, a taxpayer cannot carry forward any capital losses incurred in relation to PFICs. These ramifications greatly penalize investors in foreign mutual funds, particularly when compared to how the same holdings would be treated if they were held in the U.S.
The QEF election
Elections are available to opt-out of the default PFIC regime and as least somewhat mitigate the tax effects associated with the holding of PFICs. The first option available is the qualified electing fund (QEF) election. Under Section 1293, a taxpayer who owns stock in a QEF includes in gross income: (1) as ordinary income, such shareholder’s pro rata share of the ordinary earnings of such fund for such year, and (2) as long-term capital gain, such shareholder’s pro rata share of the net capital gain of such fund for the year.
Such an election is enormously beneficial, as it allows the PFIC to be treated in line with domestic assets. However, in order for this election to be made, the PFIC must comply with reporting requirements imposed by the U.S.; many companies are unwilling to meet these requirements, leaving the U.S. holder unable to make the election as a result. Further, complications arise when the QEF election is not made in the first year the taxpayer holds the PFIC. Prior to a QEF election, the shares held are subject to the default PFIC rules; when the election to treat it as a QEF is not made in the first year of holding the PFIC, action must be taken to “purge” the PFIC shares held by the taxpayer. The taxpayer will typically accomplish this by conducting a deemed sale of the PFIC.
Under the deemed sale approach of Section 1291(d)(2)(A), the shareholder is deemed to have sold the PFIC shares as of the first day of the PFIC’s first tax year as a QEF for its fair market value (FMV). Gain from the deemed sale is taxed as an excess distribution received on the qualification date, with the basis of the stock increased by the recognized gain. Shareholders cannot recognize losses as a result of the deemed sale (if the sale would result in a loss).
Importantly, a separate election must be made for each PFIC that the taxpayer wants to treat as a QEF. When chains of ownership exist, only the first U.S. person who is a direct or indirect shareholder of the PFIC may make the election. The election is made on Form 8621, and is made by the due date (including extensions) for filing the taxpayer’s tax return for the first tax year to which the election will apply. Once it is made, the QEF election applies to subsequent years. Under limited circumstances, retroactive elections may be made by a taxpayer; a retroactive election can be made only if: (1) the shareholder has preserved his or her right to make a retroactive election under the protective statement regime (when a taxpayer previously filed a statement regarding the PFIC with the Service), or (2) the shareholder obtains the IRS’s permission to make a retroactive election under the consent regime.
A second option available for a PFIC holder is to make a mark-to-market election under Section 1296. Such an election is available only for “marketable stock” (generally defined as PFIC stock regularly traded on a securities exchange). When the mark-to-market election is made, the taxpayer essentially recognizes gain or loss on the shares on an annual basis (based on the shares’ FMV). However, of note is that mark-to-market gains are treated as ordinary income; losses can be recognized, but only to the extent of prior gains.
In the first year of making a mark-to-market election for previously-existing PFICs, no “purging” election is required (as with the QEF election). However, Reg. 1.1296-1(i)(2) dictates that, for the first tax year the election is made, the taxpayer will: (i) apply the rules provided under Section 1291 (the default rules) to distributions/dispositions; (ii) apply the default rules to the amount of the excess (if any) of the FMV of the stock on the last day of the taxpayer’s tax year over its adjusted basis as if such amount were gain recognized from the disposition of stock on the last day of the taxpayer’s tax year; and (iii) increase adjusted basis in the stock by the amount of excess (if any) subject to the default rules under (ii). Essentially, section (ii) of the regulations requires the recognition of any gain (FMV minus basis) as an excess distribution. This treatment creates a similar result to the deemed sale approach.
Similarly to the QEF election, the mark-to-market election is made on Form 8621, and is made on or before the due date (including extensions) of the taxpayer’s tax return for the tax year in which the stock is marked to market. Once the election is made, it applies to all subsequent years unless it is revoked. When stock for which a mark-to-market election has been made becomes unmarketable, the mark-to-market election is terminated, with the PFIC stock then governed by the default rules prospectively.
Investments in PFICs are primarily reported on Form 8621. Interests in PFICs can also be required to be disclosed on Form 8938; however, when such assets are reported on Form 8621, the requirement to report those assets on Form 8938 is removed (to eliminate the need for duplicative reporting). Form 8621 must be filed by U.S. persons who are direct or indirect shareholders in PFICs. A taxpayer is required to file Form 8621 when the taxpayer: (1) receives certain direct or indirect distributions from the PFIC; (2) recognizes gain on a direct or indirect disposition of PFIC stock; (3) is reporting information with respect to a QEF or mark-to-market election; (4) is making an election reportable on Form 8621; or (5) is required to file an annual report (with the annual report rules dictated by the temporary regulations discussed below).
Temp. Reg.1.1298-1T was released in 2014 regarding reporting requirements on Form 8621; these regulations contain a number of important provisions related to the form. Under the Temporary Regulations, Form 8621 is not required if, on the last day of the taxpayer’s tax year, the value of all of its PFIC shares was less than $25,000 (or $50,000 for taxpayers filing a joint return), the taxpayer was not treated as having received an excess distribution during the tax year, and the taxpayer had no QEF or mark-to-market election in place for the year. Form 8621 is also not required for taxpayers treated as PFIC owners because they are beneficiaries of a foreign estate or trust (and, as with the prior exception, no excess distributions were received nor were QEF or mark-to-market elections in place for the PFIC).
Form 8621 is attached to and filed with an individual’s tax return; the form can be directly filed with the Service if no tax return is required for the taxpayer in the given year. No specific penalties are provided by either the regulations issued regarding Form 8621 or the form instructions. Importantly, however, failure to file Form 8621 (or failure to report a specified foreign financial asset, which is required to be reported on Form 8621) can cause the statute of limitations for the tax year to remain open for all or part of the income tax return itself (in accordance with Section 6501(c)(8)). When this occurs, the statute of limitations remains open until three years after the date on which Form 8621 is filed. A reasonable cause exception is available, whereby the statute of limitations remains open only in relation to the foreign assets that should have been reported.
Given the growth of globalization and the relevance of international tax law, it is important for practitioners to be familiar with related reporting requirements. Because of the prevalence of foreign mutual funds and PFICs, it is necessary to have a basic understanding of the reporting requirements and tax ramifications of these instruments.
Patrick J. McCormick is an associate with the firm. He earned his J.D. from Vanderbilt University Law School in 2008, and his LL.M. from New York University School of Law in 2009. Mr. McCormick specializes in the areas of international taxation, tax compliance, and offshore reporting obligations. Mr. McCormick is licensed to practice in the States of New Jersey, Florida, and Georgia, and the Commonwealth of Pennsylvania. He has published national articles and given numerous national and local presentations on assorted areas of tax and estate planning law, including international tax and offshore compliance issues.