Decades ago, United States citizens and residents were able to defer U.S. income taxes by investing in certain foreign corporations, mainly foreign mutual funds. Because these funds were not required to distribute income to shareholders annually as U.S. mutual funds are required to do, a taxpayer could purchase shares of the mutual fund and pay no tax on an annual basis, unless the fund distributed income. The taxpayer could then pay lower capital gains rates on the sale of the mutual fund shares in the future. In an attempt to level the playing field between U.S. owners of foreign mutual funds and owners of U.S. mutual funds, Congress passed legislation containing special rules for “Passive Foreign Investment Companies” (“PFICs”).

There are two tests used to determine whether a foreign corporation is a PFIC: the income test and the asset test. A foreign corporation is considered a PFIC if it passes either test. Under the income test, a foreign corporation is a PFIC if 75 percent or more of its gross income is passive income. Under the asset test, a foreign corporation is a PFIC if 50 percent or more of the average value of its assets produce (or could produce) passive income. Foreign mutual funds generally satisfy both of these tests.

U.S. shareholders of PFICs are generally subject to the “excess distribution” regime. The excess distribution for a given tax year is determined by considering each PFIC separately. It includes all gains on dispositions of the PFIC stock, plus the portion of distributions from the PFIC that exceeds 125% of the average distributions for the prior three years. This income or gain is allocated evenly across the time the taxpayer owned the shares. The gain allocated to prior years is taxed at the maximum marginal rate in the United States during each year (regardless of the taxpayer’s own marginal rate). Then, interest is computed on the prior year tax amounts from the due date of each year’s income tax return to the date the tax is being paid. Losses realized on the disposition of PFIC shares are generally not recognized. Combined with the punitive nature of the PFIC tax regime, this makes it possible for the amount of tax due on PFIC income to exceed the amount of income earned.

U.S. shareholders of PFICs may partially or entirely avoid the above treatment by electing to include in their current income each year their share of the ordinary income and net capital gains of the PFIC, similarly to shareholders of a U.S. mutual fund. This election is effective for the year in which the election is made and future years; if it is made at the beginning of a taxpayer’s holding period of a fund, the “excess distribution” regime may be entirely avoided. If the election is made in later years, then the taxpayer will need to make another election to “purge” the earlier PFIC treatment.

Another election allows taxpayers to avoid the “excess distribution” regime by recognizing gain or loss on the PFIC shares as if they had sold the shares at fair market value. This election is available only for shares that are regularly traded on an exchange.

Under the 2010 Hiring Incentives to Restore Employment Act (the “HIRE Act”), each U.S. person who is a PFIC shareholder must file an annual report containing information required by the Internal Revenue Service (“IRS”) for each tax year beginning after March 18, 2010. The IRS is in the process of developing the specific reporting requirements that PFIC shareholders will need to follow. Most taxpayers will likely need to follow these new requirements (once they are finalized) beginning with their 2011 individual income tax return.

For tax years beginning before March 18, 2010 (for most taxpayers, calendar years 2010 and prior), PFIC shareholders who were U.S. citizens or residents were required to file a Form 8621, “Return by a Shareholder of a Passive Foreign Investment Company or a Qualified Electing Fund,” only if the shareholder had received a distribution from the PFIC or recognized gain on the disposition of PFIC shares during that year. A disposition is any transaction or event that constitutes an actual or deemed transfer of property for any purpose of the Internal Revenue Code, including, but not limited to, a sale, exchange, gift, or transfer at death. Gains recognized on the disposition of PFIC shares are reported on a tax return on Form 8621, as opposed to Schedule D, because they are subject to a different taxation regime as noted above. Additionally, the Form 8621 is used to make the elections described above. Failing to file a Form 8621 with a tax return when required may render the return incomplete and prevent the statute of limitations (the period of time the IRS may examine the return) from running.

If you think that you may have income tax or reporting requirements related to unreported or misreported foreign mutual funds, or if you have any questions related to this article, please contact Susan Choi at schoi@thewolfgroup.com or 703-502-9500.


This newsletter is for informational purposes only. It should not be construed as tax, legal, or investment advice. Information has been gathered from sources believed to be reliable, but individual situations can vary and you should consult with your investment, accounting and/or tax professional.

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