A passive foreign investment company (PFIC) is a foreign corporation that meets either of two tests: an Asset test or an Income test. A U.S. person who is a direct or indirect shareholder of a corporation that satisfies either test in a prior year is treated as holding stock in a PFIC and who does not make a timely qualified electing fund (“QEF”) election continues to be subject to taxation under section 1291’s default “excess distribution” tax regime unless the shareholder makes an election to purge the PFIC taint (for example, through a deemed sale).
A taxpayer may avoid section 1291 taxation by making a QEF election for the first year that the taxpayer holds stock in the foreign corporation. But a taxpayer who fails to make a timely QEF election will continue to be subject to the excess distribution regime, unless they make a purging election to cleanse the PFIC status.
We explore below several elections to purge the PFIC taint.
Once a PFIC, Always a PFIC?
Kind of. Section 1298(b)(1)’s ‘‘once a PFIC, always a PFIC’’ rule provides that if a foreign corporation is a PFIC for one year of a US stockholder’s holding period, the US stockholder generally continues to be subject to the section 1291 PFIC rules in later years, even if the foreign corporation no longer satisfies the PFIC test.
The once-a-PFIC-always-a-PFIC taint may, however, be avoided through a timely QEF election or purged through a cleansing election.
Qualified Electing Fund (“QEF”) Elections
Where the conditions are satisfied, a U.S. shareholder may make a §1295 qualified electing fund (QEF) election for the first year of its holding period that the foreign corporation is or would be a PFIC.
Unlike section 1291’s excess distribution regime, a shareholder of a QEF must annually include in gross income as ordinary income its pro-rata share of the ordinary earnings of the QEF and as long-term capital gain its pro-rata share of the net capital gain of the QEF.
If the QEF election is not made with respect to the first year of the shareholder’s holding period in the PFIC, the shareholder may be able to make a deemed sale election or deemed dividend election (if eligible). If the shareholder properly makes a deemed sale election or deemed dividend election in connection with its QEF election, then the PFIC will become a pedigreed QEF (as defined in Regulations section 1.1291-9(j)(2)(ii)) with respect to the shareholder.
Purging Elections Under Section 1291(d)(2)
A PFIC shareholder who owns, or is treated as owning, shares in an unpedigreed QEF may be entitled to make an election to “purge” the PFIC taint—thereby avoiding the excess distribution rules in the future with respect to that PFIC.
A PFIC shareholder may elect to recognize the gain on a deemed disposition of its PFIC stock with the gain being subject to the excess distribution rules.
Alternatively, if the unpedigreed QEF is also a CFC (that is, it is a CFC/PFIC), the PFIC shareholder may elect to include its share of the CFC/PFIC’s post-1986 accumulated earnings and profits (“E&P”) as a dividend subject to the excess distribution rules (together with the election described above, the “section 1291 purging elections”).
If the PFIC shareholder makes a section 1291 purging election, the QEF is treated as a pedigreed QEF with respect to the shareholder.
Purging Elections Under Section 1298(b)(1)
A PFIC shareholder may make certain purging elections with respect to a foreign corporation that qualifies as a “former PFIC” or a “section 1297(e) PFIC.” These purging elections result in the foreign corporation no longer being treated as a PFIC as to the shareholder.
A “former PFIC” is a foreign corporation that satisfies neither the income test nor the asset test under section 1297(a), but its stock is treated as stock of a PFIC as a result of section 1298(b)(1) (that is, the corporation was a PFIC that was not a QEF at some time during the PFIC shareholder’s holding period).
A foreign corporation is a “section 1297(e) PFIC” if it (i) qualifies as a PFIC under section 1297(a) on the first day on which the “qualified portion” of the PFIC shareholder’s holding period in the foreign corporation begins; and (ii) the stock of the foreign corporation held by the PFIC shareholder is treated as stock of a PFIC pursuant to section 1298(b)(1) because at any time during the PFIC shareholder’s holding period of the stock, other than the qualified portion, the corporation was a PFIC that was not a QEF.
A PFIC shareholder can make either a deemed sale election or deemed dividend purging election with respect to either a former PFIC or section 1297(e) PFIC.