Removing PFIC Taint with a Purging Election
When it comes to international tax law, one of the most ominous phrases created by the Internal Revenue Service is the idea that once a PFIC, always a PFIC. Nevertheless, taxpayers do have an opportunity to cleanse the PFIC taint – although it will oftentimes result in an incredibly unfair tax implication. By cleansing the PFIC taint with a purging election, the US Taxpayer can move forward and continue holding onto the foreign investment — without having the disastrous excess distribution scenario hit them later down the line when there is more (usually) to lose. By way of brief background, A PFIC is a Passive Foreign Investment Company, and the US tax regime entitles the IRS to tax the owners of PFIC with excess distributions at the highest tax rate for each day of each year the investment was held in prior years, along with interest. For investments that are held for several years, the tax implications can reach upwards of 50 to 60% — if not more. Unless certain elections are made in the first year (unless very limited exceptions or exclusion apply), the Taxpayer may be doomed to have to make a late election to cleanse the PFIC taint. Since this is a very complicated topic, let’s just focus on some of the basics.
No Election and Excess Distributions
If the Taxpayer does not make an election, then at the time the taxpayer receives distributions that are considered to be excess distributions — the Taxpayer is required to pay tax at a much higher tax rate than other similarly situated, non-PFIC investments. There is an equation that is performed to determine what portion of the current distribution is the excess distribution; which portion is not an excess distribution — and then allocating the current year distribution portion at the Taxpayer’s current-year progressive tax rate. These tax rates are usually a far cry from the 15 or 20% Long-Term Capital Gain (LTCG) or Qualified Dividend (QD) tax rate reserved for similar passive investments. Therefore, to limit the excess distributions in the future — the taxpayer may want to make a purging election now.
Two Main Types of Elections (QEF and MTM)
Depending on the type of investment to Taxpayer has; the country of source — and whether the Foreign Financial Institution is amenable to cooperating with the taxpayer and possibly providing certain information about the investment, there are two main types of PFIC elections. The two main types of elections are QEF (Qualified Electing Fund) and MTM (Mark-to-Market). In general, the QEF election is better because most income will be taxed according to its regular category of income. The Mark-to-Market election can also be good –– and usually better than excess distributions –– but there are some limitations in terms of losses, which cannot be carried over to subsequent years.
How to Purge the PFIC Taint
The concept of purging the PFIC taint is the idea that a Taxpayer was not aware that their foreign mutual fund or other PFIC previously. Remember, a PFIC is a term of art –– in other words, if a foreign person owns a foreign mutual fund they do not own a PFIC — because they are not a US person. Once a person becomes a US Citizen, Lawful Permanent Resident, Resident of the United States for US tax purposes (Substantial Presence Test), then their foreign mutual fund for example would become a PFIC — without the taxpayer doing anything other than gaining US person status for tax purposes.
Late Election and Purging the Taint
Some Taxpayers may have the opportunity to go back and make the election after the fact, but there are very strict requirements — and most Taxpayers unfortunately will simply not qualify for this type of submission. Instead, they will make an election at a later time –in addition to cleansing the PFIC –which essentially means preparing the phantom sale calculation at the time of the election. Therefore, the Taxpayer will both rid themselves of the prior taint and then operate under the QEF or MTM election regime going forward. This phantom type of income is referred to as a deemed sale and is required in order to make the late election (presuming that they cannot make a retroactive election).
Depending on whether the foreign investment is a PFIC or a PFIC/CFC crossover will impact certain cleansing opportunities.
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