Hidden PFIC Tax Dangers Lurk when US Residence Terminates

Hidden PFIC Tax Treatment Pitfalls for Termination of Residence

Hidden PFIC Tax Treatment Pitfalls for Termination of Residence

A PFIC refers to a Passive Foreign Investment Company. These types of foreign investments come in all shapes and sizes — but for many Taxpayers, they are simply foreign mutual funds. Most taxpayers have no idea that when they purchase a foreign mutual fund (either as a US Person or they become a US Person later) that they are getting embroiled in a messy PFIC tax scenario. There are many tax implications involving PFICs and unless taxpayers act quickly –– and usually within the first year –– in making tax elections such as the QEF or MTM election — the PFIC taint will follow them for years to come — until they rid themselves of the taint. One of the biggest pitfalls involving PFIC of foreign persons who later become US persons is when this US person wants to terminate or relinquish their United States Person tax status — and have to determine how to treat the PFIC for tax purposes. Let’s take a quick stroll through the proposed regulation involving the disposition of PFIC.

PFIC Fact Scenario

At our international tax law firm, the Golding & Golding team specializes exclusively in international offshore tax matters.  Here is a common scenario we see often: David is a foreign person non-resident alien. He has several investments abroad, including mutual funds and SICAVs.  David relocated to the United States, married a US person, and became a Lawful Permanent Resident. Before he relocated to the United States, David spoke with some tax professionals who warned them about the worldwide income regime and potential issues with foreign trusts and the throwback rule – – but did not discuss with him in any detail the PFIC issue.

David Learns of PFIC Tax and Reporting

When preparing his tax returns with a tax professional several years later, David, unfortunately, learns about the PFIC tax regimes — and since it has been many years since he came to the United States, and the value of the foreign mutual fund assets have grown considerably — he did not want to make a late election, and instead opted to ensure that he did not have any excess distribution so that he could contain the tax and try to figure it out later.

It is now later and David is getting near retirement. He wants to relocate with his family back to his home country. He is worth several millions of dollars, and properly planned for his exit so that he is not a Covered Expatriate — and so the question then becomes, what happens to the PFICs?

26 CFR 1-1291-3 (Disposition of PFIC)

(a) Purpose and scope.

• • • • Any direct or indirect disposition of stock of a section 1291 fund within the meaning of paragraphs (b), (c), (d), and (e) of this section is taxable to the extent provided in section 1291, this section, and § 1.1291-6.

      • For dispositions of stock of a section 1291 fund that qualify for nonrecognition treatment, see § 1.1291-6. Gain is determined on a share-by-share basis and is taxed as an excess distribution as provided in § 1.1291-2(e)(2). Unless otherwise provided under another provision of the Code, a loss realized on a disposition of stock of a section 1291 fund is not recognized.

(b) Disposition

• • • • (1) In general.—For purposes of this section, a disposition is any transaction or event that constitutes an actual or deemed transfer of property for any purpose of the Code and the regulations thereunder, including (but not limited to) a sale, exchange, gift, or transfer at death, an exchange pursuant to a liquidation or section 302(a) redemption, or a distribution described in section 311, 336, 337, 355(c) or 361(c). For purposes of this paragraph (b), any person receiving a distribution that qualifies under section 355 will be treated as disposing of all of its stock in the distributing corporation (whether or not there is an actual disposition of such stock) in exchange for stock of the distributing corporation, the controlled corporation, or both, as the case may be.

(2) Change of U.S. residence or citizenship.—

• • • • If a shareholder of a section 1291 fund becomes a nonresident alien for U.S. tax purposes, the shareholder will be treated as having disposed of the shareholder’s stock in the section 1291 fund for purposes of section 1291 on the last day that the shareholder is a U.S. person.

      • Termination of an election under section 6013(g) is treated as a change of residence (within the meaning of this paragraph (b)(2)) of the spouse who was a resident solely by reason of the section 6013(g) election.

First, It is a Proposed Regulation

One thing to keep in mind is that this is a proposed regulation and not a final regulation. While chances are the IRS and possibly courts would rely on the proposed regulation if there are no other cases, rules, or regulations to counteract on point, it is not a finalized regulation and so there is wiggle room as the regulation is clearly overbroad. 

Becoming a Nonresident Alien for US Tax Purposes

The key phrase of the proposed regulation is that it refers to persons who become non-resident aliens for US tax purposes – but it is not clear as to who would be considered a US person who becomes a non-resident for tax purposes, and if there are any exceptions or limitations to persons who were first non-residents and then become residents.

These types of unfortunate tax situations are most common with two (2) groups of people:

• Foreign nationals who make a 6013(g) election, and then withdrew the election; and
• Taxpayers who formally expatriate.

If the IRS has its way, then it sounds like in any year that a US Citizen, Lawful Permanent Resident, Foreign National who met the Substantial Presence Test or withdrew a 6013(g) election, the PFIC tax will become due. Likewise, when a person makes a treaty election or opts to formally expatriate from the United States, they could be considered to have disposed of their PFIC – 

Taxpayers Try to Should Plan Accordingly

Anytime that a foreign person non-resident alien wants to acquire US Person status (even if it is just through the substantial presence test or a 6013(g) election) it is important that they carefully evaluate all the potential tax implications and tax treatment of their foreign investments — and consider making any necessary elections from the outset. If these issues are caught early enough, Taxpayers may be able to circumvent or sidestep the issue — but oftentimes the Taxpayers are too far down the road by the time they discover the issue (due to no fault of their own)  and therefore are stuck dealing with the PFIC issue.

It is always advised to consult with a Board-Certified Tax Law Specialist to get the lay of the land.

*Sometimes, post-US person status tax and gift planning may be able to minimize or eliminate the tax implications.

Golding & Golding: About Our International Tax Law Firm

Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure and how the Substantial Presence Test works.

Contact our firm today for assistance with getting compliant.