On January 24, 2022, the IRS issued proposed regulations that impact certain elections available to U.S. taxpayers with respect to their indirect interests in passive foreign investment companies (PFICs).
Pursuant to the proposed regulations, to the extent an interest in a PFIC is owned by a domestic partnership, the U.S. partners will be considered the shareholders of the PFIC rather than the domestic partnership. Thus, any qualified electing fund (QEF) or mark to market (MTM) elections with respect to the PFIC will be made at the U.S. partner level. This is a departure from the existing rules, which treat the domestic partnership as the U.S. shareholder for purposes of making such PFIC elections. The proposed regulations similarly apply to U.S. shareholders of S corporations that own an interest in a PFIC.
PFIC elections made by a domestic partnership or S corporation under the existing rules with respect to any taxable years of PFICs that end on or before the date on which the proposed regulations become final will be respected and will apply to all relevant U.S. partners and S corporation shareholders as of that date.
What Is a PFIC?
A non-U.S. corporation will generally be treated as a PFIC if the majority of its assets constitute passive assets (e.g., shares, cash, certain intellectual property) or a significant portion of its income is generated from passive sources (e.g., dividend, interest, capital gains, royalties).
U.S. shareholders of PFICs are subject to a punitive U.S. tax regime that applies regardless of ownership percentage. In particular, U.S. shareholders will generally be subject to ordinary income tax rates (i.e., no reduced capital gains tax rate) and substantial interest charges upon any distributions from the PFIC or a disposition of the PFIC shares. In certain circumstances, U.S. shareholders could incur a total tax liability in excess of their gross return from the PFIC investment.
Relief from these punitive PFIC rules may be available if the U.S. shareholder makes a timely QEF or MTM election with respect to the PFIC investment.
In the case of a QEF election, the U.S. shareholder would be taxed on undistributed PFIC income as it is earned on a current basis. The QEF election must be made in the taxable year when the PFIC investment is first acquired by the U.S. shareholder or the non-U.S. corporation first becomes a PFIC.
In the case of an MTM election, the U.S. shareholder would recognize any unrealized gain in the PFIC shares on an annual basis as ordinary income (i.e., by effectively marking the investment to market each year). Only PFICs that are marketable securities are eligible for the MTM election.
How Can Venable Help?
The PFIC regime is complicated and can be costly for unprepared taxpayers. The Venable international tax team has significant experience evaluating PFIC risks and implementing tax-saving mitigation strategies.