PFIC Considerations For Foreign Investors With U. S PFIC Considerations For Foreign Investors With U.S. Beneficiaries STEP Presentation April 24, 2013 Dina Kapur Sanna, Esq. and Stephen Ziobrowski, Esq.

Introduction Passive Foreign Investment Company (PFIC) rules are triggered in a typical NRA structure when investments are consolidated in a holding company or foreign funds are part of the investment portfolio, and one or more beneficiaries are U.S. persons While NRA is alive and treated as the owner of the PFIC, there is no problem, but on his death, indirect ownership rules may apply to treat U.S. beneficiaries as owners of PFICs

What is a PFIC A PFIC is a foreign entity that is treated as a corporation for U.S. tax purposes and generates primarily passive investment income, or holds primarily passive assets Passive income is defined by reference to foreign personal holding company income, which includes investment income such as dividends, interest and gains No minimum threshold of U.S. ownership or control

What is a PFIC (cont.) A foreign entity is classified as a corporation under Treasury regulations if one of the following is true: It is a “per se” corporation It elected to be treated as a corporation by filing Form 8832 with the IRS It did not make an election and under the law where the entity is formed, no shareholder or member has personal liability for the debts or obligations of the entity

What is a PFIC (cont.) A foreign entity that is classified as a corporation for U.S. tax purposes will be a PFIC if 75% or more of its gross income for the taxable year is passive income, or 50% or more of the average percentage of its assets are held for the production of passive income There is a 25% subsidiary look-through rule If a foreign corporation is both a PFIC and CFC, the PFIC rules take precedence with respect to a 10% U.S. shareholder

Ownership of PFIC through an Estate or Trust Stock owned directly or indirectly by or for an estate or trust is considered as being owned “proportionately” by the U.S. beneficiaries Prop. Regs. apply facts and circumstances test to determine “proportionality” but reserve on substantive guidance TAM 200733024: absence of final or temporary regulations do not prevent PFIC rules from applying

Is the company organized under U.S. law? What is a PFIC (cont.) Is the company organized under U.S. law? Yes No Is the company treated as a corporation for U.S. tax purposes as a result of a. per se corporation rule b. default classification c. check the box election? No Yes Is either of the following true: a. 75% of the company’s gross income is passive income; or b. 50% or more of the company’s assets are held for the production of passive income? (After applying “look through” rule) No Yes Are both of the following true? 1. U.S. persons own more than 50% of the stock (by vote or value) and 2. The U.S. shareholder owns 10% or more of the voting stock Yes* Not Taxed as a PFIC *If this question is answered yes, then the U.S. shareholder is taxed under the Controlled Foreign Corporation (“CFC”) rules Taxed as a PFIC No

Ownership of PFIC through an Estate or Trust (cont.) TAM 200733024: IRS applied facts and circumstances to tax U.S. beneficiaries of discretionary trust on indirect PFIC disposition resulting from liquidation of PFIC into trust in that year (year 1), rather than when liquidation proceeds distributed to them (year 2) Analysis based on settlor’s intention to provide separate shares of equal proportion for all beneficiaries and trustee’s pattern of equal distributions

Ownership of PFIC through an Estate or Trust (cont.) Indirect ownership despite the fact that U.S. beneficiaries had no role in creating the trust and could not control distributions IRS: intent is not a factor. PFIC regime applies if there is a perceived advantage of tax-deferral achieved by investing through a foreign holding company, regardless of whether investment through that holding company was explicitly created for that purpose

Ownership of PFIC through an Estate or Trust (cont.) Pattern of past distributions seems to be most relevant fact for a discretionary trust, but the analysis falls short in many respects: What if there are no distributions? When do distributions rise to the level of a “pattern”? Do distributions have to be of a minimum value to be counted? Is there a risk that fall-back rules of intestacy could apply where there are no such distributions? No guidance on how to reconcile with Subchapter J rules

Taxation Under the Excess Distribution Regime In absence of QEF election or mark-to-market election, taxable event occurs on “excess distribution” Excess distribution is amount by which actual distributions with respect to PFIC stock exceed 125% of the average of the prior 3 years (or if shorter, taxpayer’s holding period in PFIC stock) Importantly, entire gain realized on disposition of PFIC stock is treated as an excess distribution

Taxation Under the Excess Distribution Regime (cont.) Excess distribution allocated ratably over U.S. shareholder’s holding period Portions allocated to current year and pre-PFIC years are taxed as ordinary income Portions allocated to PFIC years are taxed at highest marginal rate of U.S. shareholder in effect for that year and draw an interest charge (sum of tax and interest is “deferred tax amount”) Deferred tax amount cannot be offset by losses or deductions

Elections Under PFIC Regime QEF Election A U.S. shareholder can make a “Qualified Electing Fund” (“QEF”) election with respect to a PFIC If the QEF election is made, the U.S. shareholder includes his allocable share of the PFIC’s ordinary income and capital gains in income currently There is a separate election which can be made to defer payment of tax on undistributed income of a QEF

QEF Elections (cont.) The character of the PFIC’s income as ordinary income or capital gain passes through to a shareholder who makes the QEF election The election is made by the first U.S. shareholder in the chain of ownership In the case of a foreign nongrantor trust, the U.S. beneficiary of the trust makes the election

QEF Elections (cont.) The election is made on a shareholder by shareholder basis A PFIC, therefore, may be a QEF with respect to some U.S. shareholders but not with respect to others

QEF Elections (cont.) The QEF election must be made by the due date of the U.S. shareholder’s tax return for the first year in which it is to be effective If the QEF election is made effective as of the first day of the first year of the U.S. shareholder’s holding period, then the PFIC is a “pedigreed QEF” A “pedigreed QEF” is not subject to the PFIC default regime as long as the QEF election is maintained

QEF Elections (cont.) If a QEF election is made effective after the first day of the first year of the U.S. shareholder’s holding period, the QEF is an “unpedigreed QEF” An “unpedigreed QEF” is subject to the PFIC default rules (i.e., tax on “excess distributions”) on a sale or liquidation of the stock This result stems from the “once a PFIC, always a PFIC” rule and is called the “PFIC taint”

QEF Elections (cont.) Late QEF elections are permitted only in very narrow circumstances In general, a U.S. shareholder seeking to make a late QEF election must demonstrate that he possessed a reasonable belief as of the original due date of the late election that the foreign corporation was not a PFIC

QEF Elections (cont.) If it is not possible to make a late QEF election, the U.S. shareholder should consider making a purging election (to remove the PFIC “taint”) and combining that election with a QEF election going forward

QEF Elections (cont.) A QEF election may only be made if the PFIC is willing to compute its income and gain in accordance with U.S. tax rules and furnish the information annually that the U.S. shareholder needs to comply with the QEF election Many foreign investment funds are unable or unwilling to comply with this requirement

Elections Under the PFIC Regime Check-the-Box Elections Foreign entities which are not “per se” corporations are eligible to elect to be taxed in the U.S. as fiscally transparent entities A foreign entity which has elected to be fiscally transparent is not a PFIC

Check-the-Box Elections A check-the-box election can be made retroactively up to 75 days after the date it is to become effective Rev. Proc. 2009-41 permits late check-the-box elections for up to 3 years and 75 days after the requested effective date of the election

Check-the-Box Elections (cont.) A late check-the-box election may be permitted if: the foreign entity failed to obtain its requested classification as of the date of its formation or as of the date its classification became relevant for U.S. tax purposes only because Form 8832 was not timely filed; and the foreign entity has not filed a federal tax return for the first year of the requested election because the due date for that return has not passed; or

Check-the-Box Elections (cont.) the foreign entity has filed federal tax returns consistent with the requested classification and no inconsistent federal tax returns have been filed if the foreign entity is not required to file federal tax returns, then each “affected person” who is required to file a federal tax return has filed federal tax returns consistent with the election, and no inconsistent tax returns have been filed

Check-the-Box Elections (cont.) The eligible entity has “reasonable cause” for its failure to make the entity classification election on time; and 3 years and 75 days from the requested effective date of the election have not passed

Check-the-Box Elections (cont.) As a practical matter, the IRS has been very willing to accept late check-the-box elections made before the first federal tax returns would be due for the first year of the election

Check-the-Box Elections (cont.) A check-the-box election must be made by the foreign entity, not the U.S. shareholders The check-the-box election affects all shareholders, not just the U.S. shareholder who makes the election

Check-the-Box Elections (cont.) For these reasons, a check-the-box election may not be available with respect to most PFICs If PFICs are held in a foreign holding company, though, a check-the-box election should be considered for the foreign holding company

Check-the-Box Elections (cont.) A retroactive check-the-box election for the holding company may achieve a basis step-up in the stock of PFICs held by the holding company, with no U.S. tax This would minimize PFIC gain subject to tax under the default regime on a subsequent sale or liquidation of the PFIC stock

Elections Under the PFIC Regime Purging Elections There are a number of “purging elections” available to remove “PFIC taint” The most useful of these elections is the “deemed sale” election

Deemed Sale Election The deemed sale election can only be made if the U.S. shareholder also makes a QEF election If the deemed sale election is made, the U.S. shareholder is treated as having sold the PFIC stock as of the first date of the QEF election

Deemed Sale Election (cont.) Gain resulting from the deemed sale election is taxed under the default regime, i.e., as ordinary income with an interest charge The U.S. shareholder obtains a new basis in the PFIC stock (unless the deemed sale results in a loss) and he begins a new holding period in the stock The PFIC is a “pedigreed QEF” after the deemed sale and QEF election, and the “PFIC taint” has been expunged

Deemed Sale Election (cont.) The deemed sale election should be considered if the U.S. shareholder has a small or modest built-in gain (or loss) on the PFIC stock and the shareholder can establish the market value of the PFIC stock If the built-in gain is very large, the U.S. shareholder may have to consider an actual sale of the stock, to have the funds to pay the tax

Elections Under the PFIC Regime Market-to-Market Election A U.S. shareholder may make a “mark-to-market” election with respect to marketable PFIC stock If the election is made, the U.S. shareholder includes in income the annual increase in value of the PFIC stock at the end of each year Any increase in value is treated as ordinary income. A decrease in value may be deducted as a loss, to the extent of previous inclusions

Mark-to-Market Election The mark-to-market election is generally available only for PFIC stock which is regularly traded on a qualified stock exchange As a practical matter, this requirement greatly limits the utility of the election

Examples Direct PFIC Holding Assume a nonresident alien invests $1,000,000 in stock of a PFIC in 2002 He holds the stock in his own name or in a revocable trust which allows him to direct payments of income The PFIC stock grows 5% a year. The nonresident alien dies in 2013 and the stock is liquidated for $1,710,340 There is no “excess distribution” because the basis of the PFIC stock was stepped up to fair market value at death

Examples (cont.) Indirect PFIC Holding Assume the same facts except that the PFIC is held through a foreign corporation which is itself a PFIC If the stock in the holding company is liquidated shortly after the nonresident alien’s death in 2013, U.S. beneficiaries of his estate will be taxable on their “proportionate shares” of $710,340 of PFIC gain The amount taxable will be taxed as ordinary income, with an interest charge

Strategies for Dealing with Indirect Holdings QEF election Due by the due date of the U.S. beneficiary’s 2012 tax return Deemed Sale Election, combined with a QEF election Check-the-Box Election for the Holding Company Could be retroactive to a date before the nonresident alien’s death But first be sure there are no U.S. situs assets (e.g., stock of U.S. corporations) held by the holding company. Otherwise, a check-the-box election could trigger U.S. estate tax

Advance Planning Investing in PFICs which are targeted to U.S. investors and will accommodate QEF election or mark-to-market elections Avoiding foreign fund of funds, which trigger indirect disposition of lower-tier fund when top-tier fund is sold Avoiding funds which have liquidity restrictions and do not permit regular redemptions

Advance Planning Holding PFICs individually or directly by trust and drafting trust to permit a date-of-death basis step up Segregating PFICs in a “checkable entity” which can check the box to be disregarded