For tax years starting in 2023, US partners that hold less than 10% in a foreign corporation which is both a CFC and a PFIC through a US partnership will generally be subject to the PFIC rules and may no longer rely on the section 1297(d) overlap rule to shield their investment from the PFIC rules. However, if a US partner was covered by the section 1297(d) overlap rule throughout the partner’s holding period until 2023 (through an application of the section 958 transition rule), section 1297(d)(3)(A) may allow the US partner to make a pedigreed QEF election for the 2023 tax year without making a purging election.
Background on US Partnerships and the PFIC/CFC Overlap Rule
Unlike the CFC rules which only come into play if US persons that individually own at least 10% in the foreign corporation (“US shareholders”) collectively own more than 50% of the corporation, the PFIC rules apply to US persons regardless of their ownership percentage. However, section 1297(d) prevents a “shareholder” from being subject to both the CFC and PFIC rules by turning off the PFIC rules during the time when it is a “US shareholder” and the corporation is a CFC (the “qualified portion” of a shareholder’s holding period).
Prior to the issuance of the final section 958 regulations in 2022 when the CFC rules shifted more toward the aggregate treatment of partnerships, a US partnership that held at least 10% in a foreign corporation was treated as a “US shareholder” both for purposes of classifying the foreign corporation as a CFC and for taking into account a Subpart F inclusion. Many tax professionals interpreted the term “shareholder” in section 1297(d) as referring to a shareholder within the meaning of section 958 because section 1297(d) cross-references section 951(b) which cross-references section 958. As a result, many US investors who owned shares in a foreign corporation through a US partnership generally believed they were protected from the PFIC rules by the section 1297(d) overlap rule and took into account their distributive share of Subpart F from the US partnership rather than complying with the PFIC provisions. The IRS also issued a number of PLRs to that effect.1
On Jan. 25, 2022, Treasury and the IRS released Prop. Reg. 1.1291-1 (REG-118250-20). The preamble to Prop. Reg. 1.1291-1 states that the term “shareholder” in section 1297(d) should be defined according to the definition of “shareholder” in Reg. 1.1291-1(b)(7), not section 951(b) which cross references section 958. Reg. 1.1291-1(b)(7) provides that a US partnership is not treated as a “shareholder” of a PFIC (except for information reporting purposes). The relevant language in Reg. 1.1291-1(b)(7) came into effect in 2013 and predates the shift to aggregate treatment of US partnerships in the 2022 section 958 regulations. Thus, Treasury and the IRS apparently take the position that, at least going back to 2013, section 1297(d) does not apply to a partner in a US partnership if the partner does not indirectly hold at least 10% in the CFC.2
Under Treasury and the IRS’ interpretation of section 1297(d), since a US partnership cannot be a “shareholder” under Reg. 1.1291-1(b)(7) (even if it owns 10% or more in a CFC and was considered a “US shareholder” within the meaning of section 951(a) until the 2022 final section 958 regulations were issued), the section 1297(d) overlap rule cannot apply to the US partnership. As a result, one needs to look through the US partnership and apply the section 1297(d) overlap rule at the partner level. The consequence of doing so is that US partners that hold less than 10% in a CFC through a US partnership are not protected from the PFIC rules even if the US partnership holds at least 10% in the CFC. To clarify this position, Prop. Reg. 1.1297-1(c)(5)(i) provides that, for purposes of applying section 1297(d) to a partner who owns an indirect interest in a foreign corporation through a US partnership, the shareholder’s “qualified portion” does not include any portion of a partner’s holding period during which it was not a “US shareholder” (as defined in section 951(b)).
On Jan. 25, 2022, the final section 958 regulations (TD 9960) came into effect which provide that a US partnership is not treated as owning stock within the meaning of section 958 for purposes of taking into account a Subpart F inclusion.3 Thus, following the effective date of the 2022 section 958 regulations, a US partnership is not classified as a “shareholder” within the meaning of section 1297(d), regardless of whether the term is defined under section 958 (through a cross-reference in section 951(b)) or under the PFIC regulation. As a result, for tax years starting in 2023, the section 1297(d) CFC/PFIC overlap rule cannot be applied based on a US partnership’s ownership percentage in the foreign corporation and taxpayers must look to each partner’s interest in the foreign corporation.
Treasury and the IRS recognized that taxpayers were previously taking contrary positions until the final section 958 regulations came into effect and included a transition rule in Prop. Reg. 1.1291-1(c)(5)(ii) to accommodate taxpayers. The transition rule provides that for tax years beginning before the date Prop. Reg. 1.1291-1 are published as final regulations, a partner’s “qualified portion” of its holding period includes the time during which it included its distributive share of Subpart F in income from the US partnership. Thus, the transition rule allows the section 1297(d) overlap rule to apply to US partners that indirectly own less than 10% in a CFC through a US partnership, provided the US partner included its distributive share of Subpart F in income from the US partnership. The Proposed Regulations’ transition rule includes reliance language which allows taxpayers to apply the transition rule until the final section 958 regulations came into effect (generally for tax years starting in 2023). Thus, for US partners that did not elect to adopt the section 958 regulations prior to their effective date and continued to include their distributive share of Subpart F from the US partnership through the 2022 tax year, the “qualified portion” of their holding period will generally continue until the first day of their 2023 tax year (assuming the US partnership held at least 10% in the foreign corporation and foreign corporation was a CFC throughout their holding period).
Making QEF Elections in 2023
The question arises whether these US partners that become subject to the PFIC rules starting in 2023 can make a QEF election with their 2023 tax returns that would be considered a ‘pedigreed QEF’ without making a purging election.
US persons who own shares (directly or indirectly) in a PFIC are subject to a number of potentially adverse tax consequences under section 1291 unless they make a timely QEF election, including (i) the recharacterization of gain on the disposition of PFIC stock as ordinary income, and (ii) subjecting gain and distributions to an interest charge for the period of time between the date the income was earned by the PFIC and the date the earnings are taxed as gain or as an extraordinary distribution.4 To avoid these negative tax consequences, many US investors in privately held foreign corporations make a QEF election.5 A shareholder that makes a timely QEF election is required to include its pro rata share of earnings and capital gains from the PFIC on a current basis regardless of whether the PFIC makes a distribution. However, if a QEF election is made for the first year the shareholder held the shares in the PFIC (a “pedigreed QEF”) the shareholder will be eligible for capital gains rates on the disposition of the PFIC shares and will avoid the interest charge on the PFIC’s earnings. If a QEF election is not made for the first year the shareholder held the shares that the foreign corporation was classified as a PFIC (and a ‘purging election’ is not made), gain on the disposition of shares in the PFIC will continue to be classified as ordinary income and distributions will be subject to the excess distribution regime, even if the corporation is no longer a PFIC when the shares are sold or the earnings are distributed.6 This is often referred to as the ‘once a PFIC, always a PFIC’ rule.
Generally, a QEF election may only be made on a timely filed return (including extensions). It cannot be made on an amended return and is only effective for the tax year it is filed and subsequent years. Section 1295(b)(2) prohibits retroactive QEF elections except in cases where a shareholder failed to make a timely election because the taxpayer reasonably believed the company was not a PFIC. Regulations issued under section 1295 allow shareholders only two avenues for making retroactive QEF elections. The first method is through the protective regime, which requires that a shareholder file a protective statement with a timely filed return declaring that it has a reasonable belief that the corporation is not a PFIC or is relying on a public notice issued by the company to that effect. The protective regime for retroactive QEF elections is unlikely to be available to less than 10% shareholders that relied on the section 1297(d) overlap rule because shareholders frequently did not file such protective statements with their returns. The second method of making a retroactive QEF election is to seek the consent of the IRS Office of Associate Chief Counsel International by requesting a private letter ruling, which can be costly and time consuming.7
If a shareholder does not make a QEF election in the first year of the shareholder’s holding period during which the foreign corporation was classified as a PFIC, it must make a purging election to avoid the interest charge and recharacterization of the gain as ordinary income. There are two main forms of purging elections, a deemed sale election and a deemed dividend election. However, both elections normally result in a deemed income inclusion. A deemed sale election under section 1291(d)(2)(A) causes a deemed sale of the PFIC shares and characterizes any gain as ordinary income subject to an interest charge on the period of deferral.8 A deemed dividend election under section 1291(d)(2)(B) causes a deemed dividend of the foreign corporation’s earnings that were accumulated during the shareholder’s holding period during which time the PFIC was not a QEF and is also subject to an interest charge on the period of deferral. Although the deemed dividend election can only be made if the foreign corporation is also a CFC, it does not require that the shareholder be a “US shareholder” within the meaning of section 951(b). Consequently, a US partner that indirectly owns less than 10% of a PFIC through a US partnership which is no longer covered by the section 1297(d) CFC/PFIC overlap rule may make a deemed dividend election.
However, if a US partner was covered by the section 1297(d) overlap rule throughout the partner’s holding period until 2023 (through an application of the section 958 transition rule), these US partners may make a pedigreed QEF election for the 2023 tax year without making a purging election. Section 1297(d)(3)(A) essentially provides that a shareholder’s holding period will begin anew the day after the section 1297(d) overlap rule no longer applies. As previously discussed, section 1297(d)(1) states that a corporation will not be treated with respect to a “shareholder” as a PFIC during the “qualified portion” of such shareholder’s holding period. A “qualified portion” is defined in section 1297(d)(2) as the portion of the shareholder’s holding period during which the shareholder is a “US shareholder,” as defined in section 951(b), and the corporation is a CFC. Section 1297(d)(3)(A) provides that when the “qualified portion” of a shareholder’s holding period ends, the shareholder’s holding period will be treated as beginning on the following day for purposes of applying the PFIC provisions. Thus, pursuant to section 1297(d)(3), if the US partner was covered by the section 1297(d) overlap rule throughout its holding period until 2023 when the section 958 transition rule expired, it would be treated as having a new holding period that commenced on the first day of its 2023 tax year. This rule may allow shareholder to make a pedigreed QEF election for its 2023 tax year without making a purging election.
However, section 1297(d)(3)(A) does not apply if the shareholder’s holding period includes a period of time that precedes the “qualified portion” of its holding period and during which time the foreign corporation was a PFIC. Thus, if the US partner held stock indirectly in a foreign corporation that was a PFIC prior to becoming a CFC (i.e., prior to the application of section 1297(d)), it may need to make a purging election to avoid the negative consequences of owning shares in a PFIC.
1 See e.g., PLR 201108020 and PLR 200943004.
2 In other words, they interpret section 1297(d) as only applying to a “shareholder,” as defined in Reg. 1.1291-1(b)(7) to exclude US partnerships, if it is a “US shareholder” as defined in section 958 through a cross-reference in section 951(b).
3 However, Reg. 1.958-1(d)(2) provides that a U.S. partnership continues to be treated as a “US shareholder” for purposes of classifying a foreign corporation as a CFC.
4 PFIC shareholders are also ineligible for the capital gains rates on qualified dividends under section 1(h)(11) and generally do not qualify for deferral in a section 368 reorganization.
5 US investors in publicly traded corporations can also make a mark-to-market (MTM) election.
6 Section 1298(b)(1) provides that stock held by a taxpayer shall be treated as stock in a PFIC if, at any time during the holding period of the taxpayer, such corporation was a PFIC and was not a QEF, unless a deemed sale election is made under section 1291(d)(2) (a “purging election). . Reg. 1.1291-1(b)(2)(ii) provides that a PFIC is a “pedigreed QEF” with respect to a shareholder if the PFIC has been a QEF for all tax years during which the corporation was a PFIC and the shareholder held the shares.
7 The Biden administration is proposing to introduce legislation that would revise section 1295(b)(2) to allow taxpayers to make retroactive QEF elections without going through the consent procedure where the interests of the government are not prejudiced (e.g., for open tax years). See the Biden administration’s 2025 fiscal year budget proposal explanations (the ‘green book’). Similar legislation was also included in the 2024 and 2023 fiscal year budget proposals.
8 The result of the deemed sale election is to provide the shareholder with a new holding period for purposes of applying the PFIC provisions. See Reg. 1.1291-10(g). It is this new holding period that allows the shareholder to avoid the ‘once a PFIC, always a PFIC rule’ because the shareholder no longer holds stock in a foreign corporation that was a PFIC and was not also a QEF.
