PFIC Pro Training

Retroactive QEF Elections

Reporting ownership in Passive Foreign Investment Companies (PFICs) by Americans

Tax compliance can be a daunting task, especially for individuals with investments in passive foreign investment companies or qualified electing funds

The Trouble with QEF Reporting

BY MARY BETH LOUGEN, EA, USTCP

Mary Beth Lougen examines the issues surrounding the sale of a fiscal year qualified electing fund (QEF) by passive foreign investment companies (PFICs).

Practitioners that work with clients who have international connections often have to run the gauntlet of Code Secs. 1291–1298, the portion of the statute that covers passive foreign investment companies or PFICs. As someone who frequents the PFIC regulations, I am always in awe of this section of the Internal Revenue Code (“the Code”). The men and women who took the directive provided by Congress in the Tax Reform Act of 1986 and put to paper how we are to treat passive foreign investment companies on a U.S. tax return were geniuses. They have woven an intricate and complex web of “if this, then that” rules that speak to many other sections of the Code—if the PFIC is also a CFC, then … , if the shareholder becomes a U.S. person after already owning an investment that became a PFIC the minute they crossed into U.S. personhood, then … , if the investment was owned prior to 1987 when the regulations came into play, then … . But there is one place where the interaction between the PFIC rules and the rest of the regulations is not in sync, this is the case when there is a sale of a fiscal year qualified electing fund (QEF) during the period between the end of the fiscal reporting year and the taxpayer’s calendar year end.

It is widely thought that QEF election is the best solution to a bad problem— but I am going to have to disagree, or at least disagree when the PFIC reports on a fiscal year. But I digress for a moment to go back and review the basics of PFICs—the definition and taxation options for anyone who has not had the pleasure of spending enough time with them to know them by heart.

PFICs are foreign corporations that meet one of the two tests:

• The income test is met if greater than 75 percent of the corporation’s gross income for its tax year is passive income.
• The asset test is met if 50 percent or more of the average gross value of the assets in the foreign corporation produces passive income.

Passive income for this purpose includes income generally considered to be passive, such as interest, dividends, rents, royalties, annuities, foreign currency gain and other types of foreign personal holding company income. ¹ Essentially, a PFIC is a non-U.S. corporation whose assets or income are predominantly passive.

The most common PFICs are mutual funds based outside the United States.

The IRS requires annual reporting from U.S. persons who directly or indirectly receive distributions from, recognize gain on, are making an election for, are required to report information as a result of an election or who directly own an aggregate $25,000 ($50,000 MFJ) in PFIC investments on the last day of their tax year. The $25,000 threshold drops to $5,000 if the PFIC is indirectly owned.

Even though at this point in time Form 8621 does not carry a monetary penalty if the filing is missed, it is still very important to identify PFICs and report them each year the client meets the requirements since not filing for any year it is required will toll the statute of limitations on the entire tax return. ² With reasonable cause you may be able to have the open statute apply only to the income items flowing from Form 8621. ³ In fact, taxpayers who otherwise do not need to file a tax return must still file form 8621 directly with the Ogden Service Center of the IRS. I find this surprising given that the form does not contain a jurat and signature line like most standalone forms.

There are three taxation regimes under which a PFIC may be taxed, with a few sub-elections that provide various ways to purge accumulated unrealized gain inside the investment when a QEF or mark to market (MTM) election is not being made in the first year. Each of the methods is multi-layered calculations performed per PFIC share or block of shares that have been purchased at the same time. Basis and unreversed inclusions (only applicable to MTM elections) must be adjusted and tracked per share or block of shares. And just to make things a little more complicated, consider the minefield presented by various state tax codes and options for income inclusion for the Net Investment Income Tax.

The default method of PFIC taxation is laid out in Code Sec. 1291. Code Sec. 1291 taxation is event based and punitive. Any distribution or disposition of a share of Code Sec. 1291 stock will trigger multiple calculations and the requirement to file Form 8621. A Code Sec. 1291 PFIC with only purchases and no other activity will not create income inclusions nor tax. Code Sec. 1291 also includes a deferred or throwback tax when distributions are made or the shares are sold for a gain. This deferred taxation is meant to mirror when the income would have been included in the taxpayer’s income had the investment been based in the United States by allocating gains over the entire holding period. Once the amount of “gain per day” has been computed, the regime turns ugly and the income for each year is taxed at the highest tax rate imposed for that year—currently this is 39.6 percent as well as adding interest to the tax for each year on the value of the deferral. Interest is calculated from the due date of the tax return for the year of attribution until the due date of the year of disposition (or deemed disposition).

The other two methods—MTM and QEF—both require making an election that will apply to the current and all subsequent years. Once either election is made, the taxpayer will be required to file Form 8621 each year. Both methods require the inclusion of phantom income each year and for adjustments to the cost basis of the shares.

The MTM election values each share at the end of each year and any amount of capital appreciation will be added to Form 1040 line 21 and taxed as ordinary income. Since the regulations say that the calculation of appreciation is done per share keep in mind that gains and losses of shares purchased on different dates may not offset each other. Shares that have dropped in value do not create income, and the unrealized losses are allowed only up to the amount of gain previously included in income (unreversed inclusions) for those shares. Unreversed inclusions like everything else must be tracked by share or block of shares. Any unused unreversed inclusions when the related shares are sold are dropped from the available pool. There is no capital gain treatment for income. Losses on disposition are ordinary losses up to the amount of unreversed inclusions attributable to the shares disposed of, and capital losses for the loss over and above the unreversed inclusions. There is also a special alternate resolution MTM computation that is allowed for taxpayers in the Offshore Voluntary Disclosure Program (OVDP), but that is a different animal and not relevant for our purposes today.

And finally, today’s subject—QEFs. 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. ⁴ Any amounts of this phantom income included in income will increase the
cost basis, and any actual distributions received will reduce the basis. Again remember that the income inclusions and basis adjustments are tracked per share. The best part of QEF is that any gain on a sale of the shares is allowed capital gains treatment. This is very similar to the taxation of domestic mutual funds. Another really great feature of QEF elections is that it appears as though the mutual
fund company has done all the work for us by providing a PFIC Annual Information Statement that gives us the amounts of ordinary income and capital gains to add to our client’s tax return.

Although the PFIC is making the annual reporting of income inclusions easy for us, do not forget to track the basis of each share by adding the amount in income and subtracting any actual distributions or dividends so that when the shares are sold you have correct basis numbers. This leads us into the main problem I see with PFIC taxation under Code Sec. 1293. QEF funds will report ordinary income and capital gains based on its accounting year, and if that year happens to be a fiscal year you only have a correct basis up to the end of that fiscal year. What happens when the taxpayer sells or otherwise disposes of shares between the end of the PFIC’s fiscal tax year and the end of the taxpayer’s calendar tax year? You will not have the information needed to calculate the basis of those
shares after the PFIC year end of the current year until the PFIC Annual Income Statement has been received for the following year. Since there is no provision in the Code to allow a basis adjustment to capital assets sold in the previous year, you will have to amend the year of sale every time. Let us take this step by step through the applicable regulations so you see what I mean.

Passive foreign investment companies are defined in Proposed Reg. §1.1291-1(b)(1):

In general.—A passive foreign investment company (PFIC) is a foreign corporation that satisfies either the income test of section 1296(a)(1) or the asset test of section 1296(a)(2). A corporation will not be treated as a PFIC with respect to a shareholder for those days included in the shareholder’s holding period before the shareholder became a United States person within the meaning of section 7701(a)(30).

(ii) PFIC characterization continued.—A corporation will be treated as a PFIC with respect to a shareholder even if the corporation satisfies neither the income test nor the asset test of section 1296(a), if the corporation (or its predecessor in a reorganization described in section 368(a)(1)(F)) was a section 1291 fund with respect to the shareholder at any time during the shareholder’s holding period of the corporation’s stock.

Once identified as a PFIC, an investment is further categorized as types of PFICs in the next section, Proposed Reg. §1.1291-1(b)(2). For our purpose, I only present the definition of a QEF:

(i) QEF.—A PFIC is a qualified electing fund (QEF) with respect to a shareholder that has elected under section 1295 to be taxed currently on its share of the PFIC’s earnings and profits pursuant to section 1293.

Next an election to tax the PFIC as a QEF is made⁵ by filing form 8621 and ticking the appropriate box in Part II. The election can generally only be made for a PFIC that provides the taxpayer with a PFIC Annual Information Statement or Annual Intermediary Statement⁶ that provides the income amounts and amounts deemed to have been distributed. When the election is made in the first
year of ownership, the PFIC is called a pedigreed QEF. Any investment for which the election was made in a year other than the first year of ownership is called a “non-pedigreed”QEF. Pedigreed status can also be achieved by purging any prior Code Sec. 1291 gain in a nonpedigreed QEF.

Taxation of pedigreed QEF investments is broken into two distinct calculations under two different parts of the Code—the annual taxation (Code Sec. 1293) and the taxation on disposition of the investment as a capital gain (Code Sec. 1(h)). The treatment of gains or losses on disposition of a nonpedigreed QEF reverts back to taxation under the punitive default method outlined in Code Sec. 1291.

Both pedigreed and nonpedigreed QEF funds are taxed the same on an annual basis. The PFIC will send the shareholder an annual statement⁷ that will provide the information necessary to compute the income inclusions and basis adjustments for the year. The taxpayer will include on their tax return the income for the fiscal year of the PFIC that ends during the tax year the taxpayer is filing a return for.⁸ This results in a timing issue that defers the reporting of some of the annual income inclusions until the subsequent year. For example, a PFIC that uses a year end of March 31, 2016, will send the amount of income the taxpayer will include on their 2016 tax return as ordinary income and capital gains based on the earnings of the fund from April 1, 2015, to March 31, 2016. Any income earned by the fund from April 1, 2016, to December 31, 2016, will be included on the 2017 tax return. Keep in mind that providing the information necessary for the taxpayer to make a QEF election requires that the PFIC essentially keep a second set of books to conform to U.S. rules, and although a PFIC may choose any date for its year end, many companies choose a fiscal year end to allow themselves more time to prepare the numbers to report the annual QEF income to their investors.⁹

Taxation on dispositions of QEF shares depends on whether the QEF is pedigreed or nonpedigreed. The clearest explanation I have seen on this subject is in the 1986 Blue Book, “General Explanation of the Tax Reform Act of 1986,” 10 Title XII(D)(6) Coordination of Code Sec. 1291 with taxation of shareholders of QEFs.

Pedigreed QEF:

Gain recognized on the disposition of stock in a PFIC by a U.S. investor is not taxed under section 1291 if the PFIC is a qualified electing fund for each of the fund’s taxable years which begin after December 31, 1986 and which include any portion of the investor’s holding period. This provision allows any unrealized appreciation in the stock of the qualified electing fund to be taxable as capital gain income (if the stock is a capital asset) and without the imposition of an interest charge.

Nonpedigreed QEFs:

Any shareholder who owns stock in a PFIC which previously was not a qualified electing fund for a taxable year but which becomes one for the subsequent taxation year may elect to be taxed on the unrealized appreciation inherent in his or her PFIC stock up through the first day pf the subsequent taxable year, pay all prior deferred tax and interest, and acquire a new basis and holding period in his or her PFIC investment. Thereafter the shares will be taxed under the rules applicable for qualified electing funds. Absent this election, U.S. investors will be taxed under both provisions applicable to qualified electing funds and section 1291, and will, consequently pay deferred tax and interest not only on gain attributable to the years in which the PFIC is not a qualifying electing fund but also on gain attributable to the period during which an investor is taxed currently on his on her share of PFIC earnings.

The information above makes it pretty clear so far what we need to do with a QEF PFIC. The technical guidance disappears as soon as our calendar year taxpayer sells or otherwise disposes of a QEF (pedigreed or nonpedigreed) between the end of the fiscal year and the calendar year. Consider that we will not know the true basis of the shares that were sold until the PFIC sends the next year’s annual statement.

Below is an example based on the purchase and sale of an actual QEF showing the income, distributions and share prices using the PFIC annual information statements and spot currency conversion rates.

On August 5, 2013, a U.S. citizen residing in Canada purchases 10,000 shares of RBC O’Shaughnessy U.S. Value Fund—Class A (RBF552). The cost per share is $12.5578. USD (13.05 CAD) for a total purchase price of $125,578 USD. If the taxpayer is planning on making a QEF election for the mutual fund, in 2013 the taxpayer is required to file Form 8621 under Code Sec. 1298(f ) but only part I
and only because their aggregate PFIC investments are in excess of $25,000 on the last day of their tax year.

In 2014, RBC provides a PFIC Annual Information Statement to the taxpayer, which indicates the following income inclusions and distributions per share of RBF552 owned for the period of July 1, 2013–June 30, 2014, in USD:

• Ordinary Earnings—$0.0010755706 per share per day
• Net Capital Gains—$0.0061606207 per share per day
• Cash/Property Distributions—$0.2751653668 per share annually

The shares were owned for 330 days during the PFIC’s fiscal year, and we would need to include income based on 330 days of ownership. Further we need to adjust basis up by the amounts included in income and adjust basis down by the pro rata amount of the distribution for 330 days.

Resulting in a new basis per share of $14.6969 after adjustments as follows:

• Ordinary earnings: 0.0010755706 per share per day
• Net cap gains: 0.0061606207 per share per day
• Distributions: 0.0007538777 per share per day (0.2751653668/365)
• Adjustment per share per day: 0.0064823136
• Number of days: 330
• Total adjustment per share: $2.1392

The 2014 tax return entries would be:

• 1040 Line 21 = $3549 => 0.0010755706 × 10,000 × 330 days
• Schedule D = $20,330 => 0.0061606207 × 10,000 × 330 days

The basis of the entire 10,000 share investment as of June 30, 2014, would be $146,969 calculated in one of two ways:

• $14.6969 new share basis × 10,000, or
• $125,578 original cost + $3549 ordinary income + $20330 cap gains − $2488 distributions.

Now let us assume the taxpayer sells all 10,000 shares on December 1, 2014, for $14.1490 per share ($16.06 CAD)—total proceeds are $141,489 USD. The last basis you have is $146,969 ($14.6969/sh) as of June 30, 2014, but no idea what the basis of the shares was on the sale date. Under the general rules, sales of capital assets are reportable in the year of sale. With the information you have, the taxpayer has a long-term capital loss of $5,480 ($141,489 − 146.969) and this is what you report on their 2014 Sch D.

The following year when the taxpayer receives their 2015 PFIC Annual Information Statement from RBC they find the following income inclusions and distributions for the period of July 1, 2014–June 30, 2015, in USD:

• Ordinary Earnings—$0.00 per share per day
• Net Capital Gains—$0.0021925004 per share per day
• Cash/Property Distributions—$0.9945971661 per share annually

Even though the investor sold all the shares before the beginning of 2015, they still have to file Form 8621 and include the ordinary earnings and capital gains into their 2015 income for the number of days they owned the shares during the PFIC’s tax year. In this case 154 days.

Resulting in a new basis per share of $14.6149 after adjustments as follows:

• Ordinary earnings: 0.00 per share per day
• Net cap gains: 0. 0021925004 per share per day
• Distributions: 0.002724924 per share per day (0.9945971661/365)
• Adjustment per share per day: −0.000532423
• Number of days: 154
• Total adjustment per share: −$0.8199

The 2015 tax return entries would be:

• 1040 Line 21 = $0=> 0.00 × 10,000 × 154 days
• Sch D= $3,376 => 10,000 × 0.0021925004/365 × 10,000 × 154 days

This amount will be added to the basis of the investment.

At the time of sale December 1, 2014, the actual basis of the 10,000 shares is $146,149 instead of the $146,969 we used on the 2014 Schedule D. The actual capital loss is $4661, an overstatement of basis in the amount of $820 from what was reported on the 2014 schedule D.

Even though the amounts are generally minimal in the grand scheme of things, when the return was prepared the preparer and taxpayer had to sign under the penalty of perjury that the return is true, complete and accurate. We knew the return was not true, complete and accurate at the time it was filed due to a pending adjustment to the basis of a capital asset that was disposed of. Since the basis rules in Code Secs. 1011–1016 do not have a provision for basis adjustments occurring in a year after the year of disposition, has the lack of being able to make the adjustment on the subsequent year’s return created an obligation to amend the return for the year of disposition? I cannot imagine that this was the intent of the drafters of the PFIC regulations. But unfortunately for the taxpayers, the tax practitioners and the IRS, this is what we are required to do when there has been an understatement of income or overstatement of basis. Certainly, neither we nor the IRS need any extra work on
our desks, and the clients do not need the additional costs and headaches that come with opening up an already filed return, but last time I checked we are not allowed to “make it up as we go” just to make the process easier.

About a year ago, I contacted the Office of the IRS Associate Chief Counsel (International) with the hopes that an alternative could be made available so we are not faced with constant amending when clients have QEF elections on their fiscal year PFICs. I specifically asked if we could make a one-off adjustment in the year of income inclusion to either add back any decrease of basis, or subtract any increase of basis due to the current year income inclusions and distributions reported on the PFIC statement. Unfortunately, there was nothing offered other than “That’s not what the regs say,” so we
must continue to cost our clients extra money and the IRS extra work or knowingly disregard the jurat at the bottom of the tax return.

My proposal would be to add a section to Code Sec. 1016 to address QEF shares along the lines of:

In the case of the disposition of shares of a qualified electing fund which reports ordinary income, long term capital gain, and distributions to a United States shareholder on a tax year ending that is not the same as the United States shareholder, an adjustment to income in the year of income inclusion made be elected to be made with respect to any shares disposed of during the period between the end of the qualified electing fund tax year and the US shareholder tax year. This adjustment would be a capital gain or loss in the amount of the net basis adjustment required for the shares disposed of in the immediately preceding tax year.

To illustrate from the example above, the taxpayer would include an additional $820 on their 2015 Schedule D. With this simplified way to correct a small oversight in an otherwise impressive piece of Code, QEF would once again be the best PFIC election in all cases where it is allowed.

The Nightmare of PFICs at the State Level

BY MARY BETH LOUGEN, EA, USTCP

The taxation of Passive Foreign Investment Companies is incredibly complicated because of the various ways these companies can be treated federally. In this article, Mary Beth Lougen of Expat Tax Tools brings up frequently asked questions intended to make tax professionals think about what their clients with state residency or domicile who also own a PFIC are facing.

If the federal treatment of passive foreign investment companies (PFICs) under I.R.C. §1291–§1298 isn’t enough to send you screaming from the room, have you ever considered how the various states view that same investment?

Once you start looking closely at the multiple federal treatments and how many ways a state can view those treatments, you quickly realize that the number of considerations and potential issues awaiting your clients is on a scale that is so large it can overwhelm the most seasoned professional. This article will bring up more questions than it answers and is intended to have you really think about what you are dealing with when you have a client with a U.S. state residency or domicile who also owns a PFIC.

You need to stop and thoughtfully evaluate how the state will treat income that is included in federal AGI but does not meet the definition for constructive receipt, income that is constructively received but not included in federal income, losses that are taxed differently than gains for the same investment, losses that are accounted for in different years than gains, income not included in AGI but instead subject to an additional tax by the IRS and just as many variations of basis adjustments.

As I see it, the main issues are:

• determining when state adjustments are required to accurately reflect state income,
• how to recognize when state and federal basis may be different due to timing of income inclusions, and
• lack of guidance by many state tax codes.

Let’s start with the basic concepts of PFICs and how the federal regulations may create confusion when preparing the state tax return for a client who has a PFIC.

Under federal code, a U.S. person with ownership in a foreign corporation is not taxed until the corporation makes a distribution or is disposed of. The Tax Reform Act of 1986 (TRA86) introduced the concept of passive foreign investment companies and enacted IRC §§1291- 1297¹ in order to prevent U.S. persons from indefinitely deferring taxation of passive income inside of foreign corporations.

A foreign corporation is a PFIC if it meets either the income test or the asset test. The income test² is met if greater than 75 percent of the corporation’s gross income for its tax year is passive income. Passive income includes income you generally consider to be passive, such as interest, dividends, rents, royalties, annuities, foreign currency gain and other types of foreign personal holding company income. ³ The asset test⁴ is met if 50 percent or more of the average gross value of the assets in the foreign corporation produce passive income. Essentially, a non-U.S. corporation whose assets or income are predominantly passive.

The most common PFICs are mutual funds based outside the United States, although the debate is heated over whether foreign mutual funds are truly subject to the PFIC rules since their structure may be a trust in the country of origin, which may not necessarily have been vetted as a corporation under U.S. Code—but that is a different article for a different day. The non-U.S. mutual fund is the type of investment referred to in this article.

The IRS requires annual reporting from U.S. persons who receive distributions from, recognize gain on, are making an election for, are required to report information as a result of an election, or who directly own an aggregate $25,000 ($50,000 MFJ) in PFICs on the last day of their tax year.⁵ The $25,000 threshold drops to $5,000 if the PFIC is indirectly owned. Keep in mind that each of these triggers for mandatory filing of Form 8621 is in regard to not only shares owned directly by the individual, but also indirectly. Indirect ownership rules will kick in when a person owns a PFIC that owns a PFIC, when they own 50 percent or more of a domestic or foreign corporation that owns a PFIC, or they have an interest in foreign or domestic pass through entities that own PFICs. One must also consider that this will have some individuals reporting income owned by another taxable entity.

Below are some frequently asked questions about the taxation of PFICs.

If the income does not directly belong to the taxpayer and has not been distributed yet, is it really taxable at the state level, especially in a year where it has not been received, actually or constructively?

There is no clear answer for this question for most U.S. states. The states have a wide variance in how they recognize—or not—passive foreign investment income that falls under federal regulations 1.1291-1.1298.

There are several ways to treat passive foreign investment companies for federal tax purposes, ranging from extremely punitive to almost mirroring the taxation of domestic mutual funds. Let’s briefly and broadly look at potential state issues that you will need to resolve before preparing a state return for a client with a PFIC investment. There are real issues to be considered as far as how two independent yet interrelated tax codes will work together when one strays from the tax logic we have all become accustomed to. These include the timing of when gain or loss is recognized, the character of the income inclusions or deductions, capital loss carry forwards and differences in adjusted cost base as a result.

When should you adjust state income to include realized gains that are not included in federal taxable income or remove unrealized income that is included?

The first vexing section of Internal Revenue Code we will delve into is §1291, also known as “unqualified funds” or “1291 stock.” These are PFIC shares for which no federal election has been made to elect a gentler tax treatment under mark-to-market (MTM) or as a qualified electing fund (QEF). It is the “default” tax treatment of PFICs. The §1291 treatment and filing of Form 8621 is mandatory to report dividends paid, distributions received or any shares that have been sold or otherwise deemed disposed of. Distributions and gain on §1291 shares are taxed as either ordinary income or as an excess distribution. No capital gains treatment is allowed for §1291 income. A taxpayer who is otherwise not required to file Form 8621 and wishes to make the MTM election will also be required to calculate 1291 tax for any unrecognized gain in the investment. The 1291 treatment is optional at the time the QEF election is made, but must be computed by the time the shares are sold. If the 1291 tax is computed in order to “purge” the prior unrecognized gain from the PFIC, and the taxpayer still owns the shares, the purge will result in income being included on the federal return that is unrealized.

Will the state want to tax investment income that is not constructively received?

California will not. California states very clearly that “California does not recognize IRC §1291-§1298. A foreign corporation is treated as a regular corporation. Income will not be recognized, nor taxes imposed, until a distribution is received or a disposition has occurred.”⁶ But Wisconsin will—“Excess distributions from PFIC investments not included in federal income are an addition to income on Form 1 line 4 Code 05.”⁷ Others are just silent.

Taxation of excess distributions is meant to be harsh and is calculated using some of the most difficult tax regulations currently on the books. Excess distributions on dividends or distributions occur when the amounts received in a tax year exceed 125 percent of the average distribution received in the previous three years, or when a sale or deemed disposition of shares results in a gain and the shares were acquired prior to January 1 of the current tax year. Amounts that are considered excess distributions are allocated to years before the current tax year and taxed at the highest tax rate for the year of allocation.

For actual or deemed sales of shares, each date of purchase is considered a “block” of shares and all calculations are done “per block.” You cannot net gain and loss from different blocks of shares; each block stands alone throughout the period it is owned. A taxpayer can end up with a large number of blocks if the PFIC happens to be a non-U.S. mutual fund that issues dividends monthly or quarterly, and the taxpayer reinvests them to purchase more shares. For each block of shares, you must convert the purchase to USD on the date of purchase and the sale proceeds to USD on the date of disposition or deemed disposition, calculate the amount of gain for each block, divide the gain by the number of days the block was owned and allocate the gain to each year of ownership based on the number of days in each year the block was owned. Gain allocated to the current year is entered on Form 1040 as ordinary income, and gain during the earlier years is not income on the return. Instead, a separate tax is computed using the highest tax rate in place during each respective tax year and is added as an additional tax to the regular income tax liability on Form 1040 line 44 (and finally you compute interest from the due date of the earlier tax years and drop that on Form 1040 line 62). Any blocks that are sold at a loss will result in capital losses, which cannot be netted against gains to reduce the amount subject to the §1291 tax and interest calculations. Blocks that are losses in a deemed disposition situation are simply ignored. This is very similar in concept to accumulated trust distributions, but much nastier math.

Let’s assume a taxpayer has a Canadian mutual fund which was first purchased on July 1, 2010, (Block 1) with a second purchase of shares in February 2011 (Block 2). The taxpayer never made any elections as to the tax treatment of the investment for U.S. federal purposes. The taxpayer sold both blocks on December 31, 2014. Block 1 was owned a total of four-and-a-half years and the taxpayer had a gain of $4,500 USD on the disposition. Block 2 was sold the same day but for a $3,200 loss. $1,000 will be included on 2014 Form 1040 on line 21 as ordinary income, and the $3,500 balance of the gain will not be included in taxable income—instead the §1291 tax is calculated and an additional $1,271⁸ of tax will be added to regular tax on line 44. The $3,200 loss cannot be used to offset the $4,500 of §1291 income; instead it will be on Schedule D subject to the regular rules for capital losses and the $3,000/$1500 limit.

What is the state’s take on the difference in the character of income for federal purposes?

In the example, the gains are reported as both ordinary income and not income—but rather subject to the throwback tax, which means the IRS is “accepting” that the income has been “included in income” and taxed and the losses are capital losses.

Will the state allow you to treat the gain as capital gain and allow an offset by the capital losses?

If it is allowed as a capital gain, the taxpayer could reap additional benefits, such as taking advantage of the Retirement Income Exemption in Georgia, which allows exemption from tax on up to $65,000 of capital gains income for taxpayers over the age of 65.⁹ In New Jersey, capital losses cannot be carried forward or backward. They have a use it or lose it policy,¹⁰ so being able to re-characterize the income as capital can save the taxpayer New Jersey taxes.

A different outcome occurs when the computation of 1291 tax is voluntary, such as when the taxpayer makes a deemed sale or deemed dividend election in conjunction with electing QEF status, and the shares have not actually been sold. Only the gain will be recognized on the 1040, just as in the first part of the example—$1,000 as other income, $1,271 as an addition to tax. Since the taxpayer still owns the investment, the basis of those blocks will increase by the amount of income included in the §1291 computation (FMV Dec. 31 in most cases). The losses will be ignored completely and the basis of those shares will remain unchanged.

Will the state recognize income not yet received?

As mentioned before, California will not recognize income on passive foreign investment companies until it is actually received, and you will have to maintain separate accounting for the federal and state cost basis for each block. North Carolina, on the other hand, will recognize it: “the following additions to taxable income shall be made in calculating North Carolina taxable income, to the extent each item is not included in taxable income: (2) Any amount allowed as a deduction from gross income under the Code that is taxed under the Code by a separate tax other than the tax imposed in section 1 of the Code.”¹¹

Many of the other states are silent about PFICs in the specific sense, and you may need to look closely at the state tax codes for other statutes that would encompass or exclude PFICs on a broader level. Even looking at how a state deals with accumulated trust distributions may give you some insight.

Also, consider the possible mismatch of capital loss carryovers between the federal and state returns. If the state treats the income as a simple sale of shares, the gains and losses will be allowed to net each other out. Going back to our earlier example of an actual sale, the end result could be federal long-term cap loss carryover of $1,700 ($3,200 cap loss, $1,500 annual limit) and no state level carry forward.

Does your head hurt yet? Because this only gets worse?

The second treatment allowed for PFICs on the federal return is the Mark to Market (MTM) election (§1296). This is very simple-sounding on the surface, but not so much when you really delve into the details. If the FMV of any block of shares at the end of the year is larger than its adjusted cost base, the difference is reported as ordinary income on Form 1040. Basically your client is paying tax each year on the unrealized gain in the investment. If the FMV has dropped over the year, the unrealized loss may or may not be allowed, depending on how much income has been included in federal income prior to the current tax year under the MTM election.

Basis and unreversed inclusions (a fancy way to say prior unrealized gains included on the tax return) must be tracked per block of shares. This level of tracking is daunting and prone to error. If the election is not made in the first year of ownership any prior unrecognized gain must be “purged’’ under the §1291 rules and the new basis for all shares that were deemed to have a gain will step up to the FMV on Dec. 31. Shares that are under water will have the losses disregarded for purposes of §1291 and the basis will remain unchanged.

When shares are sold under the MTM regime, if the FMV of a block of shares on the date of disposition is larger than the cost basis, the gain will be ordinary income, and all unreversed inclusions associated with that block are dropped (they cannot be transferred to a different block of shares for future use). If the FMV is less than the cost basis, the loss to the extent of unreversed inclusions are ordinary losses and capital losses to the extent they exceed unreversed inclusions.

Have you figured out what the potential issues are with this federal election?

First of all, if §1291 tax is computed before the shares are sold, this is not yet “real” income under most tax precepts. When the taxpayer has not received any cash or property from the investment, they are paying tax on income that, under the regular rules of constructive receipt,¹² and income inclusion for sale of investment shares¹³ would not be reportable on a tax return yet, if not for the fact it is a passive foreign investment company. Some states will not tax income until it is actually received in a taxable event. As I mentioned before, California is one such state. I am referring to California often because they make it very clear what we as tax practitioners are to do with this income, and I respect any clear guidance that just simply says “put it here.” California has dedicated an entire chapter in their Water’s Edge Manual to the subject of PFIC taxation.¹⁴ It provides a well-written explanation of the basics of PFICs and what adjustments California requires. In addition, FAQ #3 for their OVDI program¹⁵ directly addresses the use of MTM on personal returns by stating, “you may not use the mark to market approach simply due to the fact that you hold stock in a PFIC. California does not conform to the PFIC rules contained within IRC Sections 1291-1298; therefore, the corporation in which you hold stock will be treated as a regular corporation for California purposes. As such, you must meet the requirements of IRC Section 475 in order to elect the mark to market approach. If you do not meet the requirements to elect the mark to market approach, you must recognize the capital gain or loss on any stock that you hold in a PFIC at the time of the stock’s disposition…” So now you have different timing for income inclusions, different basis and the different types of income for California and the IRS. Ohio, on the other hand, works with the same timing for income inclusion as the IRS, and the basis will remain the same for both. I could not find this fact in writing, but I called the Ohio Department of Revenue and had my call escalated to someone who could answer my questions. He said it is not written, but Ohio will include income when included by the IRS and allow losses when allowed by the IRS. The Instructions to Ohio IT-1040 state that “In all cases, line 1 of your Ohio income tax return must match your federal adjusted gross income as defined in the Internal Revenue Code.” As a side note, §1291 income not included in federal AGI would be added back to Ohio income on line 37f with a statement of explanation.

Finally, we move to the final and gentlest of the federal treatments, called the qualified electing fund or QEF election. It may be gentler, but it isn’t simpler. The IRS will allow the taxpayer to calculate tax on gains from sales as capital gain if they elect to include their share of the fund’s ordinary income and capital gains in U.S. federal income each year. The mutual fund company must provide a “PFIC Annual Information Statement” each year to the taxpayer that provides these amounts. Dividends are not included in income on Schedule B; the ordinary income amount goes on Form 1040 line 21, and the capital gains amount on Schedule D as long-term gains. Basis is increased by earnings included in income and decreased by distributions received (this is where the dividends come in). And once again all transactions in the investment must be calculated per block of shares. The QEF election, like MTM, is including unrealized income on Form 1040 and not including in income monies that the taxpayer may have received.

What is the state’s position on not including actual dividends received in lieu of prorate share of ordinary income as calculated by the fund? Could failure to include the dividends be considered understating income?

Another fly in the ointment is that unless the QEF election is made in the first year, the person owns the investment. The prior unrecognized capital appreciation in the account will need to be addressed at some point. The taxpayer has the choice of whether to purge the 1291 gain in any year or wait until the fund is sold. When the purge happens, you are back to dealing with the income inclusion, timing and basis issues outlined in the 1291 section of this article.

Unfortunately, it is easier than you might think to end up owning PFIC shares. Many of the popular exchange-traded funds known as ishares are PFICs. Mutual funds based outside the U.S. are widely accepted as PFICs (even if they own all U.S. investments), and even money market funds outside the U.S. can be PFICs.

In the world of state taxation of PFICs, ambiguity is the only thing you can be sure of.

Alleviating State Double Foreign Taxation

As the fiscal lives of an increasing number of U.S. residents cross international borders, tax planning for these individuals is full of complications. In this article, Mary Beth Lougen, EA, discusses tax strategies and tips to alleviate double taxation on foreign income at the state level, using tax relief provisions offered by the states to offset taxation by a foreign jurisdiction.

For those of U.S. who work in the arena of international taxation our idea of a great client is one who lives in Texas, Washington or any of the sevens states that do not impose income tax on their residents. On a good day figuring out how to prepare the federal tax returns for people whose fiscal lives cross international borders can be vexing and time consuming. But throw an extra taxing jurisdiction into the mix and there are now another set of regulations to consider. What may have been the best outcome when considering only the implications at the federal level may no longer be the case.