Please contact customerservices lexology. For many years the United States has taxed certain US shareholders of closely held or controlled foreign corporations CFCs deriving principally passive or related-party income on their pro rata share of the corporation's earnings, whether or not distributed.

These rules are commonly referred to as 'anti-deferral provisions' and are contained in the Internal Revenue Code.

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The primary anti-deferral provisions for corporations are the CFC rules and the passive foreign investment company PFIC rules. The principal benefit associated with the use of foreign corporations is the deferral of US taxes on the foreign source income of a foreign corporation until it is repatriated to a US shareholder in the form of a dividend distribution. Moreover, if US shareholders sold stock in the foreign corporation to raise cash in the United States instead of taking dividends, they could potentially convert the foreign corporation's ordinary income to capital gains subject to preferential tax rates.

Congress enacted the CFC rules in to tax US owners of certain foreign corporations on their pro rata share of certain types of income earned by the foreign corporation — generally speaking, income that could be easily shifted from the United States to an offshore tax haven, thereby obtaining tax deferral.

Congress enacted the PFIC provisions as part of the Tax Reform Act of in order to restrict the ability of US persons to defer tax in this way, and thereby to equalise the treatment of foreign and US investment vehicles.

Although the PFIC rules originally targeted US persons' investments in offshore mutual funds, the scope of the rules as enacted is broad and can capture a range of investments in offshore companies and investment vehicles. The rules can apply to any US person that owns an interest in an offshore subsidiary with generally passive assets or income. There is no minimum level of stock ownership required by a US person to be subject to the PFIC rules; therefore, even foreign public companies can be considered PFICs for US tax purposes.

Thus, even a small percentage of ownership can result in severe tax and reporting consequences. Both the CFC and PFIC rules look not only to direct ownership, where shares of foreign corporations are owned outright by a US person, but also to indirect ownership through foreign corporations, partnerships, trusts and estates, and take into account certain attributed ownership from certain related persons although attributed or 'constructive' share ownership does not generally lead to income inclusion.

This update provides a general overview of the substantive rules regarding the taxation of interests in PFICs, including the excess distribution regime, the qualified electing fund regime and the mark-to-market regime. In addition to the substantive rules, significant recordkeeping and reporting burdens are placed on US shareholders of a foreign corporation that is a CFC or PFIC. Although the recordkeeping and reporting obligations are not discussed here, with regard to PFICs, each US shareholder of a PFIC must file Form "Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund" to report distributions from or sales of interests in a PFIC, or to make certain elections.

There may be additional filing requirements depending on transactions occurring between the US shareholder and the foreign company eg, Form "Return of a US Transferor of Property to a Foreign Corporation" to report transfers of property to the foreign corporation. Following a general discussion of the substantive rules, this update identifies certain challenging areas in the current rules and proposes some preliminary thoughts on ways to improve them.

For the purposes of these tests, 'passive income' generally includes any income item that meets the definition of 'foreign personal holding company income' as defined in Section cwhich generally includes, among other things, dividends, interest and net gains from the sale of stock or interests in a trust, partnership or real estate mortgage investment conduit.

A PFIC can be organised as a corporation or a unit trust, but is generally taxed the same in either event. PFICs are generally marketed by large foreign financial institutions, including banks and money managers. PFICs are usually operated as open-ended investment funds and do not generally distribute current income by way of dividends or other distributions. An investor usually realises his or her gains and losses by having shares or 'units' redeemed by the fund.

There is no US shareholder control requirement under the PFIC regime; if a US person holds even a de minimis amount of PFIC shares, it may be subject to tax under the PFIC rules.

In addition, while the test for determining PFIC status is based on the income or assets in a given tax year, once a shareholder's investment in a foreign corporation has been characterised as a PFIC, it will generally be treated as a PFIC with respect to that shareholder in future years.

This is known as the 'PFIC taint' or the 'once a PFIC, always a PFIC' rule. Coordination rules determine how to tax income subject to both the PFIC and CFC rules.

Generally, where a foreign corporation qualifies both as a CFC and PFIC with respect to the same US shareholder aftersuch foreign corporation is treated solely as a CFC and subject to tax under the Subpart F income rules.

However, for this rule to apply the US shareholder must generally make an election to 'purge' the PFIC taint. The PFIC regime applies to US taxpayers that directly or indirectly own shares of a PFIC. Indirect ownership rules apply when a foreign trust owns the shares. Shares in a PFIC owned by a trust will be considered as owned proportionately by the beneficiaries of the trust. The Treasury Department has issued regulations that, although in proposed form, still apply. However, the proposed regulations do not address the question of how to apply the proportionate ownership rules to trusts and their beneficiaries.

PFIC shares directly owned by foreign entities are further attributed to US persons who beneficially own the stock. In that case, the person is treated as owning his or her proportionate share of the stock held by the intervening PFIC.

Options to purchase stock of a PFIC are covered under special rules. Proposed regulations provide that for the purposes of the Section excess distribution regime, an option is considered to be stock. If a foreign company meets the requirements of the PFIC income or asset test, the company will be considered a PFIC with respect to each US shareholder in the company.

The PFIC regime is essentially a penalty provision. No favourable outcomes or planning opportunities arise once a shareholder falls within these rules. All gain recognised on the should i buy bsc stock of PFIC stock is treated as an excess distribution. By contrast, some, all or none of an actual distribution from a PFIC may be treated as an excess distribution.

Importantly, amounts allocated to the prior-year PFIC period are never included in the investor's income. Rather, the tax and interest determined under these rules markettamer stock options trading 'deferred tax amount' are added to the investor's tax liability without regard to other tax characteristics of the investor.

Thus, the deferred tax amount is a payable tax liability, even though the investor otherwise had a current-year loss, or had net operating loss carryovers. The tax on excess distributions may be avoided if the US shareholder makes certain livestock auction middle tn to purge the prior PFIC taint. The two principal purging elections are the qualified electing fund QEF election and the mark-to-market election.

Under the QEF election, the US person effectively elects to include in each year's income its pro rata share of the PFIC's ordinary earnings and net capital gains. For each tax year in which the QEF election applies and the PFIC is treated as a QEF, the shareholder must complete Part II of Form and attach the form to its timely filed tax return.

To facilitate this, the PFIC is required to supply each shareholder with a PFIC Annual Information Statement. This statement must contain certain information, including the shareholder's pro rata share of the PFIC's ordinary earnings and profits and net capital gain for that tax year or sufficient information for those calculations to be made.

Where a PFIC is a closely held private entity, it may be possible for the US shareholders to cause the PFIC to comply with the annual statement requirements. However, in the annual statement the company must state that:. In the real world, it may be unrealistic or impractical to expect forex quotation PFIC to make adequate disclosures to support a QEF election since a foreign public company with binary options it is a divorce or not US ties will have no incentive to grant the Internal Revenue Service IRS such access or convert their financial statements to US tax principles.

To maximise the benefit, the QEF election should be filed by the due date of the shareholder's return for the year including extensions for the first tax year in which the election will apply. In certain limited situations, a shareholder may make a retroactive QEF election making the election for a tax year after the election due datebut only if:. A US shareholder of a PFIC who is unable to use the QEF rules may nonetheless avoid taxation for excess distributions by accepting current taxation under the how do free antivirus companies make money election.

For stock to qualify as marketable, it must regularly be traded on:.

Glossary (Foreign investment funds (FIF))

Under the mark-to-market election, the US shareholder includes in income each year an amount equal to the excess, if any, of the fair market value of the PFIC stock as of the close of the tax year over the shareholder's adjusted basis binary options vs penny stocks daily signals the stock.

However, losses are restricted to the amount of current year or accumulated gains. Amounts included in income under this election, as well as gain on the actual sale or other disposition of easy forex currency forex learn online trading canada11 PFIC stock, are treated as ordinary income.

Except for this coordination rule, the rules of Section do not apply to the shareholder of the PFIC if a mark-to-market election is in effect for the shareholder's tax year.

In the IRS offered an alternative tax computation initiative for taxpayers participating in the offshore voluntary disclosure programme in order to address problems faced by many participants in the programme due to lack of records necessary to determine their tax liability for the unreported years Under the initiative, PFIC valuation can be done on a basis consistent with the mark-to-market method but without reconstruction of the historical data, and some special rates and limitations apply.

The current rules regarding taxation of PFICs are highly problematic, starting with the absence of guidance in many aspects of the rules ie, most portions of the PFIC regulations have remained in proposed form since the late s. Moreover, the current rules are excessively punitive, requiring significant reporting requirements and costs and, as such, may not be economically feasible or practical.

Instead of levelling the playing field between domestic and foreign passive investments, the current PFIC rules penalise the latter significantly.

While its purpose was only to eliminate tax advantages, the PFIC tax treatment serves as a punitive tax on PFIC holders.

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Under the QEF regime, the pro rata share of the PFIC's net capital gain is taxed as capital gain, while the pro rata share in the PFIC's ordinary income is taxed as ordinary income.

Under the mark-to-market regime, all of the PFIC appreciation is included in the taxpayer's ordinary income. In taxing restricted stock options, other deductions and carryover losses, other than foreign tax credits, are not taken into consideration when the deferred tax amount is added to the taxpayer's tax liability. The discrepancy between the tax treatment of US passive investments under reduced capital gain and qualified dividend tax rates and non-US passive investments contradicts the intention of Congress, which was to level the playing field between US and foreign investments.

Congress enacted the PFIC rules in due to a concern that:. Since the tax rates on qualified dividends and long-term capital gains are identical, there is no tax disparity between distributions taxed as qualified dividends and long-term capital gains. Thus, the PFIC rules no longer serve to level the playing field, but instead unduly limit a US person's choices in investments.

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The adverse side effect of the current rules is further emphasised by the fact that the current definition of a PFIC is overly broad and can capture businesses intended to be engaged in an active trade or business. More specifically, the application of the asset or the income test in determining when a foreign corporation should be treated as a PFIC will often result in the classification of an active business as a PFIC. Thus, for example, an active foreign corporation that has a bad year with low income or losses from the active enterprise may nonetheless generate enough passive income eg, from a dividend from a portfolio investment that will cause it to be a PFIC.

In addition, sales and services companies and start-up companies are prone to meet the asset test, since they typically do not have significant assets other than working capital, which is passive.

The 'once a PFIC, always a PFIC' rule aggravates the adverse side effect of the current rules. Thus, there appears to be a need to define PFICs more squarely in order to be consistent with the intended purpose of preventing tax deferral and leveling the playing field.

One option might be to require that both the income and the asset test be met before a corporation can be classified as a PFIC ie, requiring a certain threshold of passive income and passive assets.

Another option might be to expand the exceptions to the definition of a PFIC to create safe harbours for active businesses and start-up companies that might get caught under the current PFIC definitions. The existing safe harbours are also problematic. In general, the QEF regime is not appropriate to the situation of many US taxpayers. It requires both that a taxpayer make a timely affirmative election to have the regime apply to a particular investment and that the PFIC itself provide a taxpayer with certain financial information.

Moreover, in the case of many US taxpayers with accounts in offshore jurisdictions, the decisions to invest in PFIC stock are generally made not by the taxpayers themselves but rather by foreign investment managers, who often do not understand the consequences of the PFIC regime for their customers and do not advise the taxpayers of the possibility of making a QEF election. Further, because generally shares of foreign investment companies are not intended to be offered to US persons, such PFICs generally do not keep the financial information required by US taxpayers making a QEF election and certainly did not provide it to such shareholders foreign investment funds are loath to become enmeshed in possible violations of US securities laws.

Difficulties in obtaining information and reconstructing historical data might be relevant not only for the very small investments in PFICs discussed above, but also to various investors in different settings. The potential difficulties of obtaining information have been recognised by Congress.

The Senate report provides that:. However, the only viable alternative to the QEF regime is the mark-to-market regime, which has limited application ie, the mark-to-market election is conditioned on the PFIC's stock being marketable. Thus, taxpayers with minority interests in non-marketable securities do not have the option of electing current taxation on the investment's earnings on an annual basis.

Finally, the absence of a de minimis rule for minority holdings of a PFIC is also problematic. The PFIC regime applies from the first dollar and with no percentage interest requirement.

The problem is that many US taxpayers do not choose to acquire interests in PFICs; rather, the decision to enter into such investments is often made by the taxpayer's foreign adviser, who may be unaware of the potential adverse US tax consequences to the investor.

Nevertheless, even a US taxpayer with a 0. The application of the complicated PFIC rules, which is beyond the expertise and knowledge of many tax professionals, may not be suitable and justifiable for small investments. Thus, small investors often end up being penalised for their inadvertent investments in PFICs.

This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription.

However, Congress felt that because income that would have been taxable under the FPHC rules may also have been taxable under the CFC or PFIC rules, there was unnecessary and confusing overlap. Accordingly, Congress eliminated the FPHC rules in Deemed distributions or dispositions with respect to indirectly held PFIC stock may also be subject to the excess distribution rules. See Prop Reg 1. Passive Foreign Income Company Investment Computations, Septemberavailable at: If you are interested in submitting an article to Lexology, please contact Andrew Teague at ateague GlobeBMG.

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Share Facebook Twitter Google Plus Linked In. Follow Please login to follow content. Register now for your free, tailored, daily legal newsfeed service. Taxing passive foreign investment companies: USA November 18 Introduction For many years the United States has taxed certain US shareholders of closely held or controlled foreign corporations CFCs deriving principally passive or related-party income on their pro rata share of the corporation's earnings, whether or not distributed.

Definition of 'PFIC' A foreign corporation is treated as a PFIC for a tax year if: Popular articles from this firm Limiting treaty benefits: Chapter 15 at USA Tennessee Hawaii South Carolina More Back to Top RSS feeds Contact Submissions About.

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