In the recent Tax Court case, Roberto Toso v. Commissioner, the court held that non-current year passive foreign investment company (PFIC) gains are not counted as gross income in determining whether the taxpayer has omitted gross income in excess of 25 percent of the amount shown on a tax return for purposes of the extended six-year period of limitations. Moreover, the court also concluded that PFIC gains cannot be offset by PFIC losses.
In Toso, the taxpayers failed to report, among other items, gains from the sale of PFIC stocks on their timely filed original 2006, 2007 and 2008 income tax returns. Upon subsequent audit, the IRS issued the taxpayers a notice of deficiency for their 2006, 2007 and 2008 tax returns. The central issues in this case were whether the taxpayer’s non-current PFIC gains were includable as gross income for purposes of the extended six-year period of limitations, and whether the taxpayer was entitled to offset gains from sales of PFIC stocks with losses from sales of PFIC stocks.
The taxpayer first argued the deficiency adjustments were time-barred because they were outside of the three-year period of limitations and that the gains from the sales of PFIC stock are not counted as gross income for purposes of determining whether the extended six-year limitation period applies. The taxpayers went on to argue that, in the case of any tax return not time barred, the PFIC gains should be offset against the taxpayer’s other PFIC losses in determining the overall deficiency. The IRS, on the other hand, argued that income from gains from the sales of PFIC stock should be included in gross income for purposes of determining whether the extended six-year limitation period applies and, as a result, the notice of deficiencies were timely.
The Court first looked to the question of whether gain from the sale of PFIC stock was includable in gross income when determining whether a taxpayer has omitted gross income in excess of 25 percent on a return for purposes of the extended six-year period of limitations. In addressing the question, the Court noted that gain from the sale of stock in a PFIC is generally taxed under Section 1291. That section provides special rules for taxing the PFIC stock sale gain – notably for this case, that gain on the disposition of PFIC stock is allocated ratably to each day in the taxpayer's holding period for the stock, resulting in separate treatment for current year and non-current year PFIC gains.
Importantly, the Court noted that the express terms of Section 1291 are clear that only PFIC gain allocated to the current year is included in the taxpayer’s gross income as ordinary income. In comparison, non-current year PFIC gain (PFIC gain that is re-allocated to another year under Section 1291) is not included in gross income for any year. Instead, the tax on the non-current year PFIC gain is calculated separately, and this additional tax amount is then added to the taxpayers’ income tax for the current year. Thus, contrary to the IRS argument, the court held that only gain allocated to the current year is included in the taxpayer’s gross income in determining whether a taxpayer has omitted gross income in excess of 25 percent on a return for purposes of the extended six-year period of limitations.
The Court then turned to the taxpayer’s alternative argument that, to the extent any tax return was not time barred by the three-year limitation period, PFIC gains should be offset by any PFIC losses. Here, the Tax Court noted that the flush language of Section 1291 states that the rules apply to, “any gain recognized on such disposition [i.e., on a disposition of stock in a PFIC]." In analyzing this language, the court paid particular attention to the statutory language’s use of the singular, “any gain recognized on such disposition" (emphasis added), noting that such use indicates that the rules apply to each disposition of PFIC stock separately and not on an annual aggregate basis.
As this case illustrates, the rule regarding the tax treatment of PFICs are very complex and nuanced. Taxpayers who recognize gain of the sale of a PFIC may be subject to ordinary income treatment and to a special penalty designed to eliminate the benefit of any deferral from holding the PFIC shares, which could result in a surprisingly high tax liability. In addition, special reporting rules apply to owners of PFIC shares. Accordingly, taxpayer investing in PFICs should be sure to consult their tax advisors when addressing the tax treatment of these complicated investments.