Let's talk about the QEF Election for PFICs

While many portions of the U.S. tax code possess confusing and sometimes harsh rulings, the tax regime for Passive Foreign Investment Companies (PFIC) is almost unmatched in its complexity and almost draconian features.  For a primer on PFICs, please read here - http://www.derrenjoseph.com/2015/08/what-is-pfic.html

The PFIC rules were enacted to eliminate beneficial tax treatment for certain offshore investments. Under prior law, U.S. taxpayers could accumulate tax-deferred income from offshore investments and, upon sale of the investment, recognize gain at the long-term capital gains tax rate.

Under the PFIC rules, absent a beneficial election, PFIC investments are generally subject to tax on distributions at the highest ordinary income rates in effect for the tax year, rather than the currently more beneficial dividend and capital gains rates. Sec. 6621 interest charges accrue on deferred taxes until the due date of the return (without regard for extensions) for the last PFIC year; losses are disallowed.  Typically, these PFICs are passive investments in offshore mutual funds, hedge funds, stocks, annuities, or income-producing property.

There are three (3) ways of dealing with it.  The default is under Section 1291 (known as the excess distribution method), then there is Section 1296 (known as the mark to market method).  The third and often overlooked method is the Section 1293 (or Qualifying Electing Fund) method.

Taxation under Code Sec.1293 does not include annual distributions from the investment in income but instead includes an amount of ordinary income and capital gains that the fund would have distributed had it distributed all its earnings at the end of each year into taxable income. Any amounts of this phantom income included in income will increase the cost basis, and any actual distributions received will reduce the basis. Income inclusions and basis adjustments are tracked per share. This is therefore the preferred method of PFIC accounting for many US taxpayers as it is very similar to the taxation of domestic mutual funds.

If the QEF election is made, the U.S. shareholder includes his allocable share of the PFIC’s ordinary income and capital gains in income currently.  There is a separate election which can be made to defer payment of tax on undistributed income of a QEF.  The character of the PFIC’s income as ordinary income or capital gain passes through to a shareholder who makes the QEF election. 

The election is made by the first U.S. shareholder in the chain of ownership.  In the case of a foreign nongrantor trust, the U.S. beneficiary of the trust makes the election.  The election is made on a shareholder by shareholder basis.  So a PFIC, therefore, may be a QEF with respect to some U.S. shareholders but not with respect to others. 

If the QEF election is made effective as of the first day of the first year of the U.S. shareholder’s holding period, then the PFIC is a “pedigreed QEF”.  If a QEF election is made effective after the first day of the first year of the U.S. shareholder’s holding period, the QEF is an “unpedigreed QEF”.  An “unpedigreed QEF” is subject to the PFIC default rules (i.e., tax on “excess distributions”) on a sale or liquidation of the stock.  This result stems from the “once a PFIC, always a PFIC” rule and is called the “PFIC taint”.

Late QEF elections are permitted only in very narrow circumstances.  In general, a U.S. shareholder seeking to make a late QEF election must demonstrate that he possessed a reasonable belief as of the original due date of the late election that the foreign corporation was not a PFIC.  If it is not possible to make a late QEF election, the U.S. shareholder should consider making a purging election (to remove the PFIC “taint”) and combining that election with a QEF election going forward.   The QEF election must be made by the extended due date of the taxpayer’s federal income tax return.  To make the initial QEF election for an asset, the taxpayer must file Form 8621 with his or her tax return and check the “Election to Treat the PFIC as a QEF” box. If this tax year is not the year in which the investment was first purchased, the taxpayer must also check the “Deemed Sale Election” box on Form 8621. The QEF election is revocable only with the IRS’s consent.  In every subsequent year, the taxpayer must file a separate copy of Form 8621 for each QEF asset.

To facilitate calculations and reporting under the QEF rules, PFICs are required each year to provide each investor with a “PFIC Annual Information Statement.” The statement must contain essential information for the Form 8621 filing, such as the investor’s pro rata share of the PFIC’s ordinary earnings and any net capital gain for the tax year—or provide the information on which to base those calculations. Taxpayers who do not have access to this information cannot elect the QEF tax regime.

Here are some samples of statements –

Why don’t more funds do this?  Most PFICs are unable to be classified as a QEF since the IRS demands that a QEF comply with IRS reporting requirements (a large request for a non-US based company).  Consequently, the QEF election is not frequently available.

Come talk to us if you want this done for your fund.


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