IRS releases proposed regulations regarding PFICs

On January 24, 2022, the Internal Revenue Service released proposed regulations that impact certain choices available to U.S. taxpayers regarding their indirect interests in passive foreign investment companies (PFICs).

Under the proposed rules, to the extent that an interest in a PFIC is owned by a domestic partnership, the U.S. partners will be considered shareholders of the PFIC rather than the domestic partnership. Thus, any choice of Qualified Election Fund (QEF) or Mark-to-Market (MTM) for PFIC will be made at the US partner level. This is a departure from the existing rules, which treat the domestic partnership as the US shareholder for purposes of making such PFIC elections. The proposed regulations apply equally to US shareholders of S corporations (S corporations) that own an interest in a PFIC.

PFIC elections made by a domestic partnership or S corp under the existing rules with respect to PFIC taxation years that end on or before the date the proposed regulations become final will be respected and will apply. to all relevant US and S corp partners. shareholders from that date.

What is a PFIC?

A non-U.S. corporation will generally be treated as a PFIC if the majority of its assets are passive assets (e.g., stocks, cash, certain intellectual property) or if a significant portion of its revenue is generated from sources liabilities (e.g. dividends, interest, capital gains, royalties).

US shareholders of PFIC are subject to a punitive US tax regime that applies regardless of percentage ownership. In particular, U.S. shareholders will generally be subject to ordinary tax rates (i.e. no reduced tax rate on capital gains) and substantial interest expense on PFIC distributions. or a disposition of the shares of the PFIC. In certain circumstances, US shareholders may have to pay total tax in excess of their gross return from the investment in the PFIC.

SPEP elections

Relief from these punitive PFIC rules may be available if the US shareholder makes a timely QEF or MTM election with respect to the PFIC investment. In the case of a QEF election, the US shareholder would be taxed on undistributed PFIC income as earned on a current basis. The QEF election must be made in the tax year in which the investment in the PFIC is first acquired by the US shareholder or the non-US corporation first becomes a PFIC.

In the case of an MTM election, the US shareholder would recognize any unrealized gain on the PFIC stock each year as ordinary income (i.e. effectively marking the investment to market each year) . Only PFICs that are marketable securities are eligible for the MTM election.

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