United States: IRS Issues PFIC Regulations: A New Start To An Old Beginning

New Rules Address Reporting Obligations of US Shareholders in Foreign Funds and Certain Other Foreign Corporations

On December 30, 2013, the US Treasury Department (the "IRS") published a package of proposed, temporary, and final regulations relating to Passive Foreign Investment Companies ("PFICs") and their shareholders. The most significant component of the package is its guidance on the new annual filing requirements for PFIC shareholders, but the package also includes other, generally minor, changes to existing rules governing PFICs and their shareholders.

The IRS issued the regulations just in time to meet a self-imposed year-end deadline: the IRS wanted the new reporting rules to become effective before 2013 ended so that the new reporting rules would apply during the next filing season. Still, the package includes good news for some PFIC shareholders since the new regulations eliminate a retroactive filing requirement for 2011 and 2012 taxable years that had been threatened in a 2011 IRS notice.

The new regulations address in a limited way a package of technical PFIC regulations originally proposed by the IRS in 1992. Because the new package includes, in a modified form, a small portion of the 1992 proposed regulations, the new package withdraws that portion of the 1992 proposed regulations. The remaining (and outstanding) portion of the 1992 proposed regulations includes provisions that have been severely criticized. So, US investors and tax practitioners must await further IRS action to clarify the status of those proposed provisions and the interpretation of the applicable statutory rules.

PFICs Generally

A non-US corporation is generally a PFIC if:

  1. 75% or more of its gross income for the taxable year is passive income or
  2. the average percentage of assets it holds during the taxable year which produce passive income or which are held for the production of passive income is at least 50 percent.

Special US federal income tax and reporting rules apply to US investors that are considered to hold shares in a foreign company that produces sufficient passive income or holds sufficient passive assets to meet the definition of a PFIC, even if the foreign company met the definition for only one year during the investor's holding period. The rules applicable to PFIC shareholders are detailed and complicated. For example, three different sets of rules, or regimes, apply to US shareholders in a PFIC: a basic (or default) regime that subjects "excess distributions" from a PFIC to additional US income taxes on the income considered to be deferred or one of two alternative elective regimes (the "Qualified Electing Fund" and "mark-to-market" regimes) for shareholders in PFICs that qualify for those elective regimes. Stated simply, the goal of the PFIC rules is to deny the potential deferral of US tax that might otherwise be available to a US person that invests in a foreign investment fund that accumulates income. The PFIC rules effectively force US shareholders in a PFIC, no matter how small their interests may be, to recognize income earned by the PFIC currently (whether that income is distributed to the shareholder or not) or else pay US tax at the highest possible rate, plus interest, on the income once it is distributed to the PFIC shareholder.

PFIC shareholders generally have been required to file a Form 8621, "Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund," in certain circumstances, such as when they receive amounts that are considered "excess distributions" or, for those shareholders that have made the Qualified Electing Fund (or "QEF") election, annually, A statutory change enacted in 2010, however, broadened PFIC reporting requirements to require PFIC shareholders to file annual reports containing any information required by the IRS. Failure to report the requested information to the IRS causes the shareholder's US federal income tax return to remain open until three years after the relevant information is in fact provided to the IRS. Whether the shareholder's entire tax return or just the portion of the tax return related to the investment in the PFIC remains subject to IRS audit during this period depends on whether the shareholder is eligible for the "reasonable cause" exception for failing to file the required information.

In Notice 2010-34 and Notice 2011-55, the IRS stated that it was developing future guidance on this new annual PFIC reporting requirement and would release a revised Form 8621. The IRS instructed PFIC shareholders to continue reporting in accordance with the current form and instructions. Once the new Form 8621 was released, however, PFIC shareholders which were not required to report under the old Form 8621 but which were required to report under the new Form 8621 would be required to file "catch-up" reports for the intervening years and attach the completed forms to their next US federal income tax return.

The New Regulations

The most noteworthy aspect of the new regulations is their implementation of the annual filing requirements for PFIC shareholders. In particular, the new regulations make it clear that PFIC shareholders are subject to the new, broader PFIC reporting rules only for the 2013 taxable year. Accordingly, the regulations do not implement the IRS's previously announced intention to require PFIC shareholders subject to the new reporting rules to file Forms 8621 for pre-2013 years with their 2013 income tax returns.

The new PFIC reporting rules are fairly detailed. They include some exceptions, particularly for US persons that hold PFIC stock through another US person or that hold relatively small amounts of PFIC stock. Nonetheless, because the rules for determining ownership in a PFIC are complicated and apply to indirect ownership, determining whether one qualifies for an exception may not be obvious at first blush. For example, the temporary regulations include an exception for a PFIC shareholder that:

  1. holds, in the aggregate, no more than $25,000 in PFIC stock ($50,000 if married filing jointly) or
  2. owns PFIC shares through another PFIC and the value of the shareholder's proportionate share of the upper-tier PFIC's interest in the lower-tier PFIC does not exceed $5,000. 

But this exception applies only if the PFIC shareholder has not:

  1. made an election to treat the PFIC as a QEF,
  2. made an election to subject the PFIC shares to mark-to-market treatment, and
  3. received any amounts that are treated as "excess distributions" from the PFIC.

US persons that own, directly or indirectly, interests in foreign corporations will therefore need to undertake a careful review each year to determine whether they own interests in a PFIC and whether a reporting exception applies. Of course, even if a reporting exception applies in a given year, the reporting exception does not provide any relief from the general PFIC taxation rules that apply to the shareholder.

The package also includes, in updated form, some regulatory definitions first proposed in 1992 related to different types of PFICs and to determining ownership (especially indirect ownership) of interests in a PFIC. The regulations also formalize guidance promised in prior IRS announcements, such as limiting duplicative reporting that would otherwise occur if shares owned by a US person constituted both a PFIC and a specified foreign financial asset, each with its own set of reporting rules. They also make some very minor changes to reporting for controlled foreign corporations, or "CFCs". In addition, the preamble to the temporary regulations promises more guidance for trusts and estates.

Conclusion

Because a single share of stock in a PFIC is enough to subject a shareholder to the PFIC rules and a person can be a PFIC shareholder through indirect ownership, US investors should review their holdings to determine whether they own interests in PFICs and, if they do, whether they are in compliance with the US tax and reporting rules that apply. Failure to do so could result in serious US tax exposure. Even if the amount of US income tax attributable to the PFIC is itself small, the failure to report the PFIC information can toll the statute of limitations, allowing the shareholder's entire tax return to stay open and subject to audit for as long as the PFIC information goes unreported, plus three years.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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