PFIC traps for the unwary during the pandemic and purging the taint
INSIGHT ARTICLE |
The COVID-19 pandemic created a weakened global economy, which has negatively affected many industries. In April 2020, the International Monetary Fund (IMF) released projections, which estimated a 3% contraction in the global economy for the 2020 calendar year. In October 2020, the IMF released a less severe contraction projection. However, the report notes that volatility and uncertainty still remain in the global markets, leaving global economies prone to severe setbacks. As a result of the pandemic and the downturn to the economy, many non-U.S. jurisdictions have passed measures to provide economic aid to many taxpayers under immediate distress. Notwithstanding the above, the recent downturn in the global economy and the potential devaluation in assets used in the conduct of a trade or business may result in unanticipated U.S. tax consequences with respect to foreign investments of U.S. multinational taxpayers. Specifically, these corporations may now qualify as passive foreign investment companies (PFIC), subjecting their shareholders to potentially draconian tax results.
Under section 1291, certain U.S. persons that are shareholders in a foreign corporation classified as a PFIC may be subject to tax at ordinary income tax rates on excess distributions allocated pro rata to each day of such U.S. person’s holding period, plus potential interest charges. In general, a foreign corporation may be classified as a PFIC if:
- the foreign corporation generates 75% or more of its gross income from passive sources, or
- more than 50% of the foreign corporation’s assets consist of assets that generate passive income (section 1297(a)).
To mitigate any potential tax consequences resulting from the PFIC regime, U.S. shareholders may make timely qualifying electing fund (QEF) or mark-to-market (MTM) elections.
The pandemic may result in the risk that certain foreign corporations may now be considered PFICs for U.S. tax purposes. For example, the recent devaluation of stock prices in foreign publicly traded companies may result in a greater portion of a foreign corporation’s assets treated as passive, meeting the 50% passive asset test mentioned above. For example, if an active foreign publicly traded company's market capitalization decreased as a result of a decline in stock value in the earlier half of the 2020 tax year, and there is a substantial amount of cash or recently borrowed funds on the balance sheet, this would increase the ratio of passive assets in the foreign publicly traded company. Even if the foreign corporation’s stock price rebounded by the first quarter of 2021, the quarterly calculation of the 50% passive asset test and the “once a PFIC, always a PFIC” rule may still deem such foreign corporation to be a PFIC.
In the case of privately-held foreign companies the potential devaluation of the company’s assets, or the increase in cash balances (e.g. through economic relief programs offered in many foreign jurisdictions), may result in a greater portion of the foreign corporation’s assets being treated as passive, and potentially resulting in the corporation satisfying the PFIC asset test during the 2020 tax year.
However, U.S. shareholders that own PFICs as a result of the recent global economic downturn may mitigate U.S. tax consequences by making timely QEF, MTM elections, or by “purging the taint” of PFIC status.
Timely elections to avoid adverse PFIC tax consequences
U.S. shareholders that own stock in a PFIC regularly traded on a stock exchange, directly or indirectly, may make a mark to market (MTM election under section 1297(a). U.S. shareholders that make a MTM election are required to mark their PFIC shares to market annually. Thus, any increase in the fair market value of the PFIC’s stock in excess of the U.S. shareholder’s stock basis is included in gross income and taxed at ordinary income tax rates. If the stock declines in value during the year, the U.S. shareholder is allowed a deduction during that year but only to the extent of income previously taken into account. .
According to section 1293(a), U.S. shareholders that own stock, directly or indirectly, in a PFIC may make a one-time QEF election and include into income each year any ordinary or long-term capital gain income attributable to the shares. A timely filed QEF election avoids accrued interest charges that result under the excess distribution regime and it also preserves capital gain treatment of capital gains earned by the PFIC. Under the PFIC regime, taxpayers that elect QEF treatment with respect to a PFIC generally do not have the ability to recognize overall losses realized by the PFIC. However, upon the disposition of QEF stock, shareholders may have the ability to recognize capital losses.
If a QEF or MTM election is not timely filed and the foreign corporation qualifies as a PFIC, interest for the holding period of the PFIC is generally computed by using the federal short-term rate as determined by the Treasury Secretary, plus three percentage points.
Untimely elections to mitigate PFIC tax consequences
Once a foreign corporation is considered to be a PFIC, all of the foreign corporation’s subsequent distributions and distributions of stock are subject to the excess distribution regime of section 1291, even if the foreign corporation is not a PFIC in subsequent years (i.e. this is known as the “once a PFIC, always a PFIC” rule) under section 1298(b). Thus, failure to make a QEF or MTM election effective from the date the taxpayer initially acquires the PFIC stock should subject the taxpayer to the PFIC interest charge and excess distribution rules with respect to a portion of the gain recognized on the sale of the PFIC even if the taxpayer makes a later QEF or MTM election. If U.S. shareholders do not timely make QEF or MTM elections, U.S. taxpayers may still “purge the taint” of PFIC status, and can make a QEF or MTM election going forward under section 1291(d)(2).
For example, U.S. shareholders may make a purging election and make a simultaneous QEF election if the foreign corporation remains a PFIC at the time of the purging election. A purging election results in a deemed sale of stock in the PFIC for fair market value under section 1291(d)(2). Any gain on this deemed sale is taxed as an excess distribution (i.e. at ordinary income tax rates) and an interest charge may apply. A U.S. shareholder must make the purging election for the same taxable year that the QEF election is made. The purging election may also be made on an amended return as long as the amended return is filed within three years of the due date (including extensions) of the original return.
While a purging election may result in taxation of gain as an excess distribution, no gain will result if shares have a built-in loss because of a decline in asset values resulting from the COVID-19 pandemic. In this case, the taxpayer may make a purging election with little to no tax cost.
The IRS and Treasury recently provided guidance and commentary in the preamble to final regulations issued in December 2020 under the PFIC rules. Treasury commented on concerns expressed on the potential inconsistent application by taxpayers of the “once a PFIC, always a PFIC” rule under differing interpretations between final and the 2019 proposed regulations, as well as between historic and new investors in foreign corporations. Notwithstanding the comments received, the IRS and Treasury agree that in some cases a foreign corporation that was previously a PFIC may become a former PFIC with respect to a shareholder, which may result in the need to file amended returns to make a purging. Additionally, the IRS and Treasury agree that the PFIC rules are designed in a manner, which may require the application of the “once a PFIC, always a PFIC” rule to historic shareholders, but not to new investors in the tested foreign corporation which would result in a foreign corporation being a PFIC for some but not all shareholders.
What U.S. multinationals should consider now
The pandemic has brought about a global economic downturn, which may result in unanticipated U.S. tax consequences with respect to foreign investments of U.S. multinational taxpayers. However, there may be ways to mitigate adverse tax consequences. Specifically, U.S. shareholders should be aware of the elections available to protect against the risk of accruing interest if a foreign corporation is considered to be a PFIC. If a timely election has not been made to mitigate the costs of owning a PFIC, now may be the time to purge the taint.