The QEF or Qualified Electing Fund election under §1295 is optional method of taxation available for certain PFICs. This election most closely mirrors the US taxation of US mutual funds and allows for capital gains treatment of some of the income as long as any prior §1291 gain has been dealt with. Choosing not to purge the §1291 gain when making the QEF election is possible, but doesn’t necessarily accomplish much since you are required to treat any disposition as if it were sold under the punitive default taxation method. Once the election has been made Form 8621 is required to be filed each year and the election will remain in place for all subsequent years.
Not all PFICs are eligible for Qualified Electing Fund status. In order for a mutual fund or other PFIC investment to allow for Qualified Electing Fund treatment by the shareholders it must jump through some hoops for the IRS. The PFIC must maintain books under IRS acceptable accounting procedures and compute gain, loss and income each year using those same principles. The PFIC is also required to provide a “PFIC Annual Information Statement” to its investor’s each year providing not only the amount of income to include on Form 8621 but other specific required attestations. If no annual statement is provided to the taxpayer- no QEF election can be made.
Essentially a Qualified Electing Fund looks like a partnership where the income retains its character and is reported by the shareholder each year whether they receive it or not and gains and losses on sales are treated as capital gains and losses- with some distinct differences. Losses will not flow through to the investor during the period of ownership, they are simply disregarded or put on hold. Cost basis is tracked per share and which must be adjusted up and down each year in accordance with income allocated to the taxpayer on the annual statement and actual distributions received.
There are two types of Qualified Electing Fund PFICs- pedigreed and unpedigreed. The distinction between them being whether there are any years before the election was made that is still subject to §1291 taxation. Until a QEF or mark to market election is made, all PFICs will default to taxation under §1291. When a QEF election is made the taxpayer has the option to “purge” any prior gain in the PFIC by doing a deemed disposition under §1291 rules and paying any §1291 tax and interest; or just making the QEF election and dealing with the §1291 rules when the investment is actually sold. The latter is not generally a tax efficient solution- but there are situations where it could work well.
The QEF election involves including the ordinary income and capital gains in the shareholder’s income each year –even if the money was not actually received. Making the election will allow gains on disposition of pedigreed QEFs to be taxed as capital gains when they are sold. There is a glitch in the current regulations that would require a current 8621 and an amended 8621 to be filed for any year in which a PFIC reports its annual statement using a fiscal year and a calendar year shareholder sells shares between the end of the PFIC fiscal year and December 31.
Check out our article on the mismatch of gain recognition and basis adjustment by clicking on the link below.
The trouble with QEF reporting